Financial Management

FINANCIAL
MANAGEMENT
PROF. SATISH INAMDAR

M.Com., L.L.B., F.C.A., Gr.C.W.A., A.C.S.
(FOR PRIVATE CIRCULATION ONLY)
Published by
Symbiosis Center for Distance Learning,

Pune.
Symbiosis Center for Distance Learning (SCDL)

No part of this book may be reproduced or copied or transmitted
in any form without prior permission of the publishers.
2005 Batch
PREFACE
Finance is the most basic and the most significant function in virtually every business activity.
The success of business activity depends upon the success of its finance function. From
academic point of view, finance is the subject which is considered to be one of the most
technical ones, having a very wide scope and having constantly changing rules & regulations.
This is the reason why a normal student attempts to keep himself away from the subject of
finance. This aggravates the problems for the students. One cannot afford to ignore the function
of finance. The ultimate evaluation of any business activity is profit-based evaluation and the
term profit itself is the financial phenomenon. As such, one needs to get acquainted with the
basics of finance, despite the hardships involved in the process.
My objective of writing this book is to introduce the basic principles of finance to a nontechnical student in the simplest possible language. As such, I have deliberately avoided too
much of quantitative or mathematical elaboration or explanation to any of the basic concepts
or principles. I have attempted to explain the basic concepts with the help of examples and
illustrations. Good numbers of problems have been incorporated for self-study.
I am thankful to Symbiosis Center for Distance Learning and Ms. Swati Chaudhary, Director,
SCDL, in particular for providing me this opportunity to reach out to a very wide spectrum of
readership.
Maximum efforts have been made to incorporate the latest status of the subject. Maximum
care has been taken to make the text free of errors. Still, I dont rule out the possibility of some
omissions. I will be obliged if such omissions can be pointed out and intimated so that necessary
modifications can be done in the subsequent editions.
Prof. Satish Inamdar

5, Brahma Residency, Bhusari Colony,
Kothrud, Pune 411 038
Tel.: (020) 528 2058 / 528 5749
Email : sminamdar@yahoo.com
ABOUT THE AUTHOR

Prof. Satish Inamdar is holding a Masters Degree in Commerce and Bachelors Degree in
Law. He is fellow Member of the Institute of Chartered Accountants of India, Graduate Member
of The Institute of Cost & Works Accountants of India and Associate Member of The Institute
of Company Secretaries of India. He is associated with the industry for the last two decades
in various senior capacities. For the past fifteen years, he is associated with Symbiosis
Institute of Business Management as a Faculty of Finance. He has conducted Management
Development Programmes and Executive Development Programmes for various private sector
and public sector organisations. He has authored three books on the subjects like Cost &
Management Accounting and Financial Management. He is the Charter Member of Rotary
Club of Pune, Kothrud.
Mrs. Swati Chaudhari

Director SCDL
CONTENTS
Chapter
No.
TITLE
Page
No.
Finance Function
Approaches to the term Finance
Scope of Finance Function
Goals/Objects of Finance Function
Organisation of Finance Function
The Fields of Finance
Finance Function in Relation with Other Functions
Forms of Business Organisation

Proprietory Firms, Partnership Firms,
Joint Stock Companies
Advantages and Disadvantages
15
Financial Statements
Nature of Financial Statements
Basic Concepts in Accounting
Structure of Financial Statements
Role played by Financial Statements
Limitation of Financial Statements
Analysis and Interpretation of Financial Statements
25
Interpretation of Financial Statements (Ratio Analysis)

Role of Ratio Analysis
Classification of Ratios
Illustrative problems with solutions
Problems for students to solve
45
Interpretation of Financial Statements

(Funds Flow / Cash Flow Statements)
Concept of Funds, Uses, Limitations
Construction of Funds Flow Statement
Cash Flow Statement
145
Chapter
No.
TITLE
Page
No.
Illustrative Problems with Solutions

Problems for Students to Solve
Capitalisation
Importance
Theories of Capitalisation
Overcapitalisation - Causes, Effects, Remedies
Undercapitalisation - Causes, Effects, Remedies
211
Sources of Long Term and Medium Term Finance

Shares - Advantages, Disadvantages
Debentures - Advantages, Disadvantages
Term Loans, Features of Term Loans
Public Deposits
Lease Financing, Advantages, Types of Leases
Retained Earnings
225
Capital Structure
Part - I - Capital Structure
Goals/Principles of Capital Structure Management
Factors affecting Capital Structure - Internal, External
and General
Part - II - Cost of Capital
Concepts of Cost of Capital
Composite Cost of Capital
Illustration with Solutions
Part - III - Leverages
Operating Costs - Variable, Fixed, Semi-Variable
Leverages - Operating, Financial, Combined
Part - IV - Theories of Capital Structure
Capital Structure and Cost of Capital
249
Chapter
No.
TITLE
Page
No.
Capital Market
Capital Market in General
Intermediaries in Capital Market
Credit Rating, Methodology, Limitations
Venture Capital
297
10
Capital Budgeting
Importance of Capital Budgeting,
Process of Capital Budgeting - Evaluations, Selection,
Execution
Cash Flows, Time Value of Money
Illustration with Solutions
Relevance in Capital Budgeting Decisions
Techniques of Evaluation of Capital Expenditure
Proposals - Advantages, Disadvantages
Limitations of Capital Budgeting
Planning, Organisation and Control of Capital
Expenditure
Capital Rationing
Capital Budgeting and Risk
Illustrations with Solutions
Pay Back Period, NPV, ARR, IRR
319
11
Working Capital Management

Working Capital - The Term
Principles of Working Capital Management
Factors affecting Working Capital Requirement
Financing of Working Capital Requirement
Control over Working Capital - Dahejia Committee,
Tandon Committee, Chhore Committee,
Marathe Committee, Nayak Committee and
Vaz Committee
373
Chapter
No.
TITLE
Page
No.

12
Management of Cash
Motives of Holding Cash
Estimation of Cash Requirement
Principles of Cash Management
415
13
Management of Receivables
Object
Areas Covered - Credit Analysis, Credit Terms,
Financing Receivables, Credit Collection, Monitoring of
Receivables
Techniques available on Macro and Micro basis
Factoring, Bill Discounting, Advantages, Disadvantages
437
14
Management of Inventory
Catagories of Inventory
Motives of Holding Inventory
Objects of Inventory Management
Techniques of Inventory Management
Inventory Levels, Calculation of Levels
Illustrations with Solutions
ABC Analysis
463
Chapter
No.
15
TITLE
Page
No.
Dividend Policy
Factors determining the Dividend Policy
External and Internal
Choosing of Dividend Policy
Forms of Dividend Payment
Bonus Shares - Advantages, Disadvantages
495
Reference Books
509
Chapter 1
FINANCE FUNCTION
A business is an activity which is carried on with the intention of earning the profits. If the
operations of a typical manufacturing organisation are considered, it involves the purchasing
of raw material, processing the same with the help of various factors of production like labour
and machinery, manufacturing the final product and selling the finished product in the market
to earn the profits. Thus, production, marketing and finance are the key operational areas in
case are of a manufacturing organisation, out of which finance, is the most crucial one. This is
so, as the functions of production and marketing are related with the function of finance. If the
decisions relating to money or funds fail, it may result into the failure of the business organisation
as a whole. Hence, it is utmost important to take the proper financial decisions and that too at
a proper point of time. In practical situations, in order to overcome temporary financial problems,
the organisations tend to take the hasty decisions which may prove to be fatal over a longer
span of time.
APPROACHES TO THE TERM FINANCE
The concept of finance has changed markedly with the change in times and circumstances.
The various views on the finance can be categorised as stated below.
(1)
According to the first approach, the term finance was interpreted to mean the procurement
of funds by corporate enterprises to meet their financing needs. The term procurement
was used in a broad sense to include the whole gamut of raising the funds externally.
This approach towards finance was criticised on various grounds.
a.
It is too narrow and restrictive in nature. Procurement of the funds is only one of the
functions of finance and other functions are ignored by this approach.
b.
It considers the financial problems only of corporate enterprises. In that sense, it

ignores the financial problems of non-corporate entities like proprietary concerns,
partnership firms etc.
Finance Function
c.
It considers only the basic and non-recurring problems relating to the business.
Day-to-day financial problems of a normal company do not receive any attention.
d.
It concentrates only on long term financing. It means that the working capital
management is out of the purview of finance function.
(2)
The second approach holds that finance is concerned with cash. As all the transactions
are ultimately expressed in terms of cash, the term finance will be concerned with every
activity of the enterprise. Thus, according to this approach, the finance function is
concerned with all the functional areas of the business e.g., Production, Marketing,
Purchasing, Personnel Administration, Research and Development and so on. Obviously
this approach is too broad to be meaningful.
(3)
The third approach, which is more balanced one and hence the acceptable one to the
modern scholars, interprets the term finance as being concerned with procurement of
funds and wise application of funds. This approach is supposed to be more acceptable
as it gives equal weightage to both procurement of funds as well as utilisation of the
funds. This approach is called the managerial approach to the term finance.
In the light of the above discussions, it will be worthwhile to note some of the definitions of the
finance function given by some modern scholars.
R.C. Osborn : The finance function is the process of acquiring and utilising funds of a business.
Bonneville and Dewey : Financing consists of the raising, providing, managing of all the money,
capital or funds of any kind to be used in connection with the business.
Prather and Wert : Business finance deals primarily with raising, administering and disbursing
funds by privately owned business units operating in non-financial fields of industry.
SCOPE OF FINANCE FUNCTION
According to the modern approach, the function of finance is concerned with the following
three types of decisions
a.
Financing Decisions
b.
Investment Decisions
c.
Dividend Policy Decisions
FINANCING DECISIONS
Financing decisions are the decisions regarding the process of raising the funds. This function
of finance is concerned with providing the answers to the various questions like
Financial Management
a.
What should be the amount of funds to be raised? In simple words, the amount of funds
to be raised by the organisation should not be more or less than what is required as both
the situations involve the adverse consequences.
b.
What are the various sources available to the organisation for raising the required amount
of funds? For the purpose of raising the funds, the organisation can go for internal sources
as well as external sources.
c.
What should be the proportion in which the internal and external sources should be used
by the organisation?
d.
If the organisation, particularly the corporate form of organisation, wants to raise the
funds from different sources, it is required to comply with various legal and procedural
formalities. Earlier, these legal and procedural formalities were prescribed and regulated
by Controller of Capital Issues (CCI). Since 1992, after the abolition of the office of CCI,
these formalities are prescribed and regulated by Securities and Exchange Board of
India (SEBI). Though the intention of this subject is not to consider the SEBI regulations
and guidelines in details, relevant SEBI guidelines are discussed at the appropriate
places.
e.
During the last decade of the twentieth century, lot of changes have taken place in the
capital market, which refers to the market available to the companies to raise the long
term requirement of funds. The question arises what is the nature of capital market
operations? What kinds of changes have taken place recently affecting the capital market
in the country?
INVESTMENT DECISIONS
Investment Decisions are the decisions regarding the application of funds raised by the
organisation. The investment decisions relate to the selection of the assets in which the funds
should be invested.
The assets in which the funds can be invested are basically of two types
a.
Fixed Assets Fixed Assets indicate the infrastructural facilities and properties required
by the organisation. Fixed Assets are the assets which bring the returns to the organisation
over a longer span of time. The investment decisions in these types of assets are
technically referred to as Capital Budgeting Decisions. Capital Budgeting decisions
are concerned with the answers to the questions like
1.
How the fixed assets or proposals or projects should be selected to make the
investment in? What are the various methods available to evaluate the investment
proposals in the fixed assets?
Finance Function
2.
b.
How the decisions regarding the investment in fixed assets or proposals or projects
should be made in the situations of risk and uncertainty?
Current Assets Current Assets are the assets which get generated during the course
of operations and are capable of getting converted in the form of cash or getting utilized
within a short span of time of one year. Current Assets keep on changing the form and
shape very frequently. The investment decisions in these types of assets are technically
referred to as Working Capital Management. Working Capital Management decisions
are concerned with the answers to the questions like
1.
What is the meaning of working capital management? What are the objectives of
working capital management?
2.
Why the need for working capital arises?
3.
What are the factors affecting the requirement of working capital?
4.
How to quantify the requirement of working capital?
5.
What are the sources available for financing the requirement of working capital?
6.
Working capital management is concerned with the management of current assets

on overall basis as well as on individual basis. In practical situations, current assets
may be found in the form of cash and bank balances, receivables and inventory.
Working capital management is concerned with the management of these individual
components of current assets as well.
DIVIDEND POLICY DECISIONS

Profits earned by the organisation belong to the owners of the organisation. In case of the
corporate form of organisation, shareholders are the owners and they are entitled to receive
the profits in the form of dividend. However, there is no specific law or statute which specifies
as to how much amount of profits should be distributed by way of dividend and how much
amount of profits should be retained in the business. The alternatives available to the organisation
to distribute the profits in the form of dividend on one hand and retention of profits in the
business, have reciprocal relationship with each other. If the dividends paid are higher, retained
profits are less and vice versa. If the organisation pays higher dividends, shareholders are very
happy as they get more recurring income and the company may be able to gain the confidence
of the shareholders. However, the organisation can be in financial problems as payment of
dividend results into the withdrawal of profits from the business. On the other hand, if the
organisation pays less dividends, the organisation may be in a favourable situation. However,
the shareholders are likely to be offended. As such, the organisation is required to take the
decisions regarding the payment of dividend in such a way that neither the shareholders are
offended nor the organization is in financial problems. As such, dividend policy decisions are
the strategic financial decisions and are concerned with the answers to the questions like
1.
What are the forms in which the dividends can be paid to the shareholders?
2.
What are the legal and procedural formalities to be completed while paying the dividend
in different forms.
GOALS/OBJECTS OF FINANCE FUNCTION :

Profit Maximization :
As a basic principle, any business activity aims at earning the profits. According to this
principle, all the functions of the business will have the profit as the main objective. Similarly,
the finance function will also have the profits as the main objective. But this was only a
traditional belief. Now, profit cannot be the sole and only goal or objective of the finance
function, due to the following problems connected with this objective.
(1)
The term profit is a ambiguous concept which isnt having precise connotation. E.g.
Profits can be long term or short term. Profits can be before tax or after tax and so on. If
profit maximization is accepted as the goal of finance function, the next question that
arises is Which types of profits should be maximized?
(2)
The profits always go hand in hand with risks. The more profitable ventures necessarily
involve more amount of risk. The owners of the business will not like to earn more and
more profits by accepting more risk. If the profit maximization is accepted as the goal of
finance function, it totally ignores the risk factor.
(3)
Profit maximization as the goal of financial function ignores the time pattern of returns.
Consider the following two proposals A and B which involve the same amount of returns.
A (Rs.)
B (Rs.)
Year I
70,000
Year II
20,000
Year III
10,000
1,00,000
1,00,000
1,00,000
Both the proposals A and B involve same amount of profits and hence ideally should be
treated on par. But it will not be proper as proposal A involves higher amount returns in
the earlier years, while proposal B involves the returns in the later years. It makes proposal
A more profitable ultimately, as the returns received earlier are more valuable than the
returns received later. The objective of profit maximization doesnt differentiate between
the returns received earlier and the returns received later.
Finance Function
(4)
Profit maximization as the objective doesnt take into consideration the social
considerations as well as the obligations to various interests of workers, consumers,
society etc., and the ethical trade practices. If these factors are ignored, the organisation
cant survive for long. Profit maximization at the cost of social and moral obligations is a
short-sighted policy.
As such, profit maximization cant be a prime objective of the finance function. The
objective has to be one having more broad a base, which is more precise, which considers
risk factor and time value of money and which give consideration to social and ethical
elements also. The alternative is in the form of wealth maximization as the objective of
the finance function.
Wealth Maximization :
Due to the limitations attached with the profit maximization as an objective of the finance
function, it is no more accepted as the basic objective. As against it, it is now accepted that
the objective of the business should be to maximize its wealth and value of the shares of the
company. This object can also be stated as maximization of value.
The value of an asset is judged not in terms of its cost but in terms of the benefit it produces.
Similarly the value of a course of action is judged in terms of the benefits it produces less the
cost of undertaking it. The benefits can be measured in terms of stream of future expected
cash flows, but they must take into consideration not only their magnitude but also the extent
of uncertainty.
Thus, wealth maximization goal as a decision criteria suggests that, any financial action
which creates wealth or which has discounted stream of future benefits exceeding its cost, is
desirable and should be accepted and that which does not satisfy this test should be rejected.
The goal of wealth maximization is supposed to be superior to the goal of profit maximization
due to following reasons :
(1)
It uses the concept of future expected cash flows rather than the ambiguous term of
profits. As such, measurement of benefits in terms of cash flows avoids ambiguity.
(2)
It considers time value of money. It recognises that the cash flows generated earlier are
more valuable than those generated later. That is why while computing value of total
benefits, the cash flows are discounted at a certain discounting rate. At the same time,
it recognises the concept of risk also, by making necessary adjustments in discounting
rate. As such, cash flows of a project involving higher risk are discounted at a higher
discounting rate and vice versa.
Thus, the discounting rate used to discount future cash flows reflects the concepts of
both time and risk.
Due to the above reasons, the wealth maximization is considered to be superior to profit
maximization as an objective or goal of finance function. However, it should be noted that
wealth maximization goal is only an extension of profit maximization goal. If the time period is
too short and risk element is minimum, both wealth maximization and profit maximization will
mean the same thing.
Organization of Finance Function :
At the outset, it must be cleared that there is no standard pattern for the organization of
finance function. It varies from the enterprise to enterprise and its characteristics also vary in
terms of nature, size, convention etc. In smaller concerns, where the operations are relatively
less complicated and simple, there may not be separate executive to look after finance function.
In fact, the proprietor or partners only will be looking after all the functional areas like production,
marketing, finance etc.
In bigger concerns, the execution of finance function becomes a specialised task and may be
handled by an executive who may be in the form of Treasurer, Finance Controller, Finance
Manager, Vice-President (Finance) and so on. He is generally given the charge of credit and
collection accounting, investment and audit departments. He is responsible for preparing
annual financial reports. He reports directly to the President and Board of Directors.
Secondly, it should be noted that generally the organization of finance function is centralised
one, unlike other business functions. Board of Directors takes the main financial decisions.
Board of Directors may delegate the powers to the executive committee, comprising of managing
director, other one or two directors and finance officer of the company. This executive committee
takes all the financial decisions. Routine financial matters may be delegated to lower level
officers. The reasons for finance function being a highly centralised function are very obvious.
(1)
Financial decisions are the most crucial ones on which survival or failure of the organisation
depends.
(2)
Financial decisions affect the solvency position of the organisation and a wrong decision
in this area may land the organisation into crisis.
(3)
The organisation may gain economies of centralization in the form of reduced cost of
raising the funds, acquisition of fixed assets at the competitive prices etc.
Though there is no standard pattern for organization of finance function, in general terms, the
organization of finance function takes the following form.
Finance Function
Board of Directors
Executive Committee
Vice President
(Production)
Vice President
(Finance)
Finance Controller
Vice President
(Marketing)
Treasurer
(1)
Accounting and Costing
(1) Receivables management
(2)
Annual Reporting
(2) Taxes and Insurance
(3)
Internal Auditing
(3) Cost management
(4)
Budgeting
(4) Securities
(5)
Statistics and Finance
(5) Banking Relations
(6)
Record Keeping
(6) Real Estates

(7) Dividend Distribution
DUTIES AND RESPONSIBILITIES OF FINANCE EXECUTIVE :

On the basis of the scope of the finance function, which has already been discussed, the
various duties and responsibilities which a finance executive has to fulfil can be classified as
below :
(1)
Recurring Duties :
(2)
Non-recurring Duties :
Recurring Duties :
(a)
Deciding the Financial Needs : In case of a newly started or growing concern, the
basic duty of the finance executive is to prepare the financial plan for the company.
Financial plan decides in advance the quantum of funds required, their duration, etc. The
funds may be needed by the company for initial promotional expenditure, fixed capital,
working capital or for dividend distribution. The finance executive should assess this
need of funds properly.
(b)
Raising the Funds Required : The finance executive has to choose the sources of
funds to fulfil financial needs. The sources may be in the form of issue of shares, debentures,
borrowing from financial institutions or general public, lease financing etc. The finance
executive has also to decide the proportion in which the various sources should be
raised. For this, he may have to keep in mind basic three principles of cost, risk and
control. If the company decides to go in for issue of securities say in the form of shares
or debentures, he has to arrange for the underwriting or listing of the same. If the company
decides to go in for borrowed capital, he has to negotiate with the lenders of the funds.
(c)
Allocation of funds : The financial executive has to ensure proper allocation of funds.
He can allocate the funds basically for two purposes.
(i)
Fixed Assets Management : He has to decide in which fixed assets the company
should invest the funds. He has to ensure that the fixed assets acquired or to be
acquired satisfy the present as well as future needs of the company. He has to
ensure that the funds invested in the fixed assets justify the investments in terms of
the expected cash flows generated by them in future. If there are more than one
proposals for making the investments in fixed assets, the finance executive has to
decide in which proposal, the company should invest the funds. For this purpose,
he may be required to take the help of various techniques of capital budgeting to
evaluate the various proposals, e.g. Pay Back Period, Net Present Value, Internal
Rate of Return, Profitability Index etc. If the outright purchases of fixed assets is
not useful, the finance executive has to ensure that in order to facilitate the
replacement of fixed assets after their economic life is over, proper depreciation
policies are formulated. The wrong policies in the area of providing for the depreciation
may result into over-capitalisation or under-capitalisation.
(ii)
Working Capital Management : The finance executive has to ensure that sufficient
funds are made available for investing in current assets as it is the life-blood of the
business activity. Non-availability of funds to invest in current assets in the form of
say cash, receivable, inventory etc. may halt the business operations. At the same
time he has to ensure that there is no blocking of funds in the current assets, as it
may prove to be costly in terms of cost of these funds and also in terms of opportunity
cost of their use. Thus, the finance manager has to ensure that investments in the
current assets is minimum without affecting the operations of the company.
(d)
Allocation of Income : Allocation of the income of the company is the exclusive

responsibility of the finance executive. For this purpose, basically the income may be
distributed among the shareholders by way of dividend or it may be retained in the
business for future purpose like expansion. Decision in this regard may be taken in the
light of financial position, present and future cash requirements, preferences of the
shareholders etc.
(e)
Control of Funds : The finance executive is responsible to control the use of funds
committed in the business so as to ensure that cash is flowing as per the plan and if
there is any deviation between estimates and plans, proper corrective action may be
taken in the light of financial position of the company. For this purpose, he may be
required to supervise the cash receipts and disbursements, ensure the safety of cash
balances, expediate receipts and delay the payments wherever possible etc.
Finance Function
(f)
Evaluation of Performance : The financial executive may be required to evaluate and

interpret the financial statements, financial position and operations of the company. For
this purpose, he may be required to ensure that proper books and records are maintained
in proper way so that whatever data is required of this purpose is available in time. For
the evaluation and interpretation of the financial statements, financial executive may use
the techniques like ratio analysis, funds flow statement etc.
(g)
Corporate Taxation : As the company is a separate legal entity, it is subjected to the

various direct and indirect taxes like income tax, wealth tax, excise and customs duty,
sales tax etc. The finance executive may be expected to deal with the various tax planning
and tax saving devices in order to minimize the tax liability.
(h)
Other Duties : In addition to all the above duties the financial executive may be required
to prepare annual accounts, prepare and present financial reports to top management,
carrying out internal audit, get done statutory and tax audit, safeguarding securities and
assets of company by properly insuring them etc.
Non-recurring Duties :
The non-recurring duties of the finance executive may involve preparation of financial plan at
the time of company promotion, financial readjustments in times of liquidity crisis, valuation of
the enterprise at the time of acquisition and merger thereof etc.
THE FIELDS OF FINANCE
There can be various fields in which the finance function may operate. In each field, finance
executive deals with the management of money and claims against money. The distinctions
arise due to variety of problems and variety of objects. The various fields of finance can be
stated as below.
10
(1)
Business Finance : The term business and hence business finance is a very broad
term. It covers all the activities carried on with the intention of earning profits. Thus,
business finance covers the study of finance function in the area of business which
includes both trade as well as industry.
(2)
Corporation Finance : Corporation finance is a part of business finance and deals with
the financial practices, policies and problems of corporate enterprises or companies to
describe in simple words. The corporation finance studies the financial operations carried
on by a corporate enterprise from the stage of its inception to the stage of its growth and
expansion.
(3)
International Finance : International finance is the study of flow of funds between

individuals and organisations beyond national boundaries and developing the methods to
handle these funds more effectively. This study may become crucial as it involves exchange
of currencies and also as the governments of either of the nations may have close watch
and control on these transactions involving foreign currencies.
(4)
Public Finance : It deals with the financial matters of the Governments. It becomes
crucial as the Governments deal with huge sums of money which can be raised through
the sources like taxes or other methods and are required to be utilised within the statutory
and other limitations. Further, the Government does not operate with objectives similar
to that of the private organisations i.e. earning the profits is not the intention with which
the Governments operate, but they operate with the intention of accomplishing social or
economic objectives.
(5)
Private Finance : It deals with the financial matters of non-government organisations.
FINANCE FUNCTION IN RELATION WITH OTHER FUNCTIONS

Other than finance, every business generally operates in three main functional areas viz.
Production, Marketing and Personnel. All these functions are closely related to finance function
due to the simplest reason that for executing these functions, funds are required which is the
area covered by finance function.
E.g. To produce good quality of finished goods, the business needs good infrastructural facilities
like building, machineries etc., a regular flow of production facilities like quality, raw material,
work in progress, consumable stores, quality control equipments, good maintenance facilities
etc. All these activities need the investment to be made either in terms of fixed capital and/or
working capital, which is the area of finance function. To market the finished goods properly in
market, the business has to have proper investment in the finished goods to guarantee regular
flow of goods in the market. It may be required to have good distribution systems which may
call for investment in terms of fixed assets or labour force. All these activities need the
investments to be made either in terms of fixed capital and/or working capital which is the area
of finance function. The personnel function deals with the availability of proper kinds of labourers
at proper time, training them properly and fixing their job responsibilities. All these activities
need funds e.g. to pay salaries, wages and other facilities to workers, funds are needed, to
provide training facilities to workers, it may be necessary to invest in some fixed assets like
building or equipments etc.
To conclude, it may be stated that all the functions or activities of the business are ultimately
related to finance. The success of the business depends on how best all these functions can
be coordinated.
Finance Function
11
QUESTIONS
1.
Describe the scope and importance of the finance function in the management of a
corporation.
2.
Explain the meaning, nature and scope of Business Finance.
3.
Explain the organizational frame work of finance function. State the relation of finance
function to other functions of a business enterprise.
4.
What are the duties discharged by the financial executives in a large business
organization?
5.
(a)
Explain the traditional and modern concept of finance function.
(b)
State the relation of finance function to other functions of a business enterprise.
6.
Describe the organizational structure of finance department of a large business concern.
7.
How is finance function organized in business firms?

Explain the internal structure of finance department in medium and large business
enterprises with suitable chart.
12
NOTES
Finance Function
13
NOTES
14
Chapter 2
FORMS OF BUSINESS ORGANISATION
The finance function of the organisation is greatly affected by the forms of organisation. In
practical circumstances, we come across basically three forms of business organisations.
a.
Proprietary Firms
b.
Partnership Firms
c.
PROPRIETARY FIRMS
In this case, only one person is the owner of the business who is called as the Proprietor and
the same person is the manager. All the profits earned by the business belong to the proprietor
and he is liable for the losses and liabilities of the business.
Advantages :
a.
Proprietary Firm is the easiest and most economical form of business organisation to
form and operate. Not many of the government regulations are applicable to the Proprietary
Firms.
b.
This form of organisation is very suitable where the size of the business is small and the
complexities involved in the business are comparatively less. However, if the size of the
business increases or the complexities in the business operations grow, this form may
prove to be insufficient.
Disadvantages :
a.
This form of organisation does not have any legal status. The proprietary firms exist due
to the existence of the proprietor. If the proprietor ceases to be in existence, the firm
ceases to be in existence.
b.
As only one person is the owner and the manager, the capacity of the business to raise
the funds and to cope up with the complex business operations is comparatively limited.
15
c.
Proprietary firm is always an unlimited liability organisation. In the sense, if the assets of
the firm are insufficient to meet its liabilities, personal property of the proprietor is always
at stake.
d.
The income of the proprietary firm is clubbed with the individual income of the proprietor.
As such, effective rate of income tax which the proprietor may be required to pay is likely
to be higher.
e.
It is not possible to transfer the ownership of the business to somebody else without
affecting the basic constitution of the business.
PARTNERSHIP FIRMS
In this case, more than two persons but less than twenty persons come together and form a
partnership firm. Each of these partners is the owner of the business in the proportion decided
among themselves. Partnership is a contract among the partners and the relationship among
the partners is governed on the basis of terms and conditions laid down in an official and
written document called as partnership deed or partnership agreement.
Advantages
16
a.
This form of organisation is also reasonably easy and economical to form and operate.
b.
As resources of more than one person are pooled together, capacity of the business to
handle more complex business operations or operations requiring more amount of funds
is better as compared to the proprietary firms.
c.
The tax structure applicable to the partnership firms is fairly reasonable. At present,
profit of the partnership firm is taxed at a flat rate of 35%. While calculating the profit of
the partnership firm, following amounts can be claimed by the firm as the allowable
expenditure.
i.
The firm can pay interest on capital to the partners on the amount of capital introduced
by them in the business but the rate of interest can not exceed 12% per annum.
This interest on capital can be paid by the firm to all the partners.
ii.
The firm can remunerate the partners in the form of salary, bonus, commission etc.
provided that the partners are working partners. A working partner is a partner who
is capable of participating in the day-to-day affairs of the firm by virtue of experience
or qualifications. However, the firm cannot remunerate the partners to any extent it
wants. The maximum amount of remuneration which the firm can pay to all the
working partners taken together is prescribed in Income Tax Act, 1961. Section
44AA of the said Act provides that the maximum amount of remuneration which the
firm can pay to its working partners gets decided on the basis of its book profits
which means the amount of profits as per its profitability statement after calculating
the interest on capital paid to the partners. After deciding the amount of book profit,
the remuneration is decided as below :
If the firm is carrying on a profession :
a.
On the first Rs. 1,00,000 of the book profit or in case of a loss, Rs. 50,000 or
90% of the book profit whichever is more.
b.
On the next Rs. 1,00,000 of the book profit, at the rate of 60%.
c.
On the balance amount of book profit, at the rate of 40%.
In case of any other firm :

a.
On the first Rs. 75,000 of the book profit or in case of a loss, Rs. 50,000 or
90% of the book profit whichever is more.
b.
On the next Rs. 75,000 of the book profit, at the rate of 60%.
c.
On the balance amount of book profit, at the rate of 40%.
However, it should be remembered that the amount of interest on capital paid by the firm
and the remuneration paid to the partners is taxable in the hands of individual partners.
After charging the above amounts, the balance amount of profits are transferred to the
capital account of the partners which is referred to as share of profit and this share of
profit is not taxable in the hands of individual partners.
d.
Not many of the government regulations are applicable to the partnership firms.
Disadvantages
a.
This form of organisation also does not have any legal status. The partnership firms exist
due to the existence of the partners. If the partners cease to be in existence, the firm
ceases to be in existence. The retirement or death of a partner leads to the dissolution
of the partnership firm.
b.
The capacity of the business to raise the funds and to cope up with the complex business
operations is comparatively limited though it is more than that of the proprietary firms.
c.
Partnership firm is also an unlimited liability organisation. In the sense, if the assets of
the firm are insufficient to meet its liabilities, personal property of the partners is always
at stake.
d.
It is not possible to transfer the ownership of the business to somebody else without
affecting the basic constitution of the business.
17
JOINT STOCK COMPANIES

Joint stock companies has become a major form of organisation in the recent past. This form
of organisation can raise large amount of funds as the resources of larger number of people
can be pooled together. In this case, the total requirement of funds of the organisation is split
into smaller units, each of such units being called as a share. Each such share carries a
denomination value which is called as face value or nominal value. An individual can participate
in the capital requirement of an organisation by purchasing the shares of the company and he
becomes the part owner of the company to the extent of his shareholding in the overall amount
of capital of the company. Such shareholder can exercise his ownership rights through the
voting rights offered to him. The joint stock companies have the following characteristic features.
18
1.
All the joint stock companies have a legal entity separate from their owner viz. shareholders.
They gain the legal status by being registered under Companies Act, 1956, which governs
and regulates the operations of all joint stock companies in India. As legal entities, the
joint stock companies can own assets, incur liabilities, enter into contracts, sue and be
sued. The shareholders of the company cannot be held liable for the actions of the
company.
2.
Generally all joint stock companies are limited liability organisations and the liability of
the members i.e. shareholders is limited to the extent of amount of shares they undertake
to purchase. E.g. If Mr. A undertakes to purchase 100 shares of a company of Rs. 100
each, his liability ceases once he pays Rs. 10,000 to the company. His personal property
is never in danger despite the losses and liabilities incurred by the company.
3.
Segregation of ownership and management is a typical feature of joint stock companies.

In case of the companies, shareholders are the owners. However, due to large number of
shareholders and their wide geographical spread, it may not be possible for the
shareholders to exercise their ownership rights by participating in the day-to-day affairs
of the company. As such, the shareholders appoint their representatives (viz. directors)
to manage the day-to-day affairs of the company. In case of joint stock companies,
shareholders are the owners while directors/board of directors are the managers.
4.
Transferability of shares is a feature of a joint stock company. A shareholder can transfer

his ownership rights in the company by transferring his shares to some other person. In
case of public limited companies, shares are freely transferable and such transfer can
be greatly facilitated if the shares are listed on the stock exchange. In case of private
limited companies, there may be some restrictions on the transfer of shares.
5.
Being an artificial legal person, the company enjoys a perpetual existence. The company
can die only a legal death, after complying with the prescribed legal formalities. There is
a very famous case under the Companies Act, where during the war, all the members of
a private company, while in meeting, were killed by a bomb. But the company survived.
6.
A company is an artificial legal person which does not have a body like a natural person
and hence it cannot sign any documents. However, being a legal personality, it is bound
only by those documents which bear its signature. Hence, as a substitute to the signature,
the law provides for the use of common seal. Any document having the common seal
and witnessed by at least two directors is binding on the company legally.
Advantages :
1.
The capacity of the corporate organisations to raise the funds is comparatively high. As
the number of persons contributing to the requirement of funds is large, it is possible to
raise large amount of funds.
2.
As the company has a separate legal entity, apart from its owners viz. shareholders, the
personal property of the shareholders is generally not in danger.
3.
Transferability of shares is a facility available to the shareholders. If the shareholders

want to release their investment in shares, they can transfer their shares to any other
person. However, it should be remembered that in case of private limited companies, the
shares are not freely transferable.
Disadvantages :
1.
The company form of organisation are subjected to elaborate legal and procedural
formalities to be completed not only for the purpose of formation but also for the regular
operation. The basic applicable law in this connection is in the form of Companies Act,
1956. However, it should be noted that in case of private limited companies, these
formalities are less rigorous in nature.
2.
Double Taxation is a typical characteristic feature of a company form of organization.

The profits earned by the company are taxed in the hands of company first and when the
same profits are distributed to the shareholders in the form of dividend, the same are
taxed in the hands of shareholders again. This amounts to the payment of tax by both
the company as well as the shareholders on the same amount of profits.
As the company form of organisation is the most frequently found form of organisation, for the
future discussion in the following chapters, we will refer the business organisation to be a
company.
In practical situations, we come across basically two types of limited liability companies :
a.
Private Limited Company
b.
Public Limited Company
19
PRIVATE LIMITED COMPANY

In non-technical language, operations of a private limited company affect the fate of smaller
number of people. As such, Companies Act, 1956 is very liberal towards the private limited
companies. Private Limited Company is entitled to many privileges/exemptions from the various
provisions of the Companies Act, 1956. A private limited company is characterised by the
following features.
a.
Minimum number of shareholders is 2 and the maximum number is 50.
b.
A private limited company cannot approach public in general for subscribing to the shares/
debentures of the company. Similarly, a private limited company cannot invite or accept
deposits from public in general other than its shareholders, directors or their relatives.
The funds required by the company are required to be collected through the private
circulation only.
c.
In case of a private limited company, right of the shareholders to transfer the shares is
restricted. These restrictions are usually in two forms :
d.
i.
that the shares to be transferred should be offered to the existing members on

priority basis and if the existing members do not want to take up those share, they
can be transferred to anybody else.
ii.
that the directors will have the power to refuse to register the transfer of shares
provided that such power should be exercised by the directors in good faith and in
the interest of the company.
A private limited company needs to have a minimum paid-up share capital of

Rs. 1 Lakhs or any higher amount as may be prescribed.
PUBLIC LIMITED COMPANY

In non-technical language, a public limited company affects the fate of larger number of people.
As such, operations of a public limited companies are subjected to a close control in the form
of compliance to the various provisions of Companies Act, 1956. A public limited company is
characterised by the following features :
20
a.
Minimum number of shareholders is 7 and there is no restriction on the maximum number

of shareholders.
b.
Public limited company can freely approach public in general for subscribing to the
shares and/or debentures of the company.
c.
The shareholders of a public limited company can freely transfer their shares to any
other person. As such, shares of only a public limited company can be listed on the
stock exchange.
d.
A public limited company needs to have a minimum paid-up share capital of Rs. 5 Lakhs
or any higher amount as may be prescribed.
QUESTIONS
1.
2.
Critically evaluate the following forms of business organisations.

(a)
Proprietory Firms
(b)
Partnership Firms
(c)
Write short notes on the following

(a)
Taxation of Partnership Firms
(b)
Types of Companies
21
NOTES
22
NOTES
23
NOTES
24
Chapter 3
FINANCIAL STATEMENTS
Financial statements of an organisation is the basis of data required for financial decision
making. As such, correct understanding of the structure of financial statements and also of
the tools available for the interpretation of financial statements is a must before one talks of
any of the further discussions on financial management.
NATURE OF FINANCIAL STATEMENTS
Any organisation doing the business, whether it is manufacturing activity or trading activity or
service activity, is interested in knowing basically two facts about the business.
a.
Where the business stands at any given point of time in financial terms.
b.
What is the result of operations carried out by the business organisation during a specific
period.
In order to answer these two questions, the organisation carries out the process of recording
various transactions in a defined set of records, technically referred to as accounting, which
effectively result into the preparation of what are called as financial statements. These financial
statements are basically in two forms.
a.
First financial statement is Balance Sheet. This is the answer to the first question viz.
Where the business stands in financial terms. Balance Sheet informs about the various
sources used by the organisation to raise the funds which technically result into what
are referred to as liabilities and the way these sources are used which technically
result into the creation of assets. Sometimes, Balance Sheet is also referred to as
Statement of Sources and Application of funds. Effectively, Balance Sheet is a listing
of various assets and liabilities of the organisation at any given point of time. Technically,
Balance Sheet is a position statement in the sense it refers to a particular date. As
such, Balance Sheet is referred to as Balance Sheet as on or Balance Sheet
as at .
25
b.
Second financial statement is Profitability Statement. In technical language, it is referred

to as Profit & Loss Account. This is the answer to the second question viz. What is the
result of operations of the business during the specific period i.e. whether the operations
have resulted into a profit or loss and by what amount. Technically, Profitability Statement
is a period statement in the sense it refers to a particular period . This may be a month,
a quarter, a half year or a year depending upon the organisation and the purpose for
which it is prepared. As such, Profitability Statement is referred to as Profit and Loss
Account for the year ending on .
Basic principles behind the preparation of Financial Statements
BASIC CONCEPTS IN ACCOUNTING

The theory and practice of accounting is based upon certain basic assumptions which are
referred to variously as concepts, principles, conventions and rules. For the convenience
purpose, we will term them as concepts. The various concepts which form the basic of
theory and practice of accounting can be discussed as below.
(1)
Business Entity Concept :

According to this concept, the business is assumed to be a distinct entity from the
persons who own the business E.g. If there is a partnership concern carrying the name
of M/s. X, where Mr. A and Mr. B are partners, from accounting point of view, M/s. X is
supposed to be a separate entity from Mr. A or Mr. B. The financial statements prepared
on the basis of accounting records relate to the business i.e. M/s. X and not to Mr. A or
Mr. B individually. It should be noted in this connection that the business entity concept
has nothing to do with the legal entity of the business. It applies to both corporate
organisation (which by itself is a legal entity separate from the owners) as well as noncorporate organisation. (which is not a legal entity separate from the owners.)
(2)
Money Measurement Concept :

According to this concept, only those transactions and facts find the place in the process
of accounting and hence on financial statements which can be expressed in terms of
money. As such, all those transactions and facts which cannot be expressed in terms of
money (e.g. Morale and motivation of the workers, goodwill of the organisation in the
market etc.) are not within the purview of accounting though they may be having direct or
indirect bearing on the business. This principle imposes severe restrictions on the kind
of information available from the financial statements. In fact, it is one of the major
drawbacks of financial statements.
26
(3)
Cost Concept :
According to this concept, the assets acquired by a business are recorded at their cost
of acquisition and this cost is considered for all the subsequent accounting purposes
say charging of depreciation. This concept does not take into consideration the current
market prices of the various assets.
(4)
Going Concern Concept :

According to this concept it is assumed that the business entity is going to be in business
for an indefinitely long period of time and is not likely to close down its business in a
shorter period of time. This concept affects the valuation of assets and liabilities. As
such, the assets are shown on the Balance Sheet at cost less depreciation and not at
the current market price or realisable value. If the assets are to be disclosed at the
correct value in the Balance Sheet, the current market price will be most suitable. However,
as the business is likely to be a going concern in future and as the assets are not likely
to be sold in the market in the near future, they are disclosed at cost less depreciation.
(5)
Conservation Concept :
This concept is usually expressed as Anticipate all the future losses and expenses,
however do not anticipate the future incomes and profits. This principle is applicable to
current assets generally and hence the current assets are valued at cost or market price
whichever is lower. The valuation of non-current assets is made at cost (as per the cost
concept.)
(6)
Dual Aspect Concept :

According to this concept, every business transaction has two aspects, however the
basic relationship between assets and liabilities i.e. assets are equal to liabilities, remains
the same e.g. If Mr. A starts the business by introducing the capital of Rs. 50,000 the
assets and liabilities structure will be as below :
Liabilities
Capital
Rs.
50,000
Assets
Cash
Rs.
50,000
Now, if Mr. A uses the cash to purchase the material worth Rs. 40,000, the assets and
liabilities structure will change as below :
Liabilities
Capital
Rs.
50,000
50,000
Assets
Rs.
Stock in trade
40,000
Cash
10,000
50,000
27
If Mr. A sells the above material worth Rs. 40,000 for Rs. 45,000, on credit basis, the
assets and liabilities structure will change as below :
Liabilities
Capital
Rs.
55,000
55,000
(7)
Assets
Rs.
Receivables
45,000
Cash
10,000
55,000
Accounting Period Concept :

According to this concept, eventhough a business is likely to be a going concern over a
longer period of time, in order to facilitate the preparation of financial statements
periodically, the future time is divided into shorter segment, each one of them being in
the form of Accounting Period. Income is computed according to this accounting period
(by preparing profitability statement) and financial position is assessed at the end of
such accounting period (by preparing Balance Sheet). It may be noted that the length of
accounting period may depend upon various factors like characteristics of the business,
tax considerations, statutory requirements and so on.
(8)
Matching Concept :
According to this concept, in order to calculate the profit for the accounting period in a
correct manner, the expenses and costs incurred during that period, whether paid or not,
should be matched with the revenues generated during that period.
(9)
Materiality Concept :
According to this concept, while accounting for the various transactions, only those
which are having material impact on profitability or financial position of the organisation
will be considered, ignoring the insignificant ones. E.g. If an organisation purchases
some postage stamps some of which remain non-used at the end of the accounting
period, according to matching concept, the cost of such non-used stamps should not be
treated as an item of expenditure. However, as its impact on profitability is likely to be
negligible, the cost of non-used stamps may be ignored treating the cost of purchase of
stamps as an expenditure. Now which transactions should be treated as material ones
is a subjective concept and depends upon the judgement and knowledge of the accountant.
(10) Consistency Concept :

According to this concept, whatever accounting policies and procedures are adopted,
they should be adopted consistently from one period to another to enable the comparison
between two different sets of financial statements. If there is any change in the accounting
policies and procedures, this fact coupled with its effect on profitability should be disclosed
specifically.
28
STRUCTURE OF FINANCIAL STATEMENTS

As there is no specific law applicable to the preparation of financial statements of a noncorporate organisations like proprietary firms or partnership firms, these organisations can
prepare their financial statements in whatever structure they want. However, in case of a
corporate organisation, in simple language a company form of organisation, there is a uniform
law applicable to these types of organisations viz. Companies Act, 1956. As such, a company
form of organisation is required to prepare and present its financial statements in accordance
with the provisions of Companies Act, 1956, to be more specific as per the provisions of
Schedule VI of the Companies Act, 1956. The underlying presumption of the Schedule VI
provisions is that it is through the financial statements that the companies communicate with
the various outsiders. As such, it is required that the financial statements should be as
transparent and as informative as possible. Hence, Schedule VI lays down various disclosure
requirements which the companies are required to follow while preparing their financial
statements.
Schedule VI of the Companies Act, 1956 is subdivided into four parts :
Part I deals with the format of the Balance Sheet.
Part II deals with the Profit and Loss Account.
Part III deals with notes forming part of the Profit and Loss Account and the Balance Sheet.
The last reporting requirement to Part IV was inserted recently with effect from 15th May 1995
which deals with Balance Sheet abstract and the companys general business profile.
Part I : Structure of Balance Sheet :
As stated above, Part I of Schedule VI deals with Balance Sheet. It lays down both the vertical
as well as horizontal form of preparing the Balance Sheet, though in normal circumstances
we come across vertical form of Balance Sheet.
Following items appear in the Balance Sheet.
Liabilities
Assets
a.
Share Capital
a.
Fixed Assets
b.
Reserves & Surplus
b.
Investments
c.
Secured Loans
c.
Current Assets, Loans & Advances
d.
Unsecured Loans
d.
e.
Current Liabilities &

Provisions
e.
Miscellaneous Expenditure to the extent not written off

or adjusted.
Profit & Loss Account debit Balance.
29
In addition to the above items of assets and liabilities, the various contingent liabilities are
required to be disclosed by way of a foot-note.
LIABILITIES SIDE
Share Capital :
The share capital is required to be disclosed under the following headings
a.
Authorised : ....... shares of Rs......... each
b.
Issued : ........ Shares of Rs. ........each
c.
Subscribed : ....... shares of Rs. .......... each
d.
Called up : ........ shares of Rs. .............. each
e.
Less : Calls Unpaid
f.
Add : Forfeited Shares (Amount originally paid up)
Notes :
a.
The details of issued and subscribed capital should be given after distinguishing between
the different classes of shares. It should be noted that in the Indian circumstances, the
company can issue only two types of shares i.e. Equity Shares and Preference Shares.
In case of preference shares, details of different classes of preference shares should be
given. Similarly, in case of redeemable or convertible preference shares, the terms of
redemption on conversion should be given.
b.
If the shares are allotted as fully paid shares pursuant to a contract without payments
being received in cash, the details of the same should be given.
c.
If the shares are allotted as fully paid bonus shares, details of the same should be given
alongwith the sources from which the bonus shares are issued i.e. capitalisation of
profits or reserves, share premium etc. Similarly, the details of bonus shares held by i)
directors and ii) others should be given.
d.
It is provided that any profit on the reissue of forfeited shares should be transferred to
capital reserve.
Reserves and Surplus :

Reserves indicate that portion of the earnings, receipt or other surplus of the company (whether
capital or revenue) appropriated by the management for a general or specific purpose other
than provisions for depreciation or for a known liability. The reserves can be primarily of two
types. i) Capital Reserve and ii) Revenue Reserve. Capital Reserve is that reserve which can
not be distributed by way of dividend. Revenue Reserve is any other reserve than the capital
reserve.
30
The reserves are required to be classified as below :

a.
Capital Reserve
b.
Capital Redemption Reserve (As per the provisions of Section 80 of the Companies Act,
1956, this reserve is created for the redemption of redeemable preference shares).
c.
Share Premium Account
d.
Other reserves specifying the nature of each reserve and the amount in respect thereof.
Less : Debit balance in Profit & Loss Account, if any.

e.
Surplus i.e. balance in Profit & Loss Account after providing for proposed allocations viz.
dividend, bonus shares or reserves.
f.
Proposed additions to reserves.
g.
Sinking fund
Notes :
a.
Additions and deductions since the last balance sheet is required to be given under each
head of reserves and surplus.
b.
In case of the share premium account, the details of the utilisation of the balance in
share premium account should be given. It should be noted that as per the provisions of
Section 78 of the Companies Act, 1956, the amount lying to the credit of share premium
account can be used for :
1.
For issuing fully paid bonus shares.
2.
To write off preliminary expenses.
3.
To write off the balance of commission/discount allowed/paid while issuing shares/

debentures.
4.
To provide for premium payable on the redemption of preference shares.
c.
The word fund is generally used interchangeably with the word reserve fund. The word
fund indicates that there is a specific investment against such reserves.
d.
Debit balance in Profit and Loss Account should be deducted from the unspecified
reserves. If there are no unspecified reserves, such debit balance should be shown on
assets side.
Secured Loans :
Loans borrowed by the company, secured wholly or partly, against the assets of the company
are stated as secured loans.
31
Secured Loans are classified as below :

a.
Debentures
b.
Loans and Advances from Banks
c.
Loans and Advances from Subsidiaries
d.
Other Loans and Advances
Notes :
a.
In case of debentures, the terms of redemption or conversion, if any, should be specified

together with the earliest date of redemption or conversion.
b.
Nature of security should be specified.
c.
Interest accrued and due on secured loans should be included under the appropriate
sub-head under secured loans.
d.
Loans taken from directors and managers should be shown separately.
e.
If the loans are guaranteed by director or manager, it is required to mention the guarantee
and the amount of loan under each head.
Unsecured Loans
Unsecured Loans are those loans which are not secured against the security of any of the
assets of the company. Unsecured portion of the partly secured loans should be shown under
unsecured loans.
Unsecured Loans are classified as below :
a.
Fixed Deposits
b.
Loans and Advances from Subsidiaries
c.
Short Term Loans and Advances
d.
32
i)
from Subsidiaries
ii)
from others

i)
from subsidiaries
ii)
from others
Notes :
a.
Interest accrued and due on secured loans should be included under the appropriate
sub-head under unsecured loans.
b.
Loans taken from directors and managers should be shown separately.
c.
If the loans are guaranteed by director or manager, it is required to mention the guarantee
and the amount of loan under each head.
d.
Short term loans and advances are those which are due for repayment within one year
from the date of balance sheet.
e.
Inter-corporate unsecured deposits and Commercial Papers fall under this head.
Current Liabilities and Provisions :

The Guidance Note issued by The Institute of Chartered Accountants of India on Terms used
in Financial Statements defines Current Liability as liability including loans, deposits and
bank overdraft which falls due for payment in a relatively short time, normally not more than 12
months.
Current Liabilities and Provisions are classified as below :
A.
B.
Current Liabilities :
a.
Acceptance : This includes the bills payable including the promissory notes issued
by the Company.
b.
Sundry Creditors for goods purchased or services received
c.
Subsidiary Companies
d.
Advance received and unexpired discount
e.
Unclaimed dividend
f.
Other liabilities, if any.
g.
Interest accrued but not due on loans
Provisions :
a.
Provision for Taxation
b.
Proposed Dividend
c.
Provision for contingencies
d.
Provision for Provident Fund Scheme
e.
Provision for insurance, pension and other similar staff benefit schemes
f.
Other provisions
33
ASSETS SIDE
Fixed Assets :
Schedule VI requires the company to classify the fixed assets as far as possible under the
following heads
a.
Goodwill
b.
Land
c.
Buildings
d.
Leaseholds
e.
Railway sidings
f.
Plant and Machinery
g.
Furniture and Fittings
h.
Development of Property
i.
Patents, Trade Marks and Designs
j.
Livestock
k.
Vehicles etc.
Under each of the above heads, original cost and the additions thereto or the deductions
therefrom during the year and the total depreciation written off or provided upto the end of the
year should be stated.
In the practical circumstances, in the vertical form of balance sheet, the fixed assets are
presented as below :
a.
Gross Block (which indicates accumulated original cost)
b.
Less : Depreciation (which indicates accumulated depreciation)
c.
Net Block (which indicates Gross Block less Depreciation)
d.
Capital Work-in-Progress.
Note : Capital work-in-progress indicates the fixed assets under construction or under
installation. After the construction of fixed assets is complete or the fixed assets are installed,
they are capitalised under the suitable head. No depreciation will be provided by the company
on capital work-in-progress.
Usually details of original cost, additions, deductions, depreciation etc. are shown in a separate
schedule.
34
Investments :
Investments indicate the assets held by a company for earning income by way of dividend,
interest etc. or for capital appreciation or for other benefits to the investing company.
Investments are required to be distinguished as below :
a.
Investments in Government or Trust securities.
b.
Investments in shares, debentures or bonds showing separately shares fully paid up and
partly paid up and also distinguishing different classes of shares. Similar details should
be given in case of investment in subsidiary companies.
c.
Immovable Properties
d.
Investment in capital of Partnership Firm.
e.
Balance of unutilised monies raised by issue.
Notes :
a.
It is necessary to indicate the nature of investment and mode of valuation, for example
cost or market value.
b.
It is required to disclose
i)
Aggregate amount of companys quoted investments and the market value thereof
ii)
Aggregate amount of companys unquoted investments. Quoted investments means

an investment which is traded on a recognised stock exchange and unquoted
investment means otherwise.
Current Assets, Loans and Advances :

A.
Current Assets
Cash and other assets which are expected to be converted into cash or consumed in the
production of goods or rendering the services in the normal course of business are
defined as current assets.
Current Assets are required to be classified as :
a.
Interest accrued on investments
b.
Stores and spare parts
c.
Loose tools
d.
Stock-in-Trade (This in turn may consist of stock of raw materials and stock of
finished goods)
35
e.
Work-in-Progress
f.
Sundry Debtors
i)
Debts outstanding for a period exceeding six months
ii)
Other Debts
Less : Provision
g.
Cash balance on hand
h.
Bank Balances
i)
With Scheduled Bank
ii)
With others
Notes :
a.
Mode of valuation of stock-in-trade and work-in-progress should be specified.
b.
Sundry debtors are required to be disclosed based on security in the following

manner.
i)
Debts considered good and in respect of which the company is fully secured.
ii)
Debts considered good for which the company holds no security other than
the debtors personal security.
iii)
Debts considered bad or doubtful.
Further following details are also required to be disclosed in case of debtors :
c.
i)
Debts due by directors or other officers of the company or any of them either
jointly or severally with any other person.
ii)
Debts due by firms in which any director is a partner or debts due by a private
company in which a director is a director or member.
iii)
Maximum amount due by directors or other officers of the company at any

time during the year is required to be shown by way of a note.
iv)
Debts due from the companies under the same management as defined in
Section 370(1B) of the Companies Act, 1956 are required to be shown
separately along with the names of these companies.
In case of bank balances, following details are required to be given :

i)
36
Balance lying with Scheduled Bank in current account, call account or deposit
account. It should be noted here that a Scheduled Bank is defined in
Section 2(e) of the Reserve Bank Act, 1934.
B.
ii)
Balances lying with banks other than Scheduled Banks in current account,
call account or deposit account. It is further required to state the names of all
such banks and the maximum amount outstanding at any time during the
year from each such bank.
iii)
Nature of interest of the directors or the relatives of the directors in the nonscheduled bank is also required to be stated.
Loans and Advances :

The Loans and Advances may not always be in the form of current assets. However, for
the purpose of Schedule VI they are clubbed with current assets.
The Loans and Advances are classified as :
a.
Advances and loans to subsidiaries.
b.
Advances and loans to partnership firms in which the company or any of its
subsidiaries is a partner.
c.
Bills of exchange.
d.
Advances recoverable in cash or in kind or for value to be received e.g. Rates,

Taxes, Insurance etc.
e.
Balances with customs, port trust etc. (where payable on demand)
Disclosure requirements applicable to sundry debtors equally apply to Loans and

Advances.
a.
Loans and advances are required to be classified as

i)
Outstanding for a period exceeding six months
ii)
b.
Provision for bad and doubtful advances is required to be reduced from the balance
of loans and advances.
c.
Advances due by directors or other officers of the company or any of them either
jointly or severally with any other person are required to be disclosed separately.
d.
Advances due by firms in which any director is a partner or debts due by a private
company in which a director is a director or member is required to be disclosed
separately.
e.
Maximum amount due by directors or other officers of the company at any time
during the year is required to be shown by way of a note.
37
f.
Advances due from the companies under the same management as defined in
Section 370(1B) of the Companies Act, 1956 are required to be shown separately
alongwith the names of these companies.
MISCELLANEOUS EXPENDITURE
(to the extent not written off or adjusted)
In accounting language, this amount arises due to the deferred revenue expenditure incurred
by the company. Deferred revenue expenditure is that expenditure which is neither capital
expenditure nor revenue expenditure. It is not a capital expenditure as no fixed asset is
created due to this expenditure. It is not a revenue expenditure also as the benefits received
from such expenditure are staggered benefits. Such expenditure should not be transferred to
Profit & Loss Account in the year of incurrance. In practical circumstances, following expenditure
may appear under this head.
a.
Expenditure incurred in connection with drafting and printing of Memorandum of Association

and Articles of Association of the Company, legal charges, stamp duty and filing fees
paid for getting the company registered as per the provisions of Companies Act, 1956
etc.
b.
Expenditure incurred in connection with the preparation of feasibility report, conducting

the market survey etc.
c.
Expenditure incurred in connection with the public issue of shares and debentures like
underwriting commission, brokerage, drafting & printing of prospectus, advertisement &
legal charges etc.
As per the provisions of Section 35D of the Income Tax Act, 1961, such expenditure can be
written off to Profit and Loss Account over the period of five years.
Contingent Liabilities :
Contingent liabilities may be defined as the liabilities the crystalisation of which depends
upon the happening or non-happening of certain events. Contingent Liabilities are never a part
of main Balance Sheet. They are to be disclosed below the Balance Sheet by way of Foot
Note. In practical circumstances, contingent liabilities are disclosed in the Annexure to the
Balance Sheet in the form of Notes on Accounts.
The contingent liabilities referred to in Schedule VI are as below :
a.
38
Claims against the company not acknowledged as debts. (In simple language they are
the disputed claims. They are likely to become final liability only if the company looses
the suit.)
b.
Uncalled liability on shares partly paid. (This liability may arise if the company has
invested some amount in the shares of another company the entire amount of which is
not called.)
c.
Arrears of dividend on cumulative preference shares.
d.
Estimated amount of contracts remaining to be executed on capital accounts and not

provided for.
e.
Other money for which the company is contingently liable. (In practical circumstances,
it may include the amounts like bills discounted by the company with banks, the amount
of guarantees given by the company on behalf of directors or other officers of the company
etc.)
Part II : Structure of Profitability Statement :

The profitability statement of a company may be split into the following components.
a.
First component discloses profits earned by the company after the manufacturing function
is over. This profit is technically referred to as Gross Profit and is calculated as Sales
less Cost of Goods Manufactured (also called as Factory Cost).
b.
Second component discloses profits earned by the company after all the operating
activities are over. This profit is technically referred to as Operating Profit and is calculated
as Sales less Operating Cost.
c.
Third component discloses final profit earned by the Company after all the activities are
over. This profit is technically referred to as Profit After Tax and is calculated as
Operating Profit
Add : Non-operating incomes
Less : Non-operating expenses
Less : Taxation
d.
Forth component indicates the profits retained in the business after the Profit After Tax is
distributed among the owners by way of dividend.
Based upon the above discussion, the structure of the profitability statement can be
drafted as below :
Sales
Less : Factory Cost
Gross Profit
Less : Administrative and Selling Overheads
39
Operating Profits
Less : Non-Operating Expenses
Add : Non-Operating Incomes
Profit Before Tax
Less : Taxes
Profit After Tax
Less : Dividend Paid
Retained Profit
ROLE PLAYED BY FINANCIAL STATEMENTS
In the present circumstances the process of financial accounting and hence the preparation of
financial statements has been made a mandatory legal requirement, either directly or atleast
indirectly. As such, the preparation of financial statements indicates the compliance with the
various legal requirements. Moreover, it is through the financial statements that a host of persons
dealing with an organisation get the information to enable them to take proper decisions eg. on
the basis of financial statements, the shareholders may decide whether to retain the investment
in the company or not or the prospective shareholders may decide whether to invest in the
shares of the company or not. On basis of financial statements, the creditors of an organisation
may decide whether to continue extending the credit or not, and if yes to what extent. On the
basis of financial statements, the employees may base their demands for additional wages or
various benefits i.e. the employees demands will definitely carry weight if the organisation is
having good profitability. It is on the basis of financial statements that the banks and/or financial
institutions appraise the applications made by the organisations for the grant of or renewal of or
continuance of credit facilities, as the financial statements give a good indication about the
performance and financial condition of an organisation. The financial statements may be used
by the various agencies like Government or Reserve Bank of India, to formulate certain policy
decisions. The financial statements may be used by the various tax authorities to ascertain the
tax liability of the organisation in various areas like Income Tax, Sales Tax etc. Last but not
least, on the basis of financial statements the management may review the progress of the
organisation and decide about the course of action to be taken in future. However, it may be
stated that the financial statements may not be really available to the management as a tool for
decision making due to the various limitations attached to the same. Nevertheless, their basic
role in the decision making process is undeniable. Thus, it is by way of the financial statements
that an organisation speaks to the various persons dealing with it and gives the report to them
about the performance and financial position of itself. It may not be out of place to mention here
that if the accounts are required to be audited as per any of the statutory requirements (like
provisions of Companies Act, 1956 or Income Tax Act, 1961) the financial statements prepared
therefrom may be treated as more credible by the readers.
40
Limitations of Financial Statements :

(1)
Financial statements are available only after the specific period of time is over e.g. the
Balance Sheet as on 31st March, 1990 is available only after 31st March, 1990 is over.
The various legal provisions also provide for sufficient time lag for the preparation of
financial statements. Thus, the financial statements give the information about the historic
facts which may not be sufficient from decision making point of view for the management.
(2)
Financial statements are necessarily interim reports and cannot be final ones. E.g. to
understand the correct profitability and to understand the correct position of various
assets and liabilities, it will be necessary to stop the business operations and dispose
off all the assets and liquidate all the liabilities which may not be practicable and feasible.
In order to prepare the financial statements for a specific period, it may be necessary to
cut off various transactions involving costs and incomes at the date of closing the accounts
which may involve the personal judgements. Various policies and principles are required
to be formulated and followed consistently for such cutting off of incomes and costs.
(3)
As going concern principle is followed while preparing the Balance Sheet, the various
assets and liabilities are shown at historical prices and do not necessarily represent the
current market prices or the liquidation prices. This may affect the profitability statement
as well in the form of incorrect provision for depreciation. This problem may be more
critical during the periods of extreme inflation or depression. As such, any conclusions
drawn on the basis of such financial statements may be misleading ones.
(4)
Financial statements consider only those transactions which can be expressed in

monetary terms. All other transactions or factors which cannot be expressed in terms of
money are ignored by the financial statements. E.g. Assuming that the business of a
company is such that it is likely to be injurious to the health of local community. As
such, there is a strong opposition from the local community for the companys carring on
of business at that location. This opposition is something which cannot be expressed in
terms of money and hence finds no place in the financial statements though it is affecting
the business operations of the company to a very great extent.
(5)
The financial statements prepared may be useful for the use of normal users under
normal circumstances. If a user wants to use the financial statements for some special
purposes, the necessary information or details may not be available from the financial
statements. E.g. If a user, on the basis of financial statements available wants to value
the equity shares of the company with the methods considering earnings capacity of the
company, the required details may not be available from the financial statements. Similarly,
the financial statements may not give correct indications about the profitability or the
financial conditions of the business under abnormal circumstances. E.g. Suppose that
the production and sales of a company in a particular year are abnormally high due to
41
the prolonged strike in one of the major competitor companies, and hence profits in that
particular year are abnormally high. Now when both the sales and profits are at normal
level, the performance of that year may be treated as bad as compared to abnormal year.
(6)
Financial statements, howsoever carefully and correctly prepared, do not mean anything
all by themselves unless the information stated therein is properly studied, analysed and
interpreted. As such, merely the preparation of financial statements is not sufficient,
equally important is the task of their analysis and interpretation.
ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

As stated earlier the financial statements are not useful unless they are properly analysed
and interpreted. The process of analysis of financial statements involves the arrangement and
rearrangement, grouping and regrouping of the financial and operational data appearing on the
financial statements, and the calculations of ratios and trends therefrom. The process of
interpretation follows that of analysis and involves the attempts to arrive at logical conclusions
regarding the performance and financial position of the business organisation.
Types of Analysis :
There can be basically two ways in which the analysis of financial statements can be carried
out.
(1)
Internal Analysis :
This indicates the analysis carried out by those parties who have the access to the
books and records of the company. Naturally, it indicates basically the analysis carried
out by the management of the company to enable the decision making process. This
may also indicate the analysis carried out in the legal or statutory matters where the
parties who are not a part of the management of the company may have the access to
the books and records of the company.
(2)
External Analysis :
This indicates the analysis carried out by those parties who do not have the access to
the books and records of the company. This may involve the analysis carried out by
creditors, prospective investors and other outsiders. Naturally, those outsiders are required
to depend upon the published financial statements. As such, the depth and correctness
of the external analysis is restricted, though some of the recent amendments to the
statutes like Companies Act, 1956 have made it mandatory for the companies to reveal
maximum information relating to the operations and financial position, in order to facilitate
the correct and proper analysis and interpretation of the financial statements by the
readers.
42
Techniques of Analysis and Interpretation :

Though there may be numerous techniques available for the analysis and interpretation of
financial statements, we will consider the following two techniques in details.
(a)
Ratio Analysis
(b)
Funds Flow/Cash Flow Analysis.
43
NOTES
44
Chapter 4
INTERPRETATION OF FINANCIAL
STATEMENTS (RATIO ANALYSIS)
INTRODUCTION
Generally, an absolute figure conveys no meaning. A figure may become meaningful if it is
compared with some other information. Similarly, the absolute figures appearing on the financial
statements, either the profitability statement or the balance sheet, may not give the qualitative
indication regarding the financial position or performance of an organisation which may be
available if the accounting figures appearing in the financial statements can be compared with
each other. E.g., If the profitabilty statement discloses the amount of Rs. 1 Lakh as the net
profit, it appears to be a good performance. But if this information is supported by the fact that
the sales turnover during the corresponding period was Rs. 10 crores. It can be immediately
concluded that the performance of the organisation is not all that fabulous, as the net profit as
a percentage of sales turnover is only 0.1%. The comparison of profit on one hand and sales
turnover on the other hand, gives a qualitative indication about the performance of the
organisation. Here comes into the picture the technique of Ratio Analysis.
The term ratio implies arithmetical relationship between two related figures. The technique of
Ratio Analysis as technique for interpretation of financial statements deals with computation
of various ratios, by grouping or regrouping the various figures and/or informations appearing
on the financial statments (either profitablity statement or Balance sheet or both) with the
intention to draw the fruitful conclusions therefrom.
It should be remembered that ratios, depending on the nature of ratio, may be expressed in
either of the following ways :
(a)
Percentage e.g., Net Profit as 10% of Sales.
(b)
Fractions e.g., Retained Earnings as 1/3rd of Share Capital.
(c)
Stated comparison between numbers e.g., Current Assets as twice the Current Liabilities.
45
INTERPRETATION OF RATIOS
The ratios calculated on the basis of grouping and regrouping of the figures appearing on
either profitability statement or Balance Sheet or both, may not all by themselves mean
anything, unless they can be compared with some yardstick. The yardstick with which the
ratios can be compared may be in following three forms :
1)
The ratios of one organisation may be compared with the ratios of the same organisation
for the various years, either the previous years or the future years. This may be in the
form of intra-firm comparison.
2)
The ratios of one organisation may be compared with the ratios of other organisations in
the same industry and such comparison will be meaningful as the various organisations
in the same industry may be facing similar kinds of financial problems. This may be in
the form of inter-firm comparison.
3)
The ratios of an organisation may be compared with some standards which may be supposed
to be thumb rule for the evaluation of the performance e.g., If the comparison of current
assets and current liabilities of an organisation is to be made, the resutl of 2 : 1 i.e., two
rupees of current assets for one rupee of current liabilities is supposed to be ideal. The
position as reflected by the actual current assests and actual current liabilities may be
compared with this standard to evaluate the performance of the organisation.
ROLE OF RATIO ANALYSIS

It is true that the technique of Ratio Analysis is not a creative technique in the sense that it
uses the same figures and information which is already appearing in the financial statements.
At the same time, it is also true that what can be achieved by the technique of Ratio Analysis
cannot be achieved by the mere preparation of financial statements.
Ratio Analysis helps to appraise the firms in term of their profitablity and efficiency of
performance, either individually or in relation to those of other firms in the same industry. The
process of this appraisal is not complete until the ratios so computed can be compared with
something, as the ratios all by themselves do not mean anything. This comparison may be
the intra-firm comparison, inter-firm comparison or comparison with standard ratios. Thus,
proper comparison of ratios may reveal where a firm is placed as compared with earlier periods
or in comparison with other firms in the same industry.
Ratio Analysis is one of the best possible techniques available to the management to impart
the basic functions like planning and control. As the future is closely related to the immediate
past, ratios calculated on the basis of historical financial statements may be of good assistance
to predict the future. E.g., On the basis of inventory turnover ratio or debtors turnover ratio in
the past, the level of inventory and debtors can easily be ascertained for any given amount of
46
sales. Similarly, the ratio analysis may be able to locate and point out the various areas which
need the managements attention in order to improve the situation. E.g., Current Ratio which
shows a constant declining trend may indicate the need for the further introduction of long
term finance in order to improve the liquidity position. It should be remembered that a few
specific ratios indicate certain specific aspects of the conduct of business. As such, the
importance of various ratios may vary for different catagory of persons as well. E.g., the
commercial bankers, trade creditors and lenders of short term credit are basically interested
in the liquidity position of the organisation and as such the ratios like current ratio, acid test
ratio, inventory turnover ratio and average collection period are more important. On the other
hands, the financial institutions and lenders of long-term finance are basically interested in
the solvency and profitabilty position of the organisation and as such the ratios like debt
equity ratio, debt service coverage ratio, interest coverage ratio and return on investment are
more important.
As the ratio analysis is concerned with all the aspects of a firms financial analysis i.e.,
liquidity, solvency, activity, profitability and overall performance, it enables the interested persons
to know the financial and operational characteristics of an organisation and take the suitable
decisions.
CLASSIFICATIONS OF RATIOS :
The ratios may be classified under various ways which may use various criterians to do the
same. However, for convenience purposes, we will classify the ratios under the following
groups.
(A)
(a)
Liquidity Group.
(d)
Profitability Group
(b)
Turnover Group.
(e)
Overall Profitability Group.
(c)
Solvency Group.
(f)
Miscellaneous Group.
LIQUIDITY GROUP
The ratios computed under this group indicate the short term position of the organisation and
also indicate the efficiency with which the working capital is being used. Commercial banks
and short term creditors may be basically interested in the ratios under this group. Two most
important ratios may be calculated under this group.
47
(1)
Current Ratio :
It is calculated as :
Current Assets
Current Liabilities
Components :
Current Assets include cash in hand or at bank, marketable securities, sundry debtors, bills
receivables, inventories, prepaid expenses and short term loans and advances
Current liabilities include sundry creditors, bills payable, outstanding expenses and bank
overdraft or cash credit.
Following propositions should be considered.
(i)
Disagreement may be there for inclusion of bank overdraft or cash credit in current
liabilities. Strictly speaking, in legal terminology, cash credit or overdraft facilities are the
demand facilities i.e., Banks can ask for repayment at any time. However, in practice,
these facilities are usually permanent facilities. Hence, it may be argued that they should
be considered as non current liabilities. However, considering the legal implications of
the same, it is better to treat them as current liabilities.
(ii)
If bills receivables raised by the organisation are discounted with the Bank, they cease
to appear as the receivables in the Balance Sheet except by way of the note to the
same. At the same time, they indicate the working capital facility granted by the Bank to
that extent. For the purpose of correct computation of current ratio, the amount of bills
discounted with Banks should be added to both current assets as well as current liabilities.
Indication/Precautions :
Current ratio indicates the backing available to current liabilities in the form of current assets.
In other words, a higher current ratio indicates that there are sufficient assets available with
the organisation which can be converted in the form of cash, without any reduction in value, in
a short span of time i.e., current assets, to pay off the liabilities which are to be paid off in the
short span of time, i.e. current liabilities. As such, higher the current ratio, better will be the
situation. A current ratio of 2:1 is supposed to be standard and ideal. However, a blind comparison
of actual current ratio with the standard current ratio, may lead to unrealistic conclusions. As
such, before drawing the conclusion that higher current ratio indicates safe situation, following
propositions should be kept in mind.
1)
48
It should be ensured that the valuation of current assets and current liabilities is made on
a consistant basis and as per the accepted accounting principles.
2)
It should be ensured that the current assets do not include the inventories which are
obsolete or non moving and the receivables do not include debts which are outstanding
for a very long time and are not provided for which may be almost non recoverable. If the
current assets include these types of assets, for correct computation of current ratio,
they may be excluded form current assets.
3)
If current ratio is computed on the basis of Balance Sheet figures, abnormal purchases
of inventories or abnormal creation of receivables towards the end of accounting period
should be considered in the right perspective.
4)
A higher current ratio indicate unnecessarily high investment in current assets in the
form of inventories or receivables or both.
(2)
Liquid Ratio or Acid Test Ratio or Quick Ratio

It is an improved version of current ratio.
Liquid Assets
Liquid Liabilities
Components :
Liquid Assets include all current assets except inventories and prepaid expenses.
Liquid Liabilities include all current liabilities except bank overdraft or cash credit.
Indications/Precautions :
Liquid ratio indicates the backing available to liquid liabilities in the form of liquid assets. The
term liquid assets indicates the assets which can be converted in the form of cash, without
any reduction in value, almost immediately whereas, the term liquid liabilities indicates the
liabilities which are required to be paid almost immediately. In other words, a higher liquid ratio
indicates that there are sufficient assets available with the organisation which can be converted
in the form of cash almost immediately to pay off those liabilities which are to be paid off
almost immediately. As such, higher the liquid ratio, better will be situation. A liquid ratio of
1:1 is supposed to be standard and ideal.
Before drawing any conclusions regarding the indications given by the liquid ratio, following
propositions should be kept in mind:
1)
Liquid assets exclude the current assets in the form of inventories and prepaid expenses,
but include the current assets in the form of receivables. Whereas the exclusion of
49
prepaid expenses cannot be argued upon as they indicate the assets which cannot be
converted in cash, the exclusion of inventories and inclusion of receivables may be
challenged. There may be some kinds of inventories which can be disposed off almost
immediately, due to their specific nature, and thus may be treated as liquid assets. At
the same time, there may be some receivables outstanding for a very long time and not
provided for, which may be almost non-recoverable and thus ideally will not be in the form
of liquid assets.
2)
(B)
Non consideration of bank overdraft or cash credit as liquid liability can hardly be challanged
as by its practical nature, it indicates the liability which is not required to be paid
immediately.
TURNOVER GROUP
The ratios computed under this group indicate the efficiency of the organisation to use the
various kinds of assets by converting them in the form of sales. As the assets can be basically
catagorised as Fixed Assets and Current Assets and as the current assets may further be
classified according to the individual components of current assets viz. inventory and receivables
(debtors) or as net current assets i.e., current assets less current liabilites viz., working
capital, under this group of classification of ratios, following ratios may be computed.
1)
Fixed Assets Turnover Ratio :

Net Sales
Fixed Assets.
Components :
Net sales include sales after returns if any, both cash as well as credit.
Fixed assets include net fixed assets i.e., fixed assets after providing for depreciation.
A high fixed assets turnover ratio indicates the capability of the organisation to achieve maximum
sales with the minimum investment in fixed assets. It indicates that the fixed assets are
turned over in the form of sales more number of times. As such, higher the fixed assets
turnover ratio, better will be the situation.
50
2)
Current Assets Turnover Ratio :

Net Sales
Current Assets
Components :
Net sales includes sales after returns if any, both cash as well as credit.
Current Assets include the assets like inventories, sundry debtors, bills receivables, cash in
hand or at bank, marketable securities, prepaid expenses and short term loans and advances.
A high current assets turnover ratio indicates the capability of the organisation to achieve
maximum sales with the minimum investment in current assets. It indiates that the current
assets are turned over in the form of sales more numer of times. As such, higher the current
assets turnover ratio, better will be the situation.
3)
Working Capital Turnover Ratio :

It is calculated as
Net sales
Working capital
Components :
Net sales include sales after returns if any, both cash as well as credit.
Working capital includes difference between current assets and current liabilities.
Indications/precautions :
A high working capital turnover ratio indicates the capability of the organisation to achieve
maximum sales with the minimum investment in working capital. It indicates that working
capital is turned over in the form of sales more number of times. As such, higher this ratio,
better will be the situation.
51
4)
Inventory/Stock Turnover Ratio :

It is Calculated as :
(a)
Cost of goods sold

Average inventory
Or
(b)
Net Sales
Average inventory
Or
(c)
Cost of goods sold

Closing inventory
Or
(d)
Net sales
Closing inventory
It can be seen from above that the inventory turnover ratio may be expressed in either of the
four ways as stated above though alternative a may be the best possible way to express
inventory turnover ratio. It is specifically due to the fact that other alternatives have certain
flaws as stated below :
(i)
Alternatives b and d consider the amount of sales as the numerator which includes the
amount of profits where as the denominator in the form of either average or closing
inventory is normally valued at costs (assuming market price is more.)
(ii)
Alternatives c and d consider closing inventory which ignores the possibility of certain
seasonal or abnormal purchases at the end of accounting period which may increase
the closing inventory. Alternative a does not have both the above stated limitations. As
numerator is in the form of cost of goods sold, it does not consider proft. As denominator
is in the form of average inventory, it considers possibility of seasonal or abnormal
purchases at the end of accounting period. Ideally, average inventory should be the
average of monthly inventory specifically when the size of inventories fluctuates
substantially during the year. As such, average inventory may be computed as Opening inventory + inventory at the end of every month
13
52
However, in many cases, for conveniance purposes, inventory may be computed as the average
of opening and closing inventory only.
A high inventory turnover ratio indicates that maximum sales turnover is achieved with the
minimum investment in inventory. As such, as a general rule, high inventory turnover ratio is
desirable. However, the high inventory turnover ratio should be viewed from some more angles.
Firstly, it may indicate that there is under investment in inventory whereby the organisation
may loose customer patronage if it is unable to maintain the delivery schedule. Secondly,
high inventory turnover ratio may not necessarily indicate profitable situation. An organisation,
in order to achieve a large sales volume, may sometimes sacrifice on profits, whereby a high
inventory ratio may not result into high amount of profits.
On the other hand, a low inventory turnover ratio may indicate over investment in inventory,
existence of excessive or obsolete/non moving inventory, improper inventory management,
accumulation of inventories at the year end in anticipation of increased prices or sales volume
in near future and so on.
There can be no standard inventory turnover ratio which may be considered to be ideal. It may
depend on nature of industry and marketing stragies followed by the organisation.
5)
Debtors Turnover Ratio :

Net Credit Sales
Closing Sundry Debtors
This ratio indicates the speed at which the sundry debtors are converted in the form of cash.
However, this intention is not correctly achieved by making the calculations in this way. As
such, this ratio is normally supported by the calculations of Average Collection Period, which
is calculated as below.
(a)
Calculation of daily sales :

Net Credit Sales
No. of working days
(b)
Calculation of average collection period :

Closing Sundry debtors
Daily sales.
53
Following propositions should be kept in mind.

1)
As the concept of sundry debtors does not come into the picture in case of cash sales,
while computing average collection period, only credit sales should be considered.
However, in practice, break up of cash sales and credit sales may not be available from
the published statement of accounts. Then the total sales may be considered for the
computation of this ratio.
2)
While considering the toal amount of debtors, the bill receivables should be considered
along with the debtors. Further, debtors not arising out of the regular sales transactions
should be excluded as far as possible E.g., Debtors for the sale of fixed assets.
3)
In some cases, while computing this ratio, average sundry debtors instead of only closing
sundry debtors may be considered.
4)
For the calculation of daily sales, it is customary to consider 360 days in a year instead
of 365 days in a year. In some cases, it is also argued that weightage should be given
to the holidays also when there are no busines transactions.
The average collection period as computed above should be compared with the normal credit
period extended to the customers. If the average collection period is more than normal credit
period allowed to the customers, it may indicate over investment in debtors which may be the
result of over-extension of credit period, liberalisation of credit terms, ineffective collection
procedures and so on.
However, before drawing the conclusions like this, the factor of distribution of sales throughout
the year should be considered carefully. In other words, if the credit sales are not evenly
distributed throughout the year, the result obtained from the computation of average collection
period may be misleading. E.g., Assume a situation, where the total sales amount to Rs.18
Lakhs out of which credit sales are Rs.3.60 Lakhs. The organisation rarely sells on credit
basis and the entire amount of credit sales were in the 11th month of the year, with the normal
credit period allowed of 60 days. As such, the entire amount of Rs. 3.60 Lakhs will be outstanding
at the year end in the form of Sundry debtors. The computation of average collection period
will be made as below :
(a)
Calculation of daily sales :

Net credit sales
No. of working days
=
Rs. 3,60,000
360
=
54
Rs. 1000/ per day

(b)
Calculation of average collection period :

Closing sundry debtors
Daily sales
=
Rs. 3,60,000
Rs. 1000
360 days.
The average collection period thus calculated may then be compared with the normal credit
period allowed to the customers i.e., 60 days and the conclusion may be drawn that there is
a lapse on the part of collection department to collect the dues in time which may be a
misleading one, as the outstanding sundry debtors represent the debts which are not yet due
for payment.
6)
Capital Turnover Ratio :

Sales
Capital Employed
Components :
The term in denominator i.e., capital employed indicates the long term funds supplied by
creditors and owners of the firms. As such, it can be computed in two ways.
(a)
Fixed Assets + Investments + Current Assets - Current Liabilities.
(b)
Share Capital + Reserves and Surplus + Long Term Liabilities.
This ratio indicates the efficiency of the organisation with which the capital employed is being
utilised. A high capital turnover ratio indicates the capability of the organisation to achieve
maximum sales with minimum amount of capital employed. It indicates that the capital
employed is turned over in the form of sales more number of times. As such higher the capital
turnover ratio, better will be the situation.
(C)
SOLVENCY GROUP
The ratios computed under this group indicate the long term financial prospects of the company.
The shareholders, debenture-holders and other lenders of long term finance/term loans may
be basically interested in the ratios falling under this group. Following ratios may be computed
under this group.
55
(1)
Debt Equity Ratio :

It may be calculated in two ways.
(a)
External Liabilities
Shareholders Funds
(b)
Long Term Liabilities

Shareholders Funds
Components :
As per expression a as stated above, the external liabilities include all types of liabilities viz.,
long term, short term or current.
The expression b as stated above, considers only long term liabilities which may be in the
form of debentures, term loans and deferred payment liabilities.
Shareholders funds in both the expressions consist of share capital plus reserves and surplus.
There are controversial views regarding the treatement of preference shares capital i.e., whether
the preference share capital should be treated as a part of debt or equity. No clear-cut principles
are available regarding the treatment of preference share capital. However, generally the following
type of treatment may be given.
In case of the redeemable preference share capital, it they are redeemable after the period of
12 years, they may be treated as a part of equity, assuming the period of 12 years to be a
sufficiently longer period of time. However, if the preference shares are redeemable before the
period of 12 years, they may be treated as a part debt.
It should be noted that the treatment given to the preference share capital as described above
is only a matter of convention and practice, and not of any principle.
Debt Equity ratio indicates the stake of shareholders or owners in the organisation vis-a-vis
that of the creditors. It indicates the cushion available to the creditors on liquidation of the
organisations. A high debt equity ratio may indicate that the financial stake of the creditors is
more than that of the owners. A very high debt equity ratio may make the proposition of
investment in the organisation a risky one. On the other hand, a very low debt equity ratio may
mean that the borrowing capacity of the organisation is being underutilised. In this context,
the readers of financial management may remember that to borrow the funds form outsiders is
one of the best possible ways to increase the earnings available to the equity shareholders,
basically due to two reasons. Firstly, the expectations of the creditors in the form of return on
56
their investment is comparatively less as compared to the returns expected by the equity
shareholders. Secondly, the return on investment paid to the creditors is a tax deductible
expenditure.
(2)
Proprietory Ratio :
This ratio indicates the relationship between the owners funds and total assets. As the assets
can be basically fixed or current, this ratio can be further analysed accordingly. As such, it
can be calculated as :
(a)
Total Assets
Owners funds
(b)
Fixed Assests
Owners funds
(c)
Current Assets
Owners funds
Components :
The term in denominator i.e., owners funds is the same as the term Equity used in Debt
Equity Ratio.
This ratio indicates the extent to which the owners funds are sunk in different kinds of assets.
If the owners funds exceed fixed assets, it indicates that a part of owners funds is invested in
the current assets also. If the owners funds are less than fixed assets, it indicates that a part
of fixed assets is financed by the creditors-either long term or short term.
Similarly, the ratio between the current assets to the owners funds indicates the extent to
which owners funds are locked up in current assets. In some cases, higher proportion of
current assets to owners funds, as compared to proportion of fixed assets to owners funds
may be treated as a sign of good health of the business.
(3)
Fixed Assets/Capital Employed Ratio :

Fixed Assets
x 100
Capital Employed
57
Components :
The term in denominator i.e., capital employed indicates the long term funds supplied by
creditors and owners of the firm. As such, it can be computed in two ways.
(a)
(b)
This ratio indicates the extent to which the long term funds are sunk in fixed assets. It has
been an accepted principle of financial management that not only fixed assets should be
financed by way of long term funds but also a part of current assets or working capital should
be financed by way of long term funds, and this part may be in the form of permanent working
capital. A very high trend of this ratio may indicate that a major portion of long term funds is
utilised for the purpose of fixed assets leaving a small portion for the investment in current
assets or working capital. A very high trend of this ratio coupled with a constant declining
trend of current ratio may indicate an urgent need for the introduction of long term funds for
financing the working capital in the business.
(4)
Interest Coverage Ratio :

Profits before interest and taxes
Interest changes
Components :
The numerator considers the profits before interest on both term and working capital borrowings.
In this connection, it should be noted that income tax should be added while computing the
profits because, it is calculated after paying the interest.
The denominator considers the interest charges which are in the form of interest on long term
borrowing and not the interest on working capital facilities.
Indications/Limitations :
This ratio indicates the protection available to the lenders of long term capital in the form of
funds available to pay the interest charges i.e., profits. Normally a high ratio will be desirable
but too high a ratio may indicate under-utilisation of the borrowing capacity of the organisation,
whereas too low a ratio may indicate excessive long term borrowings or inefficient operations.
58
This ratio suffers from certain limitations.
(5)
(a)
The fixed obligations in the form of preference dividend or instalments of long term
borrowings are not considered.
(b)
The funds available for meeting the obligations of interest payments may not be
necessarily in the form of profits before interest and taxes only, as the amount of
profits so calculated may consider the amount of depreciation debited to profit and
loss account which does not involve any outflow of funds.
Debt Service Coverage Ratio (DSCR) :
This may be considered to be one of the most important ratios calculated by the Bankers or
Financial Institutions giving long term finance to the organisation and the intention behind
calculating this ratio is to ascertain the capability of the organisation to repay the dues arising
as a result of long term borrowings.
Net profit after taxes + Depreciation + Interest on Term Loans
Interest on Term Loans + Installments of Term Loans
Considering the intention of computing this ratio is to give indication about the capability of the
organisation to meet the obligations of long term borrowing, the Banker or Financial Institutions
will like to get this indication before the money is lent to the organisation. As such, this ratio
calculated on estimated basis is considered by the Bankers or Financial Institutions before
granting the term finance to the borrowing organisations. Too low a DSCR Indicates insufficient
earning capacity of the organisations to meet the obligations of long term borrowings. At the
same time, if too high a DSCR is estimated during the currency of the long term borrowings,
it is quite likely that the period of term loan may be reduced from whatever is requested by the
borrowing organisation.
(D)
PROFITABILITY GROUP :
As the name itself suggests, the intention for calculating these ratios is to know the profitability
of the organisation. Following ratios may be computed under this group.
59
(1)
Gross Profit Ratio :

Gross Profit
x 100
Net Sales
Components :
The net sales consist of sales after deducting the sales returns if any.
The gross profit indicates the difference between net sales on one hand and either of the
following on the other hand.
(a)
Manufacturing cost or factory cost or production cost in the case of manufacturing

concerns.
(b)
Cost of purchases, expenses directly related to purchases and the adjustments for
stock variations if any, in cases of trading concerns.
Indications/Precautious :
The Gross Profit ratio indicates the relation between production cost and sales and the efficiency
with which the goods are produced or purchased. A high gross profit ratio may indicate that the
organisation is able to produce or purchase at a relatively lower cost. As such, a high gross profit
ratio will be desirable. Gross profit ratio may be increased by any of the following methods :
(a)
Increase sales price, production cost remaining the same.
(b)
Reduce production cost, sales price remaining the same.
(c)
Increase sales price, reduce production cost.
(d)
Increase volume of products having high gross profit margin.
An undue increase in gross profit ratio as well as an undue decrease in gross profit ratio
should be carefully investigated.
Undue increase in gross profit ratio may indicate :
(i)
Over-valuation of closing stock.
(ii)
Non-consideration of purchase invoices.
(iii) Consideration of non-sales transactions as sales transactions E.g., Goods sent on

consignment basis.
60
Undue decrease in gross profit ratio may indicate

(i)
Under-valuation of closing Stock
(ii)
Non-consideration of sales invoices.
(iii) Inability of management to control the cost or increase the sales.

(iv)
Improper utilisation of infrastuctural facilities.
(2)
Net Profit Ratio :

Net Profit after taxes
x 100
Net sales
The Net Profit Ratio indicates that portion of sales available to the owners after the consideration
of all types of expenses and costs either operating or non-operating or normal or abnormal.
A high net profit ratio indicates higher profitabliity of the business. As such a high net profit
ratio will be desirable.
(3)
Operating ratio :
It is calculated as
Manufacturing cost of goods sold + Operating Expenses
x 100
Net Sales
Components :
The numerator includes the various operating cost which a business has to incure in order to
earn the profits. Following types of non-operating expenses are excluded from the numerator
viz., Interest, Dividend (On equity as well as preference shares), loss on the sale and assets/
investments,
This ratio indicates the percentage of net sales which is absorbed by the operating costs. A
high operating ratio indicates that only a small margin of sales is available to meet the expenses
in the form of interest, dividend and other non operating expenses. As such, a low operating
ratio will always be desirable. It can be used to measure the profitabliity only to a limited
61
extent as the net profits available to the owners will be considering the non operating expenses
as well as non operating income.
(e)
Overall Profitability Group :
The ratios computed under this group indicate the relationship between the profits of a firm
and investment in the firm. These ratios are popularly termed as Return On Investment (ROI).
There can be three ways in which the term investment may be interpreted i.e., Assets,
Capital employed and Shareholders Funds. As such, there can be three broad classification
of ROI.
(1)
(1)
Return On Assets (ROA)
(2)
Return On Capital Employed (ROCE)
(3)
Return On Shareholders Funds.
Return On Asset (ROA) :

Net Profit
x 100
Assets
Components :
There can be basically two ways in which the term net profit may be treated. Sometimes, net
profit may be taken to mean net profit after taxes or sometimes it may be taken to mean net
profit after taxes plus interest.
Similarly, the term assets may also be treated in two ways. Sometimes assets may mean
fixed assets or sometimes they may indicate tangible assets.
ROA measures the profitability of the investments in a firm. As such, higher ROA will always
be preferred. However, ROA does not indicate the profitability of various sources of funds
which finance total assets.
(2)
Return On Capital Employed (ROCE) :
Net Profit + Interest on Long Term Sources
x 100
Capital Employed
62
Components :
There can be basically two ways in which the term net profit may be treated. Sometimes, net
profit may be taken to mean net profit after taxes or sometimes it may be taken to mean net
profit after taxes plus interest. The term capital employed refers to long term funds supplied
by creditors and owners of the firm. As such, the term capital employed can be computed in
two ways.
(a)
(b)
ROCE measures the profitabliity of the capital employed in the business. A high ROCE
indicates a better and profitable use of long term funds of owners and creditors. As such, a
high ROCE will always be preferred.
(3)
Return on Shareholders Funds :
This ratio indicates the profitablity of a firm in relation to the funds supplied by the shareholders
or owners. As the shareholders can be of two broad types i.e., Equity Shareholders and
Preference Shareholders, this ratio can be computed basically in two ways.
(a)
Net Profit after taxes

x 100
Total shareholders funds
Components :
The numerator considers the net profit after taxes before the preference dividend.
The denominator considers the equity capital, preference capital and reserves and surplus.
(b)
Net Profit after taxes preference dividend

x 100
Shareholders Funds
Components :
The numerator considers net profit after taxes as well as preference dividend as that is the
amount which is available to the equity shareholders for the distribution by way of dividend.
The denominators considers the equity capital and reserves and surplus.
63
This is the most important ratio to measure whether the firm has earned sufficient returns for
its shareholders or not. As such, this ratio is the most crucial one from the owners/shareholders
point of view. Higher this ratio, better will be the situation.
(E)
(1)
MISCELLANEOUS GROUP
Capital Gearing Ratio :
Fixed Income Bearing Securities
Equity Capital
Components :
Fixed income bearing securities consist of preference share capital, debentures and long
term loans.
Interpretation :
A high capital gearing ratio indicates that in the capital structure, fixed income bearing securities
are more in comparison to the equity capital and in that case the company is said to be highly
geared. On the other hand, if fixed income bearing securities are less as compared to equity
capital, the company is said to be lowly geared.
It may be worth recalling here that a company may attempt to employ the fixed income
bearing securities in the overall capital structure with the intention to increase the equity
shareholders earnings. As such, a high capital gearing ratio, to a certain extent, may be
advantageous from the equity shareholders point of view. But if it is too high, investment in the
company may become risky and further borrowing may not be possible for the company.
Further, if the income of the company is unstable, a high capital gearing ratio may prove to be
fatal, especially in the years of reducing income when a major portion of the income will be
utilised to meet the obligations towards the fixed income bearing securities.
(2)
Earnings Per Share (EPS) :

Net Profit after taxes - Preference Dividend
Number of Equity Shares Outstanding
64
It is widely used ratio to measure the profits available to the equity shareholders on a per
share basis. EPS is calculated on the basis of current profit and not on the basis of retained
profits. As such, increasing EPS may indicate the increasing trend of current profits per
equity share. However, EPS does not indicate how much of the earnings are paid to the owers
by way of dividend and how much of the earnings are retained in the business.
(3)
Price Earnings Ratio (P/E Ratio) :

Market Price Per Share
Earning Per Share
P/E Ratio indicates the price currently being paid in the market for each rupee of EPS. It
measures the expectation of the investors. A high P/E Ratio may indicate the possiblity of
increase in EPS. A low P/E Ratio may indicate that there is no possiblity of any increase in
EPS and the investors will be reluctant to invest in such shares.
This ratio is important from investors point of view. An ideal investor will compare between the
current market price and future EPS as the value of shares depend upon the future EPS also.
(4)
Dividend Payment Ratio (D/P Ratio) :

Dividend Per Share
x 100
Earnings Per Share
It measures the relationship between the earnings belonging to the equity shareholders and
the amount finally paid to them by way of dividend. It indicates the policy of management to
pay cash dividend. D/P Ratio when subtracted from 100, gives the indications about the policy
of the management to retain the profits in the business with the intention to reinvest the same
which is likely to have an effect on future market price of the share.
LIMITATIONS OF RATIO ANALYSIS
(1)
The basic limitation of the technique of ratio analysis is that it may be difficult to find a
basis for making the comparisons. In case of the intrafirm comparison, the performance
65
of an organisation may vary widely from year to year. In case of the interfirm comparison,
it may become invalid due to various reasons.
66
(i)
The ratios of other organisations in the same industry may not be readily available.
(ii)
The constituent organisations in the same industry may vary from each other in
terms of age, location, extent of automation, quality of the management and so on.
(iii)
Different accounting policies may be followed by the constituent organisations in

the industry. The accounting policies may be different in the areas of valuation of
inventories, provision for depreciation etc.
(2)
Normally, the ratios are calculated on the basis of historical financial statements. An
organisation, for the purpose of proper decision making, may need the hint regarding the
future happenings rather than transactions in the past. The managment of the organisation
may predict the future to some extent on the basis of facts and figures available to it, but
the external analyst has to depend upon the past which may not necessarily reflect
financial position and performance in future.
(3)
The technique of ratio analysis may prove to be inadequate in some situations if there is
difference of opinion regarding the interpretation of certain items while computing certain
ratios E.g., In case of the computation of debt-equity ratio, the opinions may differ as to
the treatment of preference share capital. Some may treat this as a part of debt while the
others may treat this as part of equity.
(4)
As the ratios are computed on the basis of financial statements, the basis limitation
which is applicable to the financial statements is equally applicable in case of the
technique of ratio analysis. Also i.e., Only those facts which can be expressed in financial
terms are considerd by the ratio analysis. E.g., The computation of debt equity ratio of
an organisation may show a favourable trend thereby justifying the additional borrowings
which the organisation may want to make. However, if the attitude of the management is
not to meet the outside obligations in time, the lender of the finance may be misled by
the computation of debt equity ratio.
(5)
The technique of ratio analysis has certain limitations of use in the sense that, it only
highlights the strong or problem areas. It does not provide any solution to rectify the
problem areas. Moreover, the technique of ratio analysis may indicate the strong or
problem areas and that too only partially. For the correct and comprehensive analysis of
the situations, it is necessary to investigate further in those strong or problem areas.
E.g. A very high current ratio may not necessarily indicate good situation. Further
investigations are required to be made to ensure that there are no obsolete or non moving
items of stock included in the closing stock or that there are no debts included in sundry
debtors, which are outstanding for an unreasonable period of time and which may ideally
be treated as bad debts.
(6)
Ratio Analysis often gives a misleading indication if the effect of changes in price levels
is not taken into account. Two different companies set up in different years and as such,
having the infrastructural facilities of different ages cannot be compared on the basis of
financial statements only. This is so, as the company which has purchased the
infrastructural facilities years ago may be showing their value at a very lower amount
while the other company might have purchased the same facilities at a very higher price.
Precautions to be taken :
Considering the various limitations in respect of ratio analysis, following precautions should
be taken before using it as a technique for interpretation of financial statements.
(1)
Ratios are computed on the basis of financial statements. If the statements are reliable,
then only the ratios computed therefrom will be meaningful. As such, before using the
ratio analysis, the reliability of the financial statements should be confirmed.
(2)
Ratio should be computed on the basis of inter-related figures which have a cause and
effect relationship. Computation of ratios on the basis of irrelevant figures may even lead
to wrong conclusions. Eg. Ratio between sales and trade investments.
(3)
It should always be remembered that ratios only show symptoms and the indications
given by the ratios can be interpreted correctly only after studying the realities behind
the financial statements. Eg. A high current ratio should be treated as a good sign only
after confirming the fact that there are no non-moving or obsolete stocks or non-recoverable
debtors.
(4)
If possible, the impact of the inflationary conditions or changing price levels should be
taken into account before computing the ratios. This may be done by using the technique
of current purchasing power or current cost accounting.
(5)
In case of inter-firm comparison of ratios, following propositions should be kept in mind.

(a)
The constituent units should be comparable in terms of size, age, nature of business,
degree of automation etc.
(b)
The constituent units must be following similar accounting policies more particularly
in the areas of charging the depreciation and stock valuation.
(c)
There should not be any holding back of any information or data by the constituent
units.
67
ILLUSTRATIVE PROBLEMS
(1)
The current assets and current liabilities of your company as at 30.6.79 were Rs. 16
lakhs and Rs. 8 lakhs respectively. Calculate the effect of each of the following transactions
individually and totally on the current ratio of the company :
(i)
Purchase of new machinery for Rs. 5 lakhs on C.O.D.
(ii)
Purchase of new machinery for Rs. 10 lakhs on a Medium Term loan from your
bank with 20% margin.
(iii)
Payment of dividend of Rs. 2 lakhs of which Rs. 0.47 lakhs was Tax deducted at
source.
(iv)
A shipment of raw materials of landed cost Rs.5 lakhs was received against which
the Bank finance obtained was Rs. 3 lakhs.
SOLUTION :
Current Assets
Present Current Ratio
=
Current Liabilities
Rs. 16 Lakhs
=
2:1
Rs. 8 Lakhs
Transaction 1
Purchase of new machinery on Cash on Delivery (COD) basis, will result into increase in the
debit balance of Machinery A/c (a non-current asset) and reduction in cash balance (a current
asset.) As such, as a result of this transaction, the cash balance and hence current assets
will be reduced by Rs.5 Lakhs, current liabilities remaining unaffected. Hence, the revised
current ratio will be :
Rs. 16 Lakhs - Rs. 5 Lakhs
Rs. 11 Lakhs
=
Rs. 8 Lakhs.
= 1.375 : 1.00
Rs. 8 Lakhs.
Transaction 2
Purchase of new machinery for Rs. 10 Lakhs on a Medium Term loan with 20% margin
indicates that the debit balance of Machinery A/C (a non-current asset) will increase by
Rs. 10 Lakhs and the liability in the form of medium term loan (a non-current liability, ignoring
the fact that the installments of loans due within one year may be treated as a part of current
liabilities) will be increased to the extent of Rs. 8 Lakhs and the cash balance will be reduced
68
to the extent of Rs.2 Lakhs (assuming that the margin money is paid immediately). As such,
this transaction will affect current ratio only in one way i.e. reducing the cash balance by
Rs. 2 Lakhs, current liabilities remaining unaffected. Hence, the revised current ratio will be :
Rs. 14 Lakhs
=
= 1.75 : 1.00
Rs. 8 Lakhs
Rs. 8 Lakhs
Transaction 3
The effect of payment of dividend of Rs.2 Lakhs of which Rs. 0.47 Lakhs was tax deducted at
source, can be viewed basically from two angles.
(a)
Assuming that the tax deducted at source is duly paid to the credit of Central Government,
the effective outflow of cash will be Rs.2 Lakhs which will reduce the cash balance (a
current asset), current liabilities remaining unaffected. Hence, the revised current ratio
will be :
Rs. 14 Lakhs
=
= 1.75 : 1.00
Rs. 8 Lakhs
(b)
Rs. 8 Lakhs
Assuming that the tax deducted at source is yet to be paid to the credit of Central
Government, the cash balance (a current asset) will be reduced to the extent of net
payment of dividend i.e. Rs. 1.53 Lakhs, while the current liabililities will be increased by
Rs. 0.47 Lakhs. Hence, the revised current ratio will be :
Rs. 16 Lakhs - Rs. 1.53 Lakhs
Rs. 14.47 Lakhs

=
Rs. 8 Lakhs + Rs. 0.47 Lakhs
1.708 : 1.00
Rs. 8.47 Lakhs
Transaction 4
A shipment of raw material of landed cost Rs. 5 Lakhs received against which the Bank
finance obtained is Rs.3 Lakhs, will affect the current ratio in three ways. Assuming that the
stock so purchased is still not consumed, it will increase the stock in trade (a current asset)
by Rs. 5 Lakhs. The fact that bank finance was obtained to the extent of Rs.3 Lakhs indicates
that the balance of Rs. 2 Lakhs was paid by the company which will reduce the cash balance
(i.e. a current asset). At the same time, bank finance obtained for the purchase of material will
be a working capital facility (i.e. a current liability) assuming that the bank finance is still
unpaid. Hence, the revised current ratio will be :
Rs. 16 Lakhs + Rs. 5 Lakhs - Rs. 2 Lakhs
Rs. 19 Lakhs
=
Rs. 8 Lakhs + Rs. 3 Lakhs

=
Rs. 11 Lakhs
1.727 : 1.00
69
Combined effect of all transactions :

Considering all the transactions together, the current ratio will be affected as below :
(a)
Assuming alternate a in case of Transaction 3

Rs. 16 Lakhs - Rs. 5 Lakhs (1) - Rs. 2 Lakhs (2) - Rs. 2 Lakhs (3) + Rs. 5 Lakhs
(4) - Rs. 2 Lakhs (4)
Rs. 8 Lakhs + Rs. 3 Lakhs (4)
Rs. 10 Lakhs
=
= 0.909 : 1.00
Rs.11 Lakhs
(b)
Assuming alternate b in case of Transaction 3

Rs. 16 Lakhs - Rs. 5 Lakhs (1) - Rs. 2 Lakhs (2) - Rs. 1.53 Lakhs (3) + Rs. 5 Lakhs
(4) - Rs. 2 Lakhs (4)
Rs. 8 Lakhs + Rs. 0.47 Lakhs (3) + Rs. 3 Lakhs (4)
Rs. 10.47 Lakhs
=
0.913 : 1.00
Rs. 11.47 Lakhs

Note : Number in bracket indicates the transaction number.
70
(2)
The following are the figures extracted from the books of XYZ Limited as at 30-9-1977.
Particulars
Amount (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
Debt
9,00,000
Current Liabilities
6,00,000
Total Liabilities
30,00,000
Working Capital
9,60,000
Calculate : (a) Gross profit ratio; (b) Net Profit ratio; (c) Return on assets; (d) Inventory
turnover; (e) Working capital turnover and (f) Net worth to debt.
SOLUTION :
(1)
Gross Profit Ratio

Gross Profit
x 100
Sales
6,00,000
=
x 100
= 25%
24,00,000
71
(2)
Net Profit Ratio

Net Profit
x 100
Sales
3,60,000
=
x 100
15%
12%
24,00,000
(3)
Return on Assets
Net Profit
x 100
Total Assets
3,60,000
=
x 100
30,00,000
(4)
Inventory Turnover
Net sales
Inventory
24,00,000
=
= 3
8,00,000
(5)
Working Capital Turnover

Net sales
Working Capital
24,00,000
=
= 2.5
9,60,000
(6)
Net Worth to Debt

Net Worth
Debt
15,00,000
=
= 1:67:1:00
9,00,000
72
(3)
The following data are extracted from the published accounts of two companies in an
industry :
ABC Ltd.
XYZ Ltd.
Rs.
Rs.
32,00,000
30,00,000
1,23,000
1,58,000
10,00,000
8,00,000
General Reserves
2,32,000
6,42,000
Long term debt
8,00,000
6,60,000
Creditors
3,82,000
5,49,000
60,000
2,00,000
15,99,000
15,90,000
Inventories
3,31,000
8,09,000
Other Current Assets
5,44,000
4,52,000
Sales
Net Profit after tax
Equity Capital (Rs. 10 per share fully paid)
Bank Credit (short-term)

Fixed Assets
You are required to prepare a statement of comparative ratios showing liquidity, profitability,
activity and financial position of the two companies.
SOLUTION
(A)
LIQUIDITY GROUP
ABC Ltd.
(1)
XYZ Ltd.
Current Ratio
Current Assets
8,75,000
12,61,000
Current Liabilities
4,42,000
7,49,000
= 1.98
= 1.68
i.e. Inventories + Other Current Assets

Creditors + Bank Credit
73
(2)
Liquid Ratio
Liquid Assets
5,44,000
4,52,000
Liquid Liabilities
3,82,000
5,49,000
= 1.42
= 0.82
i.e. Other Current Assets

Creditors
(B)
(1)
PROFITABILITY GROUP
Net Profit Ratio
1,23,000
x 100
Sales
(2)
30,00,000
= 3.84%
= 5.27%
1,23,000
x 100
Equity Capital
(2)
+ 2,32,000
+ 6,42,000
= 9.98%
= 10.96%
Sales
32,00,000
30,00,000
Fixed Assets
15,99,000
15,90,000
= 2.00
= 1.89
32,00,000
30,00,000
8,75,000
12,61,000
= 3.66
= 2.38
32,00,000
30,00,000
3,31,000
8,09,000
= 9.67
= 3.71
ACTIVITY GROUP
Fixed Assets Turnover :
Current Assets Turnover
Inventories + Other Current Assets
Inventory Turnover
Sales
Inventories
74
x 100
8,00,000
Sales
(3)
1,58,000
x 100
10,00,000
+ General Reserves
(1)
x 100
32,00,000
Return on shareholders funds

(C)
1,58,000
x 100
(4)
Other Current Assets Turnover

Sales
32,00,000
30,00,000
5,44,000
4,52,000
= 5.88
= 6.64
Sales
32,00,000
30,00,000
Capital Employed i.e.
20,32,000
21,02,000
= 1.57
= 1.43
8,00,000
6,60,000
12,32,000
14,42,000
= 0.65
= 0.46
Total Assets
24,74,000
28,51,000
Owners Funds
12,32,000
14,42,000
= 2.00
= 1.98
Fixed Assets
15,99,000
15,90,000
Capital Employed
20,32,000
21,02,000
= 0.79
= 0.76
(5)
Capital Employed Turnover
Equity Capital + General

Reserves + Long Term Debt
(D)
(1)
FINANCIAL POSITION GROUP

Debt Equity Ratio
Debt
Equity
Long Term Debt
=
Equity Capital
+ General Reserves
(2)
Proprietory Ratio
Total Assets
=
Equity Capital
+ General Reserves
(3)
Fixed Assets/Capital Employed Ratio
75
4)
From the following information, draw the Balance Sheet of M/s. Ravi & Co. as on
31st March, 1993 :
Current Ratio
2:1
Liquid Ratio
1:1
Return on Capital Employed
10%
Fixed Assets Turnover Ratio
5:8
Closing Stock was 12.5% of sales

Owners Equity to Fixed Assets
8 : 15
ACP
1 Month
Debt Equity Ratio
5:4
For the year ended 31st March, 1993, M/s. Ravi & Co. made a profit of Rs. 1,00,000 after
paying interest of Rs. 1,20,000 on term loan but before tax. Tax paid for the year was
Rs. 40,000, Bank Balance stood at Rs. 1,00,000 besides stock and debtors of the concern.
Solution :
Balance Sheet as on 31st March, 1993
Liabilities
Rs.
Owners Equity
Debt
Assets
Rs.
8,00,000
Fixed Assets
15,00,000
10,00,000
Cash & Bank
1,00,000
Stock
3,00,000
Sundry Debtors
2,00,000
Current Liabilities
3,00,000
21,00,000
21,00,000
Working Notes :
Profit Before Tax
Rs. 1,00,000
Less : Tax
Rs. 40,000
Hence, Profit After Tax
Rs. 60,000
Return on Capital Employed is known as 10%

Hence, Profit After Tax + Interest
x 100 = 10
Capital Employed
76
As Interest is known as Rs. 1,20,000,

Profit After Tax + Interest = Rs. 1,80,000.
Hence, Capital Employed will be Rs. 18,00,000.
As Debt Equity Ratio is 5:4
Debt
5
=
Eqity
Hence, Debt = 1.25 Equity.

As Capital Employed is Rs. 18,00,000
Debt + Equity = Rs. 18,00,000
Replacing the value of Debt in the above equation we get,
1.25 Equity + Equity = 18,00,000
Hence, 2.25 Equity = 18,00,000
Hence, Equity = 8,00,000
Hence, Debt = 10,00,000
Owners Equity to Fixed Assets is 8 : 15
As Equity is known as Rs. 8,00,000, Fixed Assets = Rs. 15,00,000
As Fixed Assets Turnover Ratio is 5 : 8,
Sales/Fixed Assets = 5/8
As Fixed Assets are Rs. 15,00,000,
Sales = Rs. 24,00,000
Closing Stock is 12.5% of sales
As sales = Rs. 24,00,000, Closing Stock will be Rs. 3,00,000
ACP is 1 month
Assuming that all the sales are credit sales,
Debtors x 12
=1
Credit Sales
77
As Credit Sales are Rs. 24,00,000,

Debtors will be Rs. 2,00,000
Currnet Ratio is 2:1,
Hence, Current Assets/Current Liabilities = 2
Hence, Current Assets = 2 Current Liabilities
Liquid Ratio is 1:1,
It is assumed that there is no cash credit or overdraft.
Hence,
Current Assets Stock

=1
Current Liabilties
As stock is known as Rs. 3,00,000

2 Current Liabilities 3,00,000
=1
Current Liabilities
This leads us to the conclusion of Current Liabilties = Rs. 3,00,000
Current Assets = Rs. 6,00,000
5)
Complete the following statements on the basis of the ratios given below :
Profit & Loss Account for the year ended 30th June 90
Cost of goods sold
6,00,000
Operating expenses
EBIT
Sales
Debenture Interest
10,000
Income Tax
Net Profit
78
20,00,000
EBIT
Balance Sheet as on 30th June, 90

Liabilities
Rs.
Assets
Rs.
Share Capital
Fixed Assets
Reserves & Surplus
Cash
10% Debentures
Stock
Sundry Creditors
60,000
Debtors
35,000
Additional Information :
a.
Net Profit to sales
5%
b.
Current Ratio
1.5
c.
Return on Net Worth
20%
d.
Inventory Turnover
(based on cost of goods sold)
15 times
e.
Share Capital to Reserves
4:1
f.
Rate of Income Tax
50%
Solution :
Profit & Loss Account for the year ended 30th June, 90
Cost of goods sold
6,00,000
Operating expenses
11,90,000
EBIT
Sales
2,10,000
20,00,000
Debenture Interest
20,00,000
10,000
Income Tax
1,00,000
Net Profit
1,00,000
2,10,000
20,00,000
EBIT
2,10,000
2,10,000
79
Balance Sheet as on 30th June, 90

Liabilities
Rs.
Assets
Rs.
Share Capital
4,00,000
Fixed Assets
5,70,000
Reserves & Surplus
1,00,000
Cash
15,000
10% Debentures
1,00,000
Stock
40,000
Sundry Creditors
60,000
Debtors
35,000
6,60,000
6,60,000
Working Notes :
a.
Net Profit to Sales is 5%

As Sales are Rs. 20,00,000 (given), Net Profit is Rs. 1,00,000.
As the rate of Income Tax is 50%, Income Tax = Net Profit
Hence, Income Tax will be Rs. 1,00,000.
b.
Current Ratio is = 1.50

As Current Liabilities are Rs. 60,000.
Current Assets are Rs. 90,000
c.
Inventory Turnover Ratio is 15.

Hence, Cost of goods sold/Closing Stock = 15
As cost of goods sold is Rs. 6,00,000 (given),
Closing Stock will be Rs. 40,000.
d.
Out of the Total Current Assets of Rs. 90,000, Stock is Rs. 40,000 and the Debtors are
Rs. 35,000. Hence, Cash is Rs. 15,000.
e.
Return on Net Worth is 20%

Net Profit/Net Worth x 100 = 20
As Net Profit is Rs. 1,00,000 (as per a above),
Net Worth will be Rs. 5,00,000.
f.
Share Capital to Reserves is 4 : 1 and

Share Capital + Reserves i.e., Net Worth is Rs. 5,00,000,
Hence, Share Capital is Rs. 4,00,000 and Reserves are Rs. 1,00,000.
6)
80
Using the following data, complete the Balance sheet given below :
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 (to cost of sales)
8 times
ACP (360 days a year)
18 days
Current Ratio
1.6
Long Term Debt to Equity
40%
Balance Sheet
Liabilities
Rs.
Creditors
Cash
Long term Debt
Debtors
Inventory
Fixed Assets
Shareholders Equity
50,000
Assets
Rs.
Solution :
Balance Sheet
Liabilities
Rs.
Assets
Creditors
30,000
Cash
Long term Debt
20,000
Debtors
12,000
Shareholders Equity
50,000
Inventory
30,000
Fixed Assets
52,000
1,00,000
Rs.
6,000
1,00,000
Working Notes :
1.
Gross Profit (20% of Sales) is Rs. 60,000.

Hence, Total Sales are 60,000 x 100/20 i.e., Rs. 3,00,000......a
Hence, Cost of sales is Rs. 2,40,000 i.e., Rs. 3,00,000 Rs. 60,000....b
2.
Credit Sales to Total Sales are 80%

As total sales are Rs. 3,00,000, (as per a above)
Credit Sales will be 80% of Rs. 3,00,000 i.e., Rs. 2,40,000 . . . .c
3.
Total Assets Turnover is 3 times

Hence, Sales/Total Assets = 3
81
Hence, Sales/3 = Total Assets

As Sales are Rs. 3,00,000 (as per a above),
Hence, Total Assets will be Rs. 1,00,000 . . . . .d
Hence, Total Liabilties will be Rs. 1,00,000 . . . . e
4.
Inventory turnover (to Cost of Sales) is 8 times.

Hence, Cost of Sales/Inventory = 8
Hence, Cost of Sales/8 = Inventory
As Cost of Sales is Rs.2,40,000 (as per b above),
Inventory will be Rs. 30,000 . . . . . f
5.
Average Collection Period (360 days a year) is 18 days.

Hence, Debtors x 360/Credit Sales = 18 days
Hence, Credit Sales x 18/360 = Debtors
As Credit Sales are Rs. 2,40,000 (as per c above),
Debtors will be Rs. 12,000 . . . . .g
6.
Long Term Debt to Equity is 40%

However, Equity is Rs. 50,000 (given).
Hence, Long Term Debt will be Rs. 20,000 . . . . .h
7.
Total Liabilities are Rs. 1,00,000 (as per e above).

Hence, Creditors + Long Term Debt + Equity = 1,00,000
Hence, Creditors + 20,000 + 50,000 = 1,00,000
Hence, Creditors will be Rs. 30,000 . . . . . . i
8.
Current Ratio 1.6

Hence, Current Assets/Current Liabilities = 1.6
Hence, Current Assets = Creditors x 1.6
As creditors are Rs. 30,000 (as per i above),
Hence, Current Assets will be Rs. 48,000 . . . . j
9.
As Current Assets are Rs. 48,000 (as per j above)

Cash + Debtors + Inventory = 48,000
Hence, Cash + 12,000 + 30,000 = 48,000
Hence, Cash will be Rs. 6,000 . . . . .k
10. Total Assets are Rs. 1,00,000 (as per d above),

Hence, Current Assets + Fixed Assets = 1,00,000
Hence, 48,000 + Fixed Asssets = 1,00,000
Hence, Fixed Assets will be Rs. 52,000 . . . . . . .l
82
Balance Sheet as on 31st December 1983

Capital & Liabilities
Issued Capital
Reserves
Current Liabilities
Profit and Loss A/c
Rs.
Assets
Rs.
2,00,000
Land and Building
1,50,000
90,000
Plant & Machinery
80,000
1,30,000
60,000
Stock in trade
1,49,000
Sundry Debtors 75,000

Less : Provision
for doubtful
debts
4,000
71,000
Cash & Bank
balances
30,000
4,80,000
4,80,000
From the above statement, you are required to calculate the following ratios and state the
purpose they serve.
(1) Current ratio (2) Operating ratio, (3) Stock turnover, (4) Fixed assets turnover, (5) Return on
capital employed
4.
Following is the Balance Sheet of Adarsh Products Ltd., as at 31st December 1982.
Liabilities
Rs.
Equity Share of Rs. 100 each
4,00,000
Premium on shares
20,000
General Reserves
70,000
Profit and Loss A/c
12,500
Creditors
1,97,700
Proposed Dividend
20,000
27,000
Total
7,47,200
115
Assets
Rs.
Fixed Assets (at cost)
4,70,000
Less Depreciation.
81,900
3,88,100
Stock-in-trade
1,70,500
Sundry Debtors
1,42,700
Cash and Bank Balance
45,900
Total
7,47,200
The following additional information is available :

(a)
The Profit for the year was Rs. 46,000
you are required to arrange the above items in the form of a financial analysis and
compute the following :
5.
(i)
Current Ratio
(ii)
Liquid Ratio (Acid Test Ratio)
(iii)
Return on proprietors funds, together with other comments in case of each ratio.
From the Balance Sheet of a corporation given below, compute, (a) Working capital (b)
Net Capital Employed (c) Current Ratio (d) Acid Test Ratio (d) Debt Equity Ratio.
Balance Sheet as on 31.12.1985
Liabilities
Equity Share Capital
Rs.
25,000
Rs.
Fixed Assets
30,000
Preference Share Capital
5,000
Stores
2,000
Reserves & Surplus
4,000
Stock in trade
4,000
Debentures
8,000
Sundry Debtors
1,000
Bank Loans
4,000
Cash in hand
Sundry Creditors
1,000
Balance with
Scheduled Bank
Proposed dividends
1,000
Provision for taxation
2,000
50,000
116
Assets
500
2,500
Preliminary Expenses
Brokerage on
subscription of shares
8,000
2,000
50,000
6.
The following are the summarised Balance Sheet of Sunrise Co. Ltd.
(Rs. in Lakhs)
Liabilities
31.12.80
31.12.81
Assets
2.00
3.00
Land &
Share Capital
31.12.80
31.12.81
Building
0.50
0.40
General Reserve
0.60
0.70
Machinery
1.50
2.30
Profit & Loss A/c
0.30
0.40
Furniture
0.30
0.30
Debentures
0.50
1.00
Stock
0.40
0.56
Creditors
1.20
1.30
Debtors
1.80
2.40
Provision for
taxation
0.60
0.70
Cash and
Bank Bal.
0.50
1.04
0.20
0.10
5.20
7.10
Preliminary
Expenses
5.20
7.10
The Summarised Profit and Loss Account is as under :

31.12.80
31.12.81
Sales
2.40
4.00
Less : Cost of goods sold
1.60
2.40
Gross Profit
0.80
1.60
Less : Administration and Selling Expenses
0.32
0.60
Net Profit
0.48
1.00
Calculate the following accounting ratios and comment in brief on each of them.
(a)
Gross Profit Ratio
(b)
Net Profit Ratio
(c)
Return on Capital Employed
(d)
Stock Turnover Ratio
117
7.
(e)
Current Ratio
(f)
Debt Equity Ratio
From the following Annual Accounts of ABC Ltd. for the year ended 31st March 1984,
you are required to calculate the following ratios and state the significance of each.
(1)
Current Ratio
(2)
Acid Test Ratio
(3)
Operating Ratio
(4)
(5)
Debtors Turnover Ratio
(6)
Return on Proprietors Ratio

Balance Sheet as on 31st March 1984
(Omitted 000)
Liabilities
Rs.
Assets
Rs.
Share Capital
500
Land & Building
500
General Reserve
400
Plant & Machinery
200
Profit and Loss A/c
150
Stock
150
Sundry Creditors
200
Sundry Debtors
250
Cash & Bank Balances
150
1250
118
1250
Profit & Loss Account for the year ended 31st March 1984
(Omitted 000)
To, Opening Stock
To, Purchases
250
1050
To, G.P. c/d
By Sales
By Closing Stock
150
650
1950
1950
To, Selling Expenses
100
By G.P. b/d
To, Administration Expenses
230
By Profit on sale of
fixed assets
To, Miscellaneous Expenses

To, Net Profit
650
50
20
350
700
8.
1800
700
From the following statement of a Limited Company as on 31st December, 1988 prepare
a statement showing
(1)
Current Ratio
(2)
Liquid Ratio
(3)
Debt Equity Ratio
(4)
Return on Proprietory Fund
(5)
Capital Gearing Ratio
The Profit for the year was Rs. 90,000

Financial Statement as at 31st December, 1988
Rs.
Issued and Paid up Share Capital
Preference. Shares of Rs. 100 each
2,00,000
Ordinary. Shares of Rs. 10 each
5,00,000
119
Reserves and Surplus

General Reserves
80,000
P & L A/c Balance
10,000
7,90,000
Debentures
1,00,000
8,90,000
Current Assets :
Closing Stock
3,50,000
Sundry Debtors
2,50,000
Cash in Hand
15,000
Cash at Bank
35,000
6,50,000
Less Current Liabilities :

Sundry Creditors
Proposed Dividend
3,00,000
25,000
Interest Accrued
5,000
Provision for Tax
20,000
3,50,000
Net Current Assets :
3,00,000
Fixed Assets
6,90,000
Less Depreciation
1,00,000
5,90,000
8,90,000
120
9.
Following are the financial statements of Greenfield India Ltd. for the year 1986
Balance Sheet as on 31st December 1986
Owners Equity
Rs.
Fixed Assets
Rs.
7% Preference Shares
Capital
1,00,000
Buildings
3,00,000
4,00,000
Plant & Machinery
2,00,000
General Reserve
4,50,000
Furniture
1,00,000
Retained Earning
12,500
Debt
Patents
25,000
Current Assets
6% Debenture
50,000
Cash
1,10,000
Loan (Long Term)
40,000
Bank
65,000
8% Bonds
10,000
Investments
(Government Securities)
90,000
Current Liabilities
Creditors
30,000
Sundry Debtors
57,500
Bills Payable
10,000
Bills Receivable
40,000
Bank Overdraft
10,000
Stock
Outstanding Expenses
10,000
Prepaid Expenses
Proposed Dividend
25,000
1,50,000
11,47,500
10,000
11,47,500
Profit and Loss Account for the year ended on 31st December 1986
Rs.
Sales
12,00,000
Less : Cost of Goods Sold
8,00,000
Gross Profit
4,00,000
Less : Expenses
3,50,000
Net Profit
50,000
121
Compute the following ratios

(1)
Current Ratio
(2)
Acid Test Ratio
(3)
(4)
Gross Profit Ratio

Return on Proprietors Funds
(5)
(6)
Debt Equity Ratio

Fixed Assets to Net Tangible Worth Ratio
(7)
Current Assets to Proprietors Funds Ratio
(8)
(9)
Total Assets Turnover Ratio

Operating Ratio
(10) Return on Capital Employed.

10. Following is the Balance Sheet of Standard Ltd. as on 31st December 1985.
Liabilities
Capital Reserve
8% loan on Mortgage
Trade Creditors
Bank Overdraft
Taxation - Current
- Future
Rs.
20,000
4,000
16,000
8,000
2,000
2,000
Assets
Goodwill
Rs.
12,000
Fixed Assets
28,000
Stock
Debtors
6,000
6,000
Investments
Bank
2,000
6,000
2,000
Profit & Loss Account

profit after
Interest and taxation
Less : Transfer to
Reserves
Dividends
12,000
4,000
2,000
6,000
6,000
60,000
60,000
Sales amounted to Rs. 120,000

You are required to calculate ratios for (a) Testing Liquidity
122
(b)
(c)
Testing Solvency
Testing Profitability
(d)
Testing Capital Gearing
(e)
Testing Capitalisation
11.
The ABC Companys financial statements contain the following information.

Balance Sheets
31.3.94
31.3.95
Cash
2,00,000
1,60,000
Sundry Debtors
Temporary Investments
3,20,000
2,00,000
4,00,000
3,20,000
18,40,000
21,60,000
28,000
12,000
Total Current Assets
25,88,000
30,52,000
Total Assets
Current Liabilities
56,00,000
6,40,000
64,00,000
8,00,000
10% Debentures
16,00,000
16,00,000
20,00,000
20,00,000
4,68,000
8,12,000
Stock
Prepaid Expenses
Retained Earnings
Profitability Statement for the year ended 31.3.95

Sales
28,00,000
Interest
1,60,000
40,00,000
Net Profit for 1995

Less : Taxes @50%
29,60,000
10,40,000
5,20,000
5,20,000
Dividend declared on Equity Shares Rs. 2,20,000

From the above figures, appraise the financial position of the company from the point of view of
(i) liquidity, (ii) solvency, (iii) profitability and (iv) activity.
12. From the information given below, calculate the six ratios for use of management. Explain
the object of each ratio and indicate, where appropriate, how, it might be refined by the
use of more detailed information than it is here available.
Summarised Balance Sheet of Prosperous Ltd. as
on 31st September 1984
Equity share capital
Issued and fully paid up
Opening Balance
Profit for the year
Long term loan
for the year
Trade Creditors
Rs. in 000
Fixed Assets
1,395
963
695
850
690
Cost
4,923
Less : Depreciation 2,599
Stocks
Finished Goods
Raw Material & WIP
Trade Debtors
Cash
2,324
1,407
840
1,277
41
900
396
5,889
5,889
123
Net sales for the year ended 30.9.84 amounted to Rs. 70 lakhs, earnings before interest
and tax (EBIT) amounted to Rs. 18.5 lakhs, interest on long term borrowing is Rs. 1 lakh
and net profit after tax figured at Rs. 8.5 lakhs
Purpose of each ratio to be determined (1)
Profitability of funds employed
(2)
Average Profit Margin
(3)
Turnover of funds employed
(4)
Measure of short term financial stability
(5)
Credit allowed to debtors.
(6)
Return on Equity.
13. From the following information of M/s. Goodwill Co. Ltd. for the year 1982, 1983 and
1984 you are required to calculate (i)
Current Ratio
(ii)
Debtors turnover ratio and number of days required to get realisation and number of
days the inventory would last.
(iii)
Inventory Turnover Ratio
(iv)
Net Profitablity Ratio
You are required to make comments on the changes in the profitability liquidity i.e.,
calculate these ratios.
1982
1983
1984
Rs.
Rs.
Rs.
Debtors
3,00,000
5,00,000
6,00,000
Inventory
5,00,000
5,00,000
7,00,000
Plant, Machinery & Equipment
1,20,000
1,50,000
2,00,000
Buildings
1,00,000
1,00,000
1,00,000
10,20,000
12,50,000
16,00,000
Assets
124
Liabilities
Bank Overdraft
1,10,000
2,60,000
3,90,000
Trade Creditors
2,50,000
3,00,000
5,00,000
Profit and Loss Account
1,00,000
1,30,000
1,50,000
5,60,000
5,60,000
5,60,000
10,20,000
12,50,000
16,00,000
10,00,000
15,00,000
15,00,000
50,000
70,000
50,000
Paid up capital - Rs. 100 Share

Rs. 75 paid up
Sales
Net Profit
The opening stock at the begining of the year 1982 was Rs. 40,000 and sundry debtors
were Rs. 3,00,000
14. On the basis of the following financial statements calculate following ratios and also
comment on them :
(a)
Current Ratio
(b)
Operating Ratio
(c)
Return on Investment Ratio
(d)
Inventory Turnover Ratio
Income Statement for 1975

Net Sales
Rs.
10,00,000
Cost of Goods
7,56,000
Operating Expenses
1,25,000
Depreciation
Income from Investment
Income Tax
44,000
1,40,000
65,000
125
Balance Sheet as at 31st December 1975

Liabilities
Rs.
Assets
Rs.
Share Capital
3,00,000
Building
2,50,000
Debentures
2,00,000
Plant and Machinery
2,10,000
Profit After Tax
1,50,000
Investments
Bills Payable
1,30,000
Stocks
1,15,000
1,60,000
80,000
Sundry creditors
60,000
Bills Receivables
Provisions for Taxation
65,000
Sundry Debtors
45,000
5,000
Accrued Income
15,000
Cash
35,000
9,10,000
9,10,000
15. A corporation gives the following information during the period ending 31.12.79 and 31.12.80.
You are required to find out :
(a)
Current Ratio
(b)
Quick Ratio
(c)
Average collection Period
(d)
Receivables Turnover Ratio.
(e)
Inventory Turnover Ratio.

Balance Sheet
Liabilities
1980
1979
Equity stock
Assets
Land & Building
Less : Depreciation
1980
1979
10.00
6.00
1.20
0.72
8.80
5.28
(Rs.10 per share)
3.00
3.00
Free Reserves
6.00
3.50
12% Debentures
5.00
5.00
Plant & Machinery
4.00
3.78
Bills Payable
2.00
1.75
Less : Depreciation
0.50
0.56
Outstanding Taxes
0.80
0.30
3.50
3.22
2.50
2.80
2.00
2.25
16.80
13.55
Inventory
Receivables
16.80
126
Rs. in Lakhs
13.55
Income Statement
1980
1979
Rs.
Rs.
Net Sales (60% on credit)
45.00
36.00
Cost of goods sold
33.00
29.00
Gross Profit
12.00
7.00
Distributing Expenses
5.00
3.00
P.B.T.
7.00
4.00
Taxes (50%)
3.50
2.00
P.A.T.
3.50
2.00
Free Reserves at the beginning
3.50
2.00
7.00
4.00
Payment of Cash Dividend
1.00
0.50
Free Reserves at the end
6.00
3.50
Inventory was valued at Rs. 2.96 lakhs as on 31.12.78

16. Following accounting information is obtained relating to a limited company
Rs.
Sales
30,00,000
Cost of goods sold
15,00,000
15,00,000
Administrative expenses
5,00,000
10,00,000
Taxes
5,00,000
Net Profit
5,00,000
127
Balance Sheet
Liabilities
Rs.
Assets
Rs.
10% Preference Share

capital
20,00,000
Fixed Assets
20,00,000
Stock
2,00,000
Reserves
10,00,000
Debtors
4,00,000
10% Debentures
11,00,000
Cash
2,00,000
Current Liabilities
3,00,000
Ficticious Assets
1,00,000
64,00,000
55,00,000
64,00,000
Opening Stock was Rs. 3,00,000

Administration expenses include depreciation and debenture interest. Assume 360
days in a year
Compute the following ratios (a)
Gross Profit Ratio
(b)
Net Profit Ratio
(c)
Current Ratio
(d)
Liquid Ratio
(e)
Proprietory Ratio
(f)
Rate of Return on Equity share capital
17. From the following financial statements of X Ltd. calculate :
128
(a)
Current Ratio
(b)
Liquid Ratio
(c)
Gross Profit Ratio
(d)
Net Profit Ratio
(e)
Fixed Assets Turnover
(f)
Net Profit to capital employed
(g)
Sales to capital employed
(h)
Debtors Turnover
Income statement for the year ending 31st December, 1988

Rs.
Sales
- Cash
64,000
- Credit
6,84,000
Rs.
7,48,000
Less
- Cost of Sales
5,96,000
Gross Profit
1,52,000
Less - Expenses
Warehouseing & Transport
48,000
Administration
38,000
Selling
28,000
Debenture Interest
4,000
1,18,000
Net Profit
34,000
Balance Sheet as at 31st December, 1988
Liabilities
Share Capital
Rs.
1,50,000
Assets
Fixed Assets (Net)
Rs.
80,000
Reserves
60,000
Current Assets
Profit & Loss A/c
24,000
Stock
1,88,000
Debenture
60,000
Debtors
1,64,000
Current Liabilities
1,52,000
4,46,000
Cash
14,000
4,46,000
129
18. Using the following information, complete the Balance Sheet of XYZ Ltd.
Long term Debt to net worth
- 0.5 to 1
Total Assets Turnover
- 2.5 times
Average collection period
-1/2 Month
Inventory turnover
- 9 times
Gross Profit Margin
- 10%
Acid test ratio
-1:1
Balance sheet of XYZ Ltd., on 31st December 1980

Liabilities
Rs.
Assets
Rs.
Equity Capital
1,00,000
Fixed Assets
Retained earnings
1,00,000
Inventory
Debtors
Cash
Long term Debt

Creditors
1,00,000
19. From the following details, you are required to prepare the Balance Sheet of M/s. Phule
& Ghule as on 31-3-1987.
(a)
Stock Velocity
(b)
Capital turnover ratio
(c)
Fixed Assets turnover ratio
(d)
Gross Profit as % of sales
20
(e)
Debt collection period in Months
(f)
Creditors payment period in days
73
The gross profit for the year ending on 31-3-1987 was Rs. 60,000. Closing stock was
Rs. 5,000 in excess of opening stock. Assume purchases and sales are on credit.
130
20. From the following information, you are required to prepare a Balance Sheet.
Working Capital
Rs. 75,000
Reserves & Surplus
Rs. 1,00,000
Overdraft
Rs. 60,000
Current Ratio
1.75
Liquid Ratio
1.25
Fixed Assets/Proprietors funds
0.75
Long Term Liabilities
Nil
21. From the following information, prepare the Balance Sheet of Rameshpathy as on 31.3.83.
Fixed Assets
Rs. 6 lakhs
Working capital
Rs. 4 lakhs
Current Ratio
Fixed Assets to turnover
G.P.
25%
Debtors velocity
1.5 months
Creditors velocity
2 months
Stock velocity
2 months
Net Profit 5% of turnover

Reserve 2/3rd of net profits
Capital Gearing
1:1
22. With the following ratios and further information given below, prepare a Trading Account,
Profit and loss Account and Balance Sheet of Shri Narain.
(i)
Gross Profit Ratio
25%
(ii)
Net Profit/Sales
20%
(iii) Stock Turnover Ratio
10%
131
(iv)
1/5
1/2
5/4
(vii) Fixed Assets/Total current Assts
5/7
(viii) Fixed Assets
Rs. 10,00,000
(ix) Closing stock
Rs. 1,00,000
(v)
(vi)
Net Profit/Capital
Capital/Total Liabilities
Fixed Assets/Capital
23. The assets of ABC Ltd. consists of fixed assets and current assets while its current
liabilties comprise of bank credit and trade credit in the ratio of 2:1. From the following
figures relating to the company for the year 1985, prepare its balance sheet, showing the
details of working.
Share Capital
Rs. 1,99,500
Working Capital (CA-CL)
Rs. 45,000
Gross Margin
20%
Inventory Turnover
Average Collection Period
2 months
Current Ratio
1.5
Quick Ratio
0.9
Reserves & Surplus to cash.
24. You are adviced by the management of ABC Ltd. to project a Trading and Profit and Loss
Account and the Balance sheet on the basis of the following estimated figures and
ratios, for next financial year ending March 31, 1986.
132
Ratio of Gross Profit
25%
5 times
Average Debt Collection Period
3 months
Creditors Velocity
3 months
Current Ratio
Proprietory Ratio
(Fixed Assets to Capital Employed)
80%
Capital Gearing Ratio

(Preference Shares & Debentures to equity
30%
Net profit to issued capital (equity)
10%
General Reserve and Profit &

Loss A/c to Capital (Equity)
25%
Preference share capital to Debentures
Cost of sales consists of 50% for materials.

Gross Profit is Rs. 12,50,000
Working should be clearly shown.
25. Following information is available to you from which you are required to prepare Balance
Sheet as on 30th September, 1984.
Current Ratio
1.8 : 1.00
Working Capital
Rs. 40,000
Liquid Ratio
1.5 : 1.00
Fixed Assets to shareholders capital
90%
Rate of Gross Profit to Turnover
25%
Rate of Net Profit to share capital
10%
Share Capital
Rs. 400,000
Stock Turnover Ratio on cost of goods sold
10 times
Average rate of outstandings for the year
54 days
(On the basis of Current Liabilities)
On 30th September 1984, Current Assets include stock, debtors and bank balances. Liabilties
include share capital and current liabilities. Assets include fixed assets, current assets and
development expenditure (not written off so far).
133
26. You have been asked by the management of The Wonderful suppliers Ltd. to project a
Trading and Profit & Loss Account and the Balance Sheet on the basis of the following
estimated figures and ratios, for the next financial year ending 31st March, 1983.
Ratio of Gross Profit
25%
5 times
Average Debt Collection Period
3 months
Creditors velocity
3 months
Current Ratio
Fixed Assets to Capital Employed
80%
Preference share & Debenture to Equity
30%
Net Profit to Issued Equity Capital
10%
General Reserve & Profit and loss a/c

to issued Equity Capital
25%
Preference share capital to Debentures
Cost of sales consist of 50% for materials

Gross Profit Rs. 12,50,000
Working should be clearly shown.
27. Prepare Balance Sheet and Profit & Loss Account from the following information :
Rs.
Capital
4,00,000
Working Capital
1,80,000
Bank overdraft
30,000
There are no fictitious assets. In current assets, there is no asset other than stock,
debtors and cash.
Closing Stock is 20% higher than opening stock
134
(1)
Current Ratio
2.5
(2)
Quick Ratio
2.0
(3)
Proprietory Ratio i.e.

Fixed Assets/Proprietory funds.)
0.6
(4)
Gross Profit Ratio
20% (To sales)
(5)
Stock velocity
(6)
Debtors velocity
73 days
(7)
Net Profit Ratio
10% (To capital employed.)
28. Below are given summarised accounts of Alok Ltd. for the years ended 31st December,
1978 and 31st December, 1979.
Balance Sheet
Rs. in Lakhs
78
79
78
79
Rs
Rs.
Rs.
Rs.
Share Capital
250
250
Fixed Assets (At cost)
500
500
General Reserve
100
172
Less : Depreciation
80
115
Debentures
180
150
420
385
Inventories
90
113
Term loan
from IFCI
30
30
Cash
55
85
Creditors
70
56
Debtors
65
75
630
658
630
658
135
Income Statement
Rs. in Lakhs
Year 1978
Year 1979
350
450
Less :Cost of Material
90
113
Less :Wages
70
70
Cost of goods sold
160
183
Gross profit
190
267
50
60
140
207
30
35
110
172
25
27
85
145
15
48
70
97
25
25
45
72
Net Sales
Less :Selling, General &

Administration costs
Earning before depreciation,
interest and tax
Less :Depreciation
Earnings before interest and tax
Less :Interest
Earnings before tax
Less :Tax
Earnings after tax
Less :Dividends
Retained earnings
Compute liquidity leverages, activity and profitability ratios and comment.

29.
136
Certain items of the annual accounts of ABC Ltd. are missing as shown below.
Trading and Profit & Loss Account for the year ended 31 st March, 1986
Rs.
To, Opening stock
Rs.
3,50,000
To, Purchases
To, Other Expenses
-87,500
To , Gross Profit
By Sales
--
By Closing Stock
--
---
To, Office & Other

expenses
--
3,70,000
To, Interest on
debentures
By, Gross Profit
30,000
To, Provision for

taxation
--
To, Net Profit for year
--
By, Commision
--
-50,000
--
To, Proposed Dividends
--
By, Balance b/fd
To, Transfer to
General Reserve
--
By, Net profit for year
To, Balance transferred

to Balance sheet
--
70,000
--
--
Balance sheet as on 31st March, 1986

Liabilities
Paid up capital
Rs.
Assets
5,00,000
Rs.
Fixed Assets
General Reserves
Plant & Machinery
Balance at beginning
Other Fixed Assets
--
of the year
--
Current Assets
Proposed Addition
--
Stock in trade
--
Sundry Debtors
--
Profit & Loss App. A/c
--
10% Debentures
--
Current Liabilities
---
Bank Balance
62,500
--
137
You are required to supply missing figures with the help of following information :
(1)
Current Ratio 2 : 1.
(2)
Closing stock is 25% of sales.
(3)
Proposed dividends are 40% of paid up capital.
(4)
Gross Profit Ratio is 60%.
(5)
Ratio of Current Liabilities to debenture is 2:1.
(6)
Transfer to General Reserves is equal to proposed dividends.
(7)
Profits carried forward are 10% of the proposed dividends.
(8)
Provision for taxation is 5% of profits.
(9)
Balance to the credit of General Reserves at the beginning of the year is twice the
amount transferred to that account from the current profits.
Working should form part of your answer.
30. From the ratios given below, draw the profit and loss account and the Balance Sheet of
A Co. Ltd.
Trading and Profit and Loss Account for the year ended on 31st December, 1982
Liabilities
Opening stock
Purchases
Purchase Expenses
Gross profit
Rs.
Assets
4,80,000
--
Sales
--
Closing stock
--
40,000
---
--
Office Expenses
2,40,000
Gross Profit
--
Selling Expenses
1,86,000
Commission
--
Interest on debentures
30,000
--
Net Profit for the year
---
138
Rs.
-Financial Management
Liabilities
Rs.
Proposed Dividends
Assets
Rs.
--
Balance b/fd
62,500
--
Transfer to General
Reserve
--
Balance carried to
Balance sheet
---
--
Balance sheet as --at 31st December 1982

Liabilities
Rs.
Assets
Share Capital Authorised
Fixed Assets
5,000 Equity shares of
Goodwill
Rs. 100 each
5,00,000
Issued subscribed &
Land
Rs.
72,000
3,00,000
Plant & Machine 2,00,000
Paid up 4,000 Equity

shares of Rs. 100 each
--
5,72,000
4,00,000
Reserves & surplus
Current Assets
Reserves-on Balance
--
Stock in trade
--
Proposed additions
--
Sundry Debtors
--
Bank Balance
40,000
Surplus - Balance from

P & L Appropriation A/c
--
Secured Loans
15% Debentures of
Rs. 100 each
--
Current Liabilities
---
(1)
Dividends proposed are 30% of share capital.
(2)
Current Ratio - 2 : 1.
(3)
Sundry Debtors represent 2 months sales.
--
139
(4)
Stock turnover ratio 6 2/3.
(5)
Gross Profit Ratio 33 1/3%.
(6)
Provision for taxation is at 50% of profits.
(7)
Profits carried forward were 10% of the transfer to General Reserve.
(8)
Transfer to General Reserve was equal to proposed dividends.
(9)
Secured Loans were half of current liabilities.
(10) Balance to the credit of General Reserves at the beginning of the year was twice
the amount transferred to that account from current profits.
Working should form part of your answer.
31. The following are the summarised Accounts of A Ltd. an B Ltd. for the two years 1979
and 1980 :
A Ltd.
Rs. in Lakhs
1980
1979
1980
1979
Turnover
54.12
45.75
17.52
14.47
Manufacturing & other expenses
51.04
43.56
14.96
11.82
Depreciation
0.56
0.51
0.60
0.35
Profit before tax
2.52
1.68
1.96
2.30
54.12
45.75
17.52
14.47
Intangible Assets
1.65
1.69
--
--
Fixed Assets
8.36
9.41
3.51
2.75
11.24
12.19
1.77
2.26
Debtors
7.28
8.24
5.82
4.02
Bank
0.93
0.33
4.64
2.46
29.46
31.86
15.74
11.49
Creditors
9.47
9.26
2.33
1.75
Taxation (Less Advance Tax)
0.56
0.68
0.87
0.58
Short Term Borrowings
4.24
8.00
4.64
2.16
Long Term Borrowings
2.54
2.10
0.10
--
Capital and Reserves
12.65
11.82
7.80
7.00
29.46
31.86
15.74
11.49
Stock
140
B. Ltd.
Rs. in Lakhs
You are required to

(1)
Indicate and calculate five ratios which in your opinion are relevant in determining the
stability of two companies as going concerns.
(2)
Compare the ratios so determined for two companies and indicate what conclusions can
be drawn therefrom.
(3)
Discuss the limitations of ratio analysis as a predictor of failure.
32. From the Following data, Find(1)
Sales
(2)
Sundry Debtors
(3)
Sundry Creditors
(4)
Closing Stock
(5)
Opening Stock
Debtors Velocity
- 3 Months
Creditors Velocity
- 2 Months
Stock Velocity
- 8 Months
Gross Profit Ratio
- 25%
Gross Profit
- Rs. 80,000
Closing Stock for the year is Rs. 2,000 more than the opening Stock. All the Sales and
purchases are on Credit.
141
33. From the following statements, calculate the various ratios alongwith your comments.
Condensed income statement of Goodluck & Co.
for the year ending 31.12.1993
Rs.
% of Sales
12,00,000
100.00
7,20,000
60.00
Gross Profit
4,80,000
40.00
Overheads
3,12,000
26.00
Operating Profit
1,68,000
14.00
8,000
0.66
1,60,000
13.34
Income Tax provision
80,000
6.67
Net Income after tax
80,000
6.67
Net Sales
Interest
Income before tax
Balance Sheet of Goodluck & Co.

as on 31.12.1992 and 31.12.1993
31.12.92
31.12.93
1,20,000
1,60,000
Accounts Receivable (Net)
1,20,000
1,20,000
Inventories
2,00,000
2,40,000
40,000
40,000
4,80,000
5,60,000
1,20,000
1,20,000
Buildings & Structures
4,80,000
4,80,000
Less : Depreciation
2,40,000
2,80,000
Net Buildings & Structures
2,40,000
2,00,000
3,60,000
3,20,000
40,000
8,40,000
9,20,000
Assets :
Current Assets :
Cash
Prepaid Expenses
Fixed Assets :
Land
Total Fixed Assets

Other Assets :
Goodwill & patents
TOTAL ASSETS
142
Liabilties & Equities :

Accounts payable
1,00,000
1,20,000
Wages & Taxes outstanding
60,000
40,000
Income Tax payable
40,000
80,000
2,00,000
2,40,000
1,60,000
1,60,000
3,60,000
4,00,000
of Rs. 20 each fully paid)
2,40,000
2,60,000
Retained earnings
2,40,000
2,60,000
Total Shareholder Equity
4,80,000
5,20,000
TOTAL LIABILITIES & EQUITY
8,40,000
9,20,000
Long Term Liabilities :

4% Mortgage Debentures
Total Liabilities
Shareholders Equity :
Share Capital (12,000 shares
143
NOTES
144
4)
Depreciation for a full one year is charged at following rates.

a)
Building 5%
b)
Machinery 10%
c)
Furniture 10%
5)
A building worth Rs. 70,000 was sold on 1.1.1987 at Rs. 60,000 and a new building was
constructed at a value at Rs. 25,000 on 31.12.1987.
6)
A machine was purchased at a cost of Rs. 40,000 on 1.1.87, while a machine having a
book value of Rs. 10,000 was sold on 1.7.87 at Rs. 20,000.
Prepare a statement showing movement in working capital, profit and loss appropriation account
and a statement showing the sources and application of funds.
Solution :
Statement showing sources and application of funds.
Sources
Operating Profit
Issue of 2,000
Share of Rs. 100/Share Premium
Sale of Building
Sale of Machine
Rs.
1,76,000
2,00,000
10,000
60,000
20,000
4,66,000
176
Application
Construction of
Building
Equity Purchase
of Machine
Purchase of
Invesments
Repayment of
Debentures
Secured Loan
Income Tax Paid
Dividend Paid
Increase in Working
Capital
Rs.
25,000
40,000
2,10,000
10,000
1,00,000
30,000
48,000
3,000
4,66,000
Statement showing movement in working capital
Current Assets
Cash in hand
Stock
Debtors
Bills Receivable
Current Liabilities
Increase in working
Capital
1987
1988
Increase
Decrease
5,000
1,55,000
1,80,000
4,000
8,000
1,45,000
1,60,000
40,000
3,000
36,000
10,000
20,000
3,44,000
3,53,000
24,000
30,000
3,20,000
3,23,000
6,000
3,000
3,23,000
3,000
3,23,000
39,000
39,000
Profit And Loss Account

To, Dividend Paid
To, Income Tax Provision
To, Transfer to Debenture
Redemption Reserve
To, Depreciation
To, Loss on sale of
building
To, Balance c/fd
48,000
25,000
10,000
73,000
By, Balance b/fd

By, Profit on sale
of Machine
By, Operating Profit
(Balancing figure)
2,00,000
10,000
1,76,000
10,000
2,20,000
3,86,000
3,86,000
Working Notes :
(a)
To, Balance b/fd.
To, Bank (Purchase)
Building Account
5,70,000
25,000
By, Bank (Sale)

By, P & L A/c
(Loss on Sale)
By, Depreciation
By, Balance c/fd
5,95,000
Interpretation of Financial Statements (Funds Flow/Cash Flow Statements)
60,000
10,000
25,000
5,00,000
5,95,000
177
(b)
Machinery Account
To, Balance b/fd.

To, Bank (Purchase)
To, P & L A/c
(Profit on Sale)
3,60,000
40,000
By, Bank (Sale)

By, Depreciation
By, Balance c/fd
20,000
39,000
3,51,000
10,000
4,10,000
(c)
4,10,000
Furniture Account
To, Balance b/fd.
90,000
By, Depreciation
By, Balance c/fd.
90,000
9,000
81,000
90,000
Interpretation of funds flow statement

For the correct interpretation of the funds flow statement, the sources and application of funds
can be catagorised as below.
(a) Sources :
i)
ii)
Long Term sources Following types of sources may be treated as long term sources.
Issue of shares/debentures.
Long Term borrowing of funds.
Operating Profit.
Sale of fixed assets.
Short Term sources Following types of sources may be treated as short term
sources.
Short term borrowing of funds.
Increase in current liabilities.
Decrease in current assets.
(b) Applications :
i)
ii)
178
Long Term applications Following types of applications may be treated as long

term applications.
Purchases of fixed assets.
Redemption of preference shares/debentures.
Repayment of long term borrowings.
Short Term applications Following types of applications may be treated as short

term applications.
Increase in current assets.
Decrease in current Liabilities.
Repayment of short term loans/deposits
Dividends/Taxes.
After catagorising the sources and applications as above, a proper interpretation of the funds
flow statement can be carried out after keeping in mind the following propositions.
1)
Generally, long term sources of funds should be used for long term applications.
2)
Generally, short term sources of funds should be used for short term applications.
3)
In some cases, the long term sources of funds can be used for short term applications
(e.g. investment in core current assets), however under no circumstances, short term
sources of funds should be used for long term applications. If the short term sources of
funds are used for long term applications, it results into diversion of funds. It indicates
that the funds raised are not utilised for the purpose for which they are intended. It indicates
that the funds which are repayable or adjustable in the immediate future, are applied for
such purposes, the returns from which are not likely to be received in the immediate
future but are likely to be spread over a longer period of time. This indicates financial
imprudency on the part of the organisation.
PROBLEMS
(1)
Following are the Balance Sheets on 31.12.85 and 31.12.86 and you are required to
prepare a statement of cash flow for the year 1986 showing particulars of your working in
details.
Share Capital
Share Premium
P & L A/c
Debentures
Bank overdraft
Creditors
Proposed
Dividend
Depreciation
Plant
Fixtures
31.12.85
31.12.86
2,00,000
30,000
56,000
1,40,000
28,000
68,000
3,00,000
70,000
1,40,000
60,000
96,000
30,000
40,000
90,000
26,000
1,08,000
30,000
6,68,000
31.12.85
31.12.86
2,20,000
260,000
2,40,000
48,000
74,000
86,000
3,02,000
58,000
1,02,000
88,000
32,000
6,68,000
2,000
8,44,000
Freehold property
At cost)
Plant &
Machinery
Fixtures
Stocks
Debtors
Bank Balance
Premium on
redemption of
Debentures
8,44,000
179
Additional information :
(1)
There has been no disposal of freehold property in the year.
(2)
A machine tool which has cost of Rs, 16,000 and in respect of which depreciation of Rs.
12,000 was provided, was sold for Rs. 6,000 and fixtures which had cost of Rs. 10,000 in
respect of which depreciation of Rs. 4,000 was provided was sold for Rs. 2,000. The
profit and loss on these transaction has been dealt through Profit and Loss A/C.
(3)
The actual premium on redemption of debentures was Rs. 4,000 of which Rs. 2000 had
been written off to Profit and Loss A/C.
(4)
No interim dividend had been paid.
(2)
Following are the Balance Sheets of A Ltd.

1986
1987
Issued Capital
Equity
Fixed Assets
15,00,000
15,00,000
3,00,000
4,00,000
30,000
40,000
Debentures
5,00,000
5,00,000
Current
Liabilities
6,20,000
4,40,000
1,80,000
1,95,000
Doubtful debts
6,000
5,000
Balance of
P & L A./c
From Previous
year
24,400
1,91,500
1.67,100
1,55,800
33,27,500
34,27,300
Preference Share
Share Premium
Current Assets
1986
1987
23,36,960
24,60,500
9,60,540
9,41,800
30,000
25,000
33,27,500
34,27,300
Debenture
Discount
Provision For
Depreciation
For the year
180
Additional information :
(1)
During the year 87, machinery costing Rs. 2,00,000 (accumulated provision for
depreciations Rs. 60,000) was sold for Rs. 1,50,000.
(2)
Rs. 1,00,000 Preference shares Capital was isssued during the year 87 at a premium of
Rs. 10,000.
(3)
The net profit for 87 was arrived at after taking into account credit for profit on sale of
machinery, reduction in the provision for doubtful debts, and writting off the discount on
the issue of debentures.
You are required to prepare

(a)
Statement showing net increasing in working capital during 87.
(b)
Statement showing sources of funds and application thereof.
(3)
From the following information, prepare a cash flow statment for the year.
(Rs. in Thousands)
31.12.85
31.12.86
140
140
Reserves
74
105
Sundry Creditors
32
35
Equity capital
Wages
Outstanding
11
260
287
31.12.85
31.12.86
Fixed Assets
90
87
Cash
75
97
Sundry Debtors
43
40
Inventory
49
58
260
287
Prepaid Rent
Misc. expenses
outstanding
Other Information :
Sales
300
Wages
23
Misc. operating expenses
47
Cost of goods sold
190
Rent
Depreciation
181
(4)
The following are the summerised Balances of Assets and Liabilities of A Ltd. as on 31st
Dec. 1987 and 88 :
Liabilities
Share Capital
General
Reserve
1987
1988
4,50,000
4,50,000
Fixed Assets
3,00,000
3,10,000
Current Assets
Investments
56,000
68,000
1,68,000
1,34,000
P & L A/c
Creditors
Provision for
Tax
75,000
Loan
Assets
1987
1988
4,00,000
3,20,000
50,000
60,000
Stock
2,40,000
2,10,000
Debtors
2,10,000
4,55,000
Bank
1,49,000
1,97,000
10,49,000
12,42,000
10,000
2,70,000
10,49,000
12,42,000
182
(a)
Investment costing Rs. 8,000 were sold during the year 1988 for Rs. 8,500 and further
investments were purchased for Rs. 18,000.
(b)
The net profit for the year was Rs. 62,000, after charging depreciation on fixed assets
Rs. 70,000 for the year and provision for taxation Rs. 10,000.
(c)
During the year, part of fixed assets costing Rs. 10,000 were sold for Rs. 12,000. The
profit was included in Profit and Loss Account.
(d)
Dividend paid during the year amounted to Rs. 40,000. Prepare a statement showing
sources and application of funds for the year end 31st December, 1988.
(5)
Following are the Balance sheets of Unique Ltd.
Creditors
Oustanding
Expenses
1.1.86
31.12.86
1,63,000
1,46,000
13,000
22,000
Cash/Bank
Balances
Debtors
5% Debentures
(Rs. 100 each)
Dep. Fund
90,000
40,000
70,000
44,000
Stock
Prepaid
Expenses
Capital Reserve
6,000
7,800
Land &
10,000
15,200
Building
P & L A/c
Equity Share
Capital
Machinery
1,80,000
1,80,000
5,02,000
4,85,000
1.1.86
31.12.86
50,000
77,000
40,000
73,000
2,02,000
1,90,000
1,000
2,000
1,00,000
1,00,000
72,000
80,000
5,02,000
4,85,000
Following additional information is also available.

(1)
10% dividend on Equity Share Capital was paid in cash.
(2)
An old machine costing Rs. 12,000 was sold for Rs. 4,000 and accumulated depreciation
on that was Rs. 6,000.
(3)
5% Debentures of Rs. 5,000 were redeemed to purchase from open market at Rs. 96 per
debenture. Profit on this redemption was transferred to Captial Reserve.
You are required to prepare schedule of changes in working capital and statement showing
sources and application of funds.
(6)
From the Balance Sheets of A Ltd. as on 31.3.86 and 31.3.87 prepare

Statement showing changes in wokring captial.
Statement of sources and application of funds.
Fixed Assets Account.
Profit and Loss Account.
183
Share Capital
31.3.86
31.3.87
6,75,000
6,75,000
Sundry
Creditors
2,52,000
2,01,000
Tax Provision
1,12,500
15,000
General
Reserve
4,50,000
4,65,000
84,000
1,02,000
4,05,000
15,73,500
18,63,000
P & L A/c
Mortgage Loan
31.3.86
31.3.87
Fixed Assets
6,00,000
4,80,000
Investments
Stock
75,000
3,60,000
90,000
3,15,500
Debtors
3,15,000
6,82,000
Cash/Bank
2,23,500
2,95,500
15,73,500
18,63,000
(1)
Net profit for the year was Rs. 93,000 after charging provision for taxation Rs. 15,000 and
depreciation on fixed assets.
(2)
During the year, part of fixed assets costing Rs. 15,000 were disposed off for Rs. 18,000
and the profit is included in the above profit.
(3)
Dividend paid during the year Rs. 60,000.
(4)
Investments costing Rs. 12,000 were sold for Rs.12,750 and further investments were
acquired for Rs. 27,000.
(7)
The following are the Balance Sheets as at 31st December 1984 and 31st December 1985
Liabilities
Share Capital 10,000 Shares of Rs.10/- each
Bank Overdraft
Loan against mortgage of building
Sundry creditors
184
1984
1985
1,00,000
1,00,000
6,000
8,000
16,000
50,000
20,000
20,000
60,000
1,42,000
2,38,000
Liabilities
1984
1985
Land & Building
30,000
60,000
Machinery
50,000
60,000
Less : Depreciation upto date
12,000
18,000
38,000
42,000
11,600
12,400
5,600
8,400
6,000
4,000
Stock
22,000
72,000
Debtors
46,000
60,000
1,42,000
2,38,000
Assets :
Vehicles
Less : Depreciation upto date
During the year 1985, the company purchased a building for Rs. 30,000 out of which Rs.
10,000 was paid in cash and for the rest, the building was mortgaged to the seller. During the
year 1985, a dividend of 10% was distributed to the shareholders.
On. 1.1.85, a vehicle which originally cost Rs. 2,000 and showing book value of Rs. 1,000
was sold for Rs. 1,600.
You are required to prepare a statement of cash flows for the year 1985, showing particulars
of your working in details.
185
(8)
From the following financial statements and additional data condensed from reports of
Rokad Chillar Ltd. prepare a cash flow statement for the year ended 31st December 1984
Profit and Loss A/c for the year ended 31.12.84
1983
1984
10,00,000
14,00,000
Opening Stock
2,50,000
1,20,000
Add : Purchases
8,50,000
8,00,000
11,00,000
9,20,000
1,20,000
1,60,000
9,80,000
7,60,000
20,000
6,40,000
2,80,000
3,20,000
(2,60,000)
3,20,000
Balance of undistributed Profit/(Loss)
1,80,000
(80,000)
Balance available for distribution
(80,000)
2,40,000
2,00,000
(80,000)
40,000
(a)
Sales
(b)
Cost of Sales
Less : Closing Stock
(c)
Gross Profit a b
Less : Operating Expenses

Net Profit/(Loss) for the year
Less : Dividends Paid

Balance of undistributed Profit/(Loss)
Balance Sheets as on 31.12
(Rs. in Lakhs)
83
84
Expenses Payable
0.50
0.40
Sundry Creditors
1.50
Long Term Loans

Paid up Capital
P & L Account
83
84
Cash
0.80
1.00
2.60
Prepaid Expenses
0.10
0.20
4.00
2.00
Sundry Debtors
0.10
0.20
2.00
4.00
Stock
1.20
1.60
0.40
Investments
1.00
2.40
Fixed Assets
4.00
4.00
P & L Account
0.80
8.00
9.40
8.00
186
9.40
(9)
(1)
Depreciation charged for 1984 Rs. 40,000
(2)
There are no sales of fixed assets during the period.
From the following information, prepare a statement showing sources and application of
the funds for the year ended 31st December 1984.
Balance Sheets
(Rs. in Lakhs)
83
84
83
84
Share Capital
4.50
4.50
Fixed Assts
4.00
3.20
General Reserve
3.00
3.10
Investments
(Non-current)
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
2.70
10.49
12.42
10.49
12.42
Mortgage Loan
(1)
Investments costing Rs. 8,000 were sold during 1984 for Rs. 8,500.
(2)
Provision for taxation 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, the profit included in Profit and Loss Account.
(4)
Dividend paid during the year amounted to Rs. 40,000.
187
(10) From the following Balance Sheets, prepare a movement of funds statement showing
the increase or decrease in working capital separately.
1.1.75
31.12.75
1.1.75
31.12.75
Rs.
Rs.
Rs.
Rs.
100.0
120.0
Building
55.4
113.2
10.0
Machinery
35.6
51.3
General Reserve
6.0
11.0
Furniture
2.4
2.5
P & L A/c
7.5
20.7
Stock
36.5
38.0
26.0
Debtors
32.1
38.0
33.5
36.4
Bank
4.8
4.0
9.8
10.9
10.0
12.0
166.8
247.0
166.8
247.0

Share Premium
5% Debentures
Sundry Creditors
Proposed Dividend
Depreciation written off during the year.

Machinery
Rs. 12,800
Furniture
Rs. 400
(11) From the following Balance Sheet as on 31.12.87 and 31.12.88, you are required to
prepare statements showing flow of funds.
31.12.87
31.12.88
31.12.87
31.12.88
Rs.
Rs.
Rs.
Rs.
30,000
47,000
1,20,000
1,15,000
Capital and
Assets
Liabilities
Share Capital
2,00,000
2,50,000
Trade Creditors
70,000
45,000
Debtors
Retained Earnings
10,000
23,000
Stock in trade
80,000
90,000
Land
50,000
66,000
2,80,000
3,18,000
2,80,000
188
3,18,000
Cash
(12)
From the following information, prepare cash flow statement of Jai Kisan Co. Ltd. for
the year ended on 31.12.1985.
Balance Sheet
Liabilities
1984
1985
Rs.
Rs.
Plant & Machinery
50,000
91,000
40,000
Inventory
15,000
40,000
14,000
39,000
Debtors
5,000
20,000
Tax Payable
1,000
3,000
20,000
7,000
P&L Alc.
7,000
10,000
2,000
4,000
92,000
1,62,000
92,000
1,62,000
Share Capital
Secured Loans
(Repayable 1995)
Creditors
1984
1985
Rs.
Rs.
70,000
70,000
Assets
Cash
Expenses
Profit and Loss Account for the year ended 31.12.85

Rs.
Rs.
To, Opening Inventory
15,000
By Sales
To, Purchases
98,000
By Closing Inventory
To, Gross Profit
27,000
1,40,000
To, General Expenses
11,000
To, Depreciation
8,000
To, Taxes
4,000
To, Net Profit c/fd
4,000
To Balance c/fd
40,000
1,40,000
By Gross Profit b/fd
27,000
To Dividend
1,00,000
27,000
27,000
1,000
By Balance b/fd
7,000
10,000
By Net Profit b/fd
4,000
11,000
11,000
189
(13) The following details are available from Narayan Company.
Share Capital
Debentures
31.12.85
31.12.86
70,000
74,000
12,000
6,000
Reserve for
Doubtful debts
31.12.85
31.12.86
9,000
7,800
Investment
14,900
17,700
Stock
49,200
42,700
Cash
700
800
Trade Creditors
10,360
11,840
Land
20,000
30,000
P & L A/c
10,040
10,560
Goodwill
10,000
5,000
1,03,100
1,03,200
1,03,100
1,03,200
In addition you are given

(1)
Dividend paid total Rs. 3,500.
(2)
Land was purchased for Rs. 10,000. Amount provided for amortisation of goodwill Rs.
5,000.
(3)
Debentures paid off Rs. 6,000.

(a)
Prepare cash flow statement.
(b)
Prepare funds flow statement and statement of the change in working capital.
14.Following is a summary of Balance Sheets of X Ample Ltd. as at 31st December.
Capital
P & L A/c
Current Liabilities
1982
1983
47,800
6,950
11,000
62,800
7,170
12,030
65,750
82,000
Fixed Assets
(Less : Dep.)
Current Assets
Goodwill
1982
1983
23,890
32,860
9,000
31,090
40,910
10,000
65,750
82,000
190
(1)
A dividend of Rs. 4,780 was paid out of profits.
(2)
Rs. 1,000 were written off the goodwill account.
(3)
In June 1983, the company spent Rs. 17,000 for acquiring the following assets from
another company.
Fixed assets
Rs. 10,000
Current Assets
Rs. 5,000
Goodwill
Rs. 2,000
In order to finance the acquisition, Rs. 10,000 worth fully subscribed shares were issued
to shareholders of X Ample Ltd.
(4)
Fixed assets were sold for Rs. 100 and these assets cost Rs. 1,200 and their present
book value was Rs. 400. The loss on the disposal of these assets was charged to the
profits of 1983.
(5)
Profit for the year amounted to Rs. 6,000 after providing for depreciation Rs. 2,400
Prepare funds flow statement for 1983.
(15) The following are the summarised balance sheets of Ashoka Ltd. as on 31.12.1977 and
31.12.1978.
(Rs. in Lakhs)
Liabilities
77
78
Rs.
Rs.
4.00
4.80
0.20
General Reserves
0.60
1.00
Plant and
Machinery
P & L A/c
0.96
1.36
12% Debentures
1.00

of Rs. 10 Each
Share Premium A/c
Creditors
Proposed Dividend
2.60
0.40
9.56
2.80
0.48
Assets
77
78
Rs.
Rs.
2.10
2.80
Cost
5.80
6.40
Less: Dep.
2.80
3.00
3.00
3.40
Equipments
Cost
0.18
0.20
Less : Dep
0.12
0.08
0.06
0.12
Inventories
2.60
2.10
Debtors
1.50
1.70
Cash
0.30
0.52
9.56
10.64
Free hold Land

and Building
10.64
191
Note :
(1)
The plant and machinery which cost Rs. 40,000 and in respect of which Rs. 26,000 had
been written off as depreciation was sold during the year 1978 for Rs. 6,000.
(2)
Equipments which cost Rs. 10,000 and in respect of which Rs. 8,000 had been written
off as depreciation was sold for Rs. 4,000 during 1978.
(3)
The dividend which was declared in 1977 was paid during 1978.
(a)
A statement showing the change in working capital during 1978.
(b)
A statement showing the sources and applications of working capital (funds flow
statement) during 1978.
(16) Prepare a funds flow statement of Atlantic Business Corporation from following information.
Balance Sheets
Liabilities
1.1.80
31.12.80
Assets
1.1.80
31.12.80
Current Liabilities
30,000
32,000
Cash at Bank
40,000
44,400
Debentures
20,000
20,000
Accounts
Receivable
10,000
20,700
15,000
15,000
4,000
4,000
Business
Premises
20,000
16,000
Plant &
Equipment
15,000
17,000
Accmulated
Dep.
(5,000)
(2,800)
1,000
900
1,00,000
1,15,200
Retained Earnings
15,000
21,200
Inventories
Share Capital
35,000
42,000
Land
Patents &
Trade Mark
1,00,000
192
1,15,200
(1)
Income for the period Rs. 10,000.
(2)
A building that costs Rs. 4,000 and which had a book value of Rs. 1,000 was sold for Rs.
1,400.
(3)
The depreciation charge for the period was Rs. 800.
(4)
There was an issue of rights shares of Rs. 7,000.
(5)
Cash dividend of Rs. 2,000 was declared.
(17) From the following Balance Sheets of Shri Hari Synthetics Limited, prepare a statement of
sources and application of funds and a schedule of changes in working capital for 1980.
Balance Sheets
Liabilties
Share Capital
General Reserve
1979
1980
Rs.
Rs.
1,00,000
1,25,000
25,000
30,000
Assets
1979
1980
Rs.
Rs.
1,00,000
95,000
Plant &
Machinery
75,000
84,500
Inventories
50,000
37,000
Debtors
40,000
32,000
Land & Building
P & L A/c
15,250
15,300
Bank Loan
35,000
Nill
Creditors
75,000
67,500
Cash
250
300
Provision for
taxation
15,000
17,500
Bank
Nil
4,000
Goodwill
Nil
2,500
2,65,250
2,55,300
2,65,250
2,55,300
(1)
Dividend of Rs. 11,000 was paid during 1980.
(2)
Depreciation on plant written off this year was Rs. 7,000.
(3)
A provision for Income Tax for Rs. 16,500 was made during the year.
193
(18) From the details given below, prepare the Cash Flow Statement of a Company for the
Year ended 31st March 80.
(a)
Share Capital
Reserves
and Surplus
Long term
Loan
31.3.79
31.3.80
80,000
80,000
60,000
1,10,000
40,000
60,000
Current
Liabilities
30,000
52,000
Dividend
Provision
16,000
2,10,000
3,18,000
(b)
31.3.79
31.3.80
1,20,000
1,85,000
Depreciation
35,000
55,000
Inventory
85,000
80,000
1,30,000
70,000
Accounts
Receivables
40,000
68,000
5,000
50,000
2,10,000
3,18,000
Fixed Assets
(Gross)
Cash
Income statement for the year ended 31-3-1980.

Sales
Rs. 2,90,000
Cost of Sales
Rs. 1,99,000
Tax Provision
Rs. 25,000
Dividend provided
Rs. 16,000
(19) The following are the summarised Balance Sheets of Honesty Ltd., as at 31st December
1981 and 31st December, 1982.
31.12.81
31.12.82
Rs
Rs.
8,00,000
8,00,000
Capital Reserve
2,00,000
8% debentures
2,50,000
4,00,000
5,00,000
Liabilities :
Issued Share Capital
Provision for depreciation of fixed assets
194
31.12.81
31.12.82
Rs
Rs.
P & L A/c balance on 1st January
3,00,000
4,50,000
2,30,000
3,00,000
20,000
35,000
Current Liabilities
3,50,000
2,50,000
Bank overdraft
2,80,000
1,00,000
23,80,000
28,85,000
5,000
5,80,000
4,80,000
10,00,000
12,50,000
Trade Investments (at cost)
1,00,000
3,00,000
Current Assets
7,00,000
8,50,000
23,80,000
28,85,000
Provision for doubtful debts
Assets
Discount on issue of debentures
Land and Building
Plant and Machinery
The following information is available :

(1)
During the year, Land and Building having an original cost of Rs. 1,00,000 and a written
down value of Rs. 75,000 have been sold for Rs. 3,00,000. The capital profit has been
transferred to Capital Reserve and the profit equivalent to the depreciation written off in
the past has been included in the profit for the year.
(2)
On 1st January, 1982, the company issued debentures of a face value of Rs. 2,50,000 at
a discount of 5%. Part of the discount has been written off out of the profits.
Prepare a statement of sources and application of funds during the year.
195
(20) Following are the comparative Balance Sheets of Bharat company as at December 31
Capital and Liabilities
1982
Rs.
1983
Rs.
Share Capital
70,000
74,000
P & L A/c
10,040
10,560
Debenture
12,000
6,000
700
800
Provision
for doubtful
Assets
1982
Rs.
1983
Rs.
Goodwill
10,000
5,000
Land
20,000
30,000
Stock in trade
49,200
42,700
Debtors
(good)
14,900
17,700
9,000
7,800
1,03,100
1,03,200
debts
Trade
Creditors
Cash
10,360
11,840
1,03,100
1,03,200
Information :
(1)
Dividend were paid totalling Rs. 3,500.
(2)
Land was purchased for Rs. 10,000 and amount provided for the amortization of goodwill
totalled Rs. 5,000.
(3)
Debenture loan was repaid Rs. 6,000.

You are required to prepare funds flow statement and statement of the change in working
capital and other assets.
(21) Balance Sheets of X and Y on 1-1-1987 and 31-12-1987 were as follows :

Balance Sheet
Liabilities
1-1-87
Rs.
31-12-87
Rs.
Creditors
40,000
44,000
Mrs Xs Loan
25,000
Loan from Bank
40,000
50,000
1,25,000
1,53,000
Capital
2,30,000
196
2,47,000
Assets
1-1-87
Rs.
31-12-87
Rs.
Cash
10,000
7,000
Debtors
30,000
50,000
Stock
35,000
25,000
Machinery
80,000
55,000
Land
40,000
50,000
Building
35,000
60,000
2,30,000
2,47,000
During the year, a machine costing Rs. 10,000 (Accumulated depreciation Rs. 3000) was sold
for Rs. 5,000.
The provisions for depreciation against machinery as on 1-1-87 was Rs. 25,000 and on 31-1287 it was Rs. 40,000. Net Profit for the year 1987 amounted to Rs. 45,000. You are required to
prepare cash flow statement.
(22) From the given Balance Sheets of A B C Co. Ltd. prepare a statement of sources and
application of funds.
A B C Co. Ltd.
Balance Sheet
(Rs. In Lakhs)
Liabilities
Paidup share
capital
As at
As at
31.12.70
31.12.71
400
450
Reserve and
surplus
190
226
Secured loans
110
70
Sundry Creditors
170
120
870
Assets
As at
As at
31.12.70
31.12.71
Fixed Assets
607
617
Inventories
180
155
Debtors
35
56
Cash & Bank

Balances
17
20
Investment
31
18
870
866
866
197
23. Following are the Balance Sheets of M/s Sanjeev Ltd. in the condensed form
Sundry
Creditors
Outstanding
Expenses
8% Debentures
1.1.87
31.12.87
51,500
48,000
6,500
6,000
45,000
35,000
1.1.87
31.12.87
Cash/Bank
Balance
45,000
45,000
Sundry
Debtors
33,500
21,500
Term
Investments
55,000
37,000
500
1,000
Depreciation
fund
20,000
22,000
Prepaid
Expense
Reserve for
Contingencies
30,000
30,000
Stock
41,000
53,000
8,000
11,500
Land &
Building
75,000
75,000
Machinery
26,000
35,000
2,76,000
2,67,500
P & L A/c
Capital
1,15,000
1,15,000
2,76,000
2,67,500
Following information is available :

(1)
10% dividend was paid in cash.
(2)
New machinery for Rs. 15,000 was purchased but old machinery costing Rs. 6,000 was
sold for Rs. 2,000.
Accumulated depreciation was Rs. 3,000
(3)
Rs. 10,000 8% Debentures were redeemed by purchase from open market at Rs. 96 for
a debenture of Rs. 100.
(4)
Rs. 18,000 investment were sold at book value.

Prepare cash flow statement.
198
(24) The following are the summaries of the Balance Sheets of a Company as on 31.3.82 and
31.3 83
(Rs. in Lakhs)
Share Capital
1982
1983
4.00
6.00
Land &
Building (at Cost)
1982
1983
3.00
4.00
Reserves &
Surplus
2.50
3.50
Plant &
Machinery
(at Cost)
4.60
6.30
Depreciation fund
0.80
1.20
Inventories
1.80
2.00
Bank Loan
1.60
0.80
Sundry Debtors
1.00
1.55
Sundry Creditors
1.20
1.35
Cash &
Bank Bal.
0.50
0.15
10.90
14.00
Proposed dividend
0.40
0.60
Provision for
taxation
0.40
0.55
10.90
14.00
(1)
A machinery which was purchased earlier for Rs. 60,000 was sold for Rs. 4,000.
The book value of the machine was Rs. 6,000. The company also purchased new
equipments during the year.
(2)
The company has issued new shares to the extent of Rs. 2,00,000 for cash.
(1)
Changes in the working capital and
(2)
Statement of sources and application of funds.
199
(25) The Balance Sheets of Narula Ltd. as at the end of 1980 and 1981 are given as below.
Share Capital
Share Premium
General Reserve
P & L A/c
6% Debentures
Depreciation
Reserve Plant
1980
1981
1980
1981
Rs.
Rs.
Rs.
Rs.
1,00,000
1,50,000
Freehold Land
1,00,000
1,00,000
5,000
Plant at Cost
1,04,000
1,00,000
50,000
60,000
Furniture
at cost
7,000
9,000
Investment
at cost
60,000
80,000
Debtors
32,000
75,000
Stock
60,000
65,000
Cash
30,000
45,000
3,93,000
4,74,000
10,000
70,000
17,000
50,000
50,000
56,000
Furniture
5,000
6,000
Provision
for tax
20,000
30,000
Sundry
Creditors
86,000
95,000
2,000
5,000
3,93,000
4,74,000
Reserve for
Bad Debts
Total
A plant purchased for Rs. 4,000 (Depreciation Rs. 2,000) was sold for cash Rs. 800 on
30.9.81, an item of old furniture was purchased for Rs. 2,000. Depreciation on plant was
provided at 8% on cost (excluding sold out items) and on furniture at 12 1/2% on average cost.
A dividend of 22 1/2% on original shares was paid.
Prepare a funds flow statement for 1981.
200
(26) The following are the summarised trial balances of ABC Company Limited as on 31.3.79
and 31.3.80
31.3.79
DR
Fixed Assets
31.3.80
CR
DR
CR
23,36,960
24,60,500
9,60,540
7,91,800
30,000
25,000
Issued Capital Equity
15,00,000
15,00,000
Preference
3,00,000
4,00,000
Share Premium A/c
30,000
40,000
Debentures
5,00,000
5,00,000
Current Liabilities
6,20,000
4,40,000
Provision for dep.
1,80,000
1,95,000
Provision for
doubtful debts
6,000
5,000
Dividend
1,50,000
Bal. Of P & L A/c

from Previous year
24,400
1,91,500
1,67,100
1,55,800
33,27,500
33,27,500
34,27,300
34,27,300
Current Assets
Debenture Discount
Total
(1)
During the year ended 31.3.80, Machinery costing Rs. 2,00,000 (accumulated
provision for depreciation Rs. 60,000) was sold for Rs. 1,50,000.
(2)
Rs. 1,00,000 preference shares capital was issued during 1979-80 at a premium of
Rs. 10,000.
(3)
The net profit for 1979-80 was arrived at after taking credit for the profit on the sale
of Machinery, reduction in the provision for doubtful debts and writting off the discount
on issue of debentures.

(a)
A statement showing the net increase in working capital during the year 1979-80.
(b)
A statement showing the sources of the increase in the working capital and application
thereof during the year.
201
(27) The financial position of ABC Ltd. on 1.1.86 and 31.12.86 was as follows
Liabilities
Current Liabilities
Loan from
Associate
Company
Loan from
Bank
Capital Reserve
1-1-86
31-12-86
Rs.
Rs.
72,000
82,000
40,000
60,000
50,000
2,96,000
2,98,000
Assets
1-1-86
31-12-86
Rs.
Rs.
8,000
7,200
Debtors
70,000
76,800
Stock
50,000
44,000
Land
40,000
60,000
1,00,000
1,10,000
2,14,000
2,44,000
54,000
72,000
1,60,000
1,72,000
4,28,000
4,70,000
Cash
Buildings
Machinery
Cost
Less:
Provision for
Dep.
Total
4,28,000
4,70,000
During the year, Rs. 52,000 were paid as dividends.

You are required to prepare the cash flow statement as well as funds flow statement.
(28) Robinson Crusee Ltd. present the following financial statements for 1980 and 1981 Prepare
a sources and application of funds statements and evaluate your findings.
Liabilities
Rs. (80)
Rs.(81)
Sundry creditors
8,26,000
12,54,000
Bills Payable
4,52,000
Loan from
Bank
Rs.(80)
Rs. (81)
Cash
1,06,000
62,000
6,28,000
Investment
1,74,000
2,00,000
4,70,000
Sundry
Debtors
6,92,000
10,56,000
Reserves &
surplus
13,84,000
17,28,000
Stock
in trade
8,64,000
13,66,000
Share Capital
12,00,000
12,00,000
Net Fixed
Assets
22,26,000
27,96,000
40,62,000
52,80,000
40,62,000
202
52,80,000
Assets
Depreciation of Rs. 3,78,000 was written off for 1981 on fixed assets.
(29) Following is the Balance Sheet of Sphnix Limited.
Share Capital
Rs. in Lakhs
As on
As on
As on
As on
30.6.80
30.6.81
30.6.80
30.6.81
10.00
20.00
Plant
13.00
18.00
Stock
8.00
9.50
15.00
14.50
Equity Shares of
Rs. 100 each
10% Redeemable
Preference shares
of Rs. 100 each
7.50
2.50
Debtors
Share Premium
0.50
0.25
Bank Balance
3.00
2.50
Misc. Exp.
1.00
1.00
5.00
General Reserve
8.00
4.50
P & L Account
3.00
5.00
Provision for
taxation
5.00
6.00
Current
Liabilities
6.00
2.25
40.00
45.50
40.00
45.50
Capital Redemption
Reserve
Following further information is furnished.

(1)
The company declared a dividend of 20% for the year ended 30.6.80 to equity share
holders as on 30.9.80. Dividend on preference shares capital for the year ended 30.6.80
was paid on 30.6.80.
(2)
The company issued notice to preference shareholders holding preference shares of the
face value of Rs. 5 Lakhs for redemption at a premium of 5% on 1.2.80 and the entire
proceedings were completed before 31.12.80 in accordance with the law.
(3)
The company provided depreciation at 10% on closing balance of plant. During the year
one Plant, whose book value was Rs. 2,00,000 was sold at a loss of Rs. 30,000.
(4)
Miscellaneous expenditure incurred during the year ended 30.6.81 Rs. 25,000 for share
issue and other expenses
203
(5)
A sum of Rs. 4 lakhs has been provided for taxation for the year. Prepare a statement of
sources and application of funds for the period ended 30.6.81.
(30) The summarised balance sheets of P Ltd. as on 31.12.81 and 31.12.82 are as follows.
(Rs. in Lakhs)
Liabilities
31.12.81
31.12.82
6.00
8.00
Fixed Assets
0.20
Cost
General Reserve
3.40
4.00
Less : Dep.
P & L Account
1.20
1.50
Share Capital
Capital Reserve
Debentures
4.00
2.80
Liabilities for
31.12.81
31.12.82
16.00
19.00
4.60
5.80
11.40
13.20
Investments
2.00
1.60
Current Assets
5.60
6.60
0.40
0.20
19.40
21.60
Trade
Preliminary
goods
and services
Assets
expenses
2.40
2.60
1.80
1.70
0.60
0.72
0.08
19.40
21.60
Provision
for tax
Proposed
Dividend
Unpaid Dividend
During 1982 the Company :

(1)
Sold one machine for Rs. 50,000, the cost of the machine was Rs. 1,28,000 and the
depreciation provided for it amounted to Rs. 70,000
(2)
Provided Rs. 1,90,000 as depreciation.
(3)
Redeemed 30% of debentures at Rs. 103.
(4)
Sold some trade investments and profit credited to Capital Reserve.
(5)
Decided to value the stock at cost, whereas previously the practice was to value the
stock at cost less 10%. The stock according to books as on 31.12.81 was Rs. 1.08,000.
The stock on 31.12.82 Rs. 1,50,000 was correctly valued at cost.
You are required to prepare the fund flow statment during 1982.
204
(31) The Balance Sheets of AB Ltd. as on 31.12.85 and 31.12.86 are as under
(Rs. in Lakhs)
Liabilities
31.12.81
31-12-82
Share Capital
Equity
1.50
2.50
31-12-82
0.60
0.47
1.00
0.75
0.90
1.91
0.10
0.35
Stock
0.85
0.78
0.60
0.90
Receivable
0.15
0.18
Goodwill
Land &
1.50
1.00
Reserves &
Building
Plant &
surplus
General Reserve
31-12-81
Fixed Assets
8% Redeemable
Preference
Assets
Machinery
0.20
0.30
Trade
Investment
Capital Reserve
P & L Account
0.25
Current Assets
0.18
0.27
Loan & Adv.
Current Liabilities
and provisions
Sundry Creditors
0.26
0.53
Sundry Debtors
Bills Payable
0.18
0.12
Bills
Provision for
taxation
0.28
0.32
Cash at Bank
0.10
0.22
0.27
0.33
Cash in hand
0.07
0.06
4.37
5.62
Total
4.37
5.62
Proposed
Dividend
Total
The following further particulars are given :

(1)
In 1986, Rs. 18,000 depreciation has been written off plant and machinery, and no
depreciation has been charged on Land and Building.
(2)
A piece of Land had been sold out and the balance has been revalued. Profit on such
sale and revaluation being transferred to Capital Reserve. There is no other entry in
Capital Reserve account.
(3)
(4)
A plant was sold for Rs. 12,000 (WDV Rs. 15,000)

Dividend received amounted to Rs. 2100 which includes Preacquisition dividend of Rs. 600.
(5)
An interim dividend of Rs. 10,000 has been paid in 1986.

You are required to prepare i) Statement of sources and application of funds and ii)
Statement of changes in working capital for the year 1986. All workings should form part
of your answer.
205
(32) The following are the summaries of the balance sheets of a limited company as on 31st
December 1986 and 1987.
Liabilities
1986
1987
1,00,000
1,00,000
General Reserve
38,400
42,000
Sundry Creditors
9,750
6,380
19,000
21,000
1,000
1,200
1,68,150
1,70,580
1986
1987
Building
46,800
45,000
Plant & Machinery
38,280
42,030
Goodwill
13,000
13,000
Investment
10,000
11,250
Stock
30,000
28,000
Sundry Debtors
22,070
22,300
8,000
9,000
1,68,150
1,70,580
Paid Up Share Capital

Provision for doubtful debts
Assets
Cash
After taking the following information into account, prepare a statement showing the changes
in working capital during 1987 and a statement of sources and application of funds during the
year.
206
a.
The profit for 1987 was Rs. 8,600. Against this has been charged depreciation Rs. 3,050
and increase in provision for doubtful debts Rs. 200.
b.
Income tax Rs. 18,000 was paid during the year charged against the provision and in
addition Rs. 20,000 was charged against the profit and carried to the provision.
c.
An interim dividend of Rs. 5,000 was paid in October 1987.
d.
Additional plant was purchased in May 1987 for Rs. 5,000.
e.
Investment (Cost Rs. 5,000) were sold in November 1987 for Rs. 4,800 and on 1st
December 1987, another investment was made for Rs. 6,250.
(33) From the following balance sheets and information of A Ltd. 1985 and 1986, prepare a
funds flow statement and statement of changes in working capital for 1986.
Liabilities
1985
1986
2,00,000
3,00,000
8% Preference Share Capital (Redeemable)
1,00,000
50,000
20,000
30,000
25,000
18,000
27,000
Proposed Dividend
28,000
39,000
Sundry Creditors
25,000
47,000
Bills Payable
10,000
6,000
8,000
6,000
28,000
32,000
4,37,000
5,62,000
1985
1986
50,000
40,000
1,00,000
75,000
Plant
90,000
1,91,000
Trade Investments
10,000
35,000
Sundry Debtors
60,000
90,000
Stock
85,000
78,000
Bills Receivable
15,000
18,000
Cash in Hand
7,000
6,000
Cash at Bank
10,000
22,000
10,000
7,000
4,37,000
5,62,000
General Reserve
Capital Reserve
Liabilities for expenses

Assets
Goodwill
Land and Building
a.
In 1986, Rs. 18,000 depreciation has been written off on plant account and no depreciation
has been charged on land and buildings.
b.
A piece of land has been sold out and the balance has been revalued, profits on revaluation
and sale being transferred to capital reserve. There is no other entry in capital reserve account.
207
c.
A plant was sold for Rs. 12,000 (WDV Rs. 15,000)
d.
Rs. 2,100 dividend has been received, but it includes Rs. 600 pre-acquisition dividend.
e.
An interium dividend of Rs. 10,000 has been paid in 1986.
(34) The balance sheet of X Ltd. as on 31st March 1989 and 1990 are given below :
Liabilities
1989
1990
3,00,000
4,00,000
50,000
65,000
10,000
1,70,000
2,00,000
Current Liabilities
1,40,000
1,50,000
Provision for Income Tax
90,000
80,000
Proposed Dividend
36,000
48,000
7,86,000
9,53,000
1986
1987
Machinery at cost
5,00,000
6,00,000
Less : Depreciation
1,50,000
1,70,000
3,50,000
4,30,000
80,000
60,000
Stock
2,00,000
2,63,000
Sundry Debtors
1,06,000
1,50,000
Cash/Bank
30,000
40,000
20,000
10,000
7,86,000
9,53,000
Share Capital
General Reserve
Capital Reserve
Assets
Trade Investments
During the year ended 31st March 1990, the company :

a.
Sold one machine for Rs. 30,000 the cost of which was Rs. 60,000 and depreciation
provided on it was Rs. 20,000.
b.
Sold trade investment at a profit which was credited to capital reserve.
c.
Decided to write off fixed assets costing Rs. 10,000 (fully depreciated),
Prepare the statement of sources and application of funds during the year ended 31st March,
1990, showing the changes in the working capital. Show all other workings also.
208
NOTES
209
NOTES
210
Chapter 6
CAPITALISATION
The assessment of the funds needed by the company should be done in such a way that the
total amount of funds available should be neither too large nor too less. As such, one of the
most important financial decisions becomes the determination of the amount which the company
should have at its disposal (which may consist of funds required for fixed assets as well as the
portion of current assets to be financed by the company out of long term sources.) This is
capitalisation.
Thus the term capitalisation means total amount of long term funds available to the company.
In the words of Dewing Capitalisation includes capital stock and debt. Therefore capitalisation
includes shares and debentures issued by the company and also the long term loans taken
from the financial institutions. The question arises regarding the inclusion of non-distributed
profit in the capitalisation.
As far as earned profits remained to be distributed (i.e. Reserves and Surplus) are concerned;
it is necessary to classify them as either capital surplus or revenue surplus. Capital Surplus
will always be a part of total capitilisation, though it is available for cash dividend under certain
circumstances. Revenue Surplus will be a part of capitalisation if the management wants to
retain it in the business.
IMPORTANCE
The importance of the determination of amount of capitalisation need not be over-emphasised.
The amount of capitalisation should be only that much which can be justified by its profits and
by the normal rate of return for the industry concerned. If the company earns less than the
other companies in the same industry, value of the shares of company will reduce and the
company will suffer.
E.g. If the company earns an after tax profit of Rs. 20 lakhs and the other companies in the
same industry earn after tax return of 10% on their capitalisation, the expectation of investors
will be the same from company. As such, the ideal capitalisation for the company will be
Rs. 200 lakhs. If the actual capitalisation is Rs. 250 lakhs, the after tax return for the company
Capitalisation
211
becomes 8% which is less than the industry standards. As a result, price of the shares of the
company will be less than that of other companies in the same industry.
THEORIES OF CAPITALISATION
There are two important theories which act as guidelines for determining the amount of
capitalisation.
Cost Theory :
Cost theory of capitalisation considers the amount of capitalisation on the basis of cost of
various assets required to set up the organisation. It gives more stress on current outlays than
on the requirements which are necessary to accommodate the investment on a going concern
basis. The company may need the funds to invest in fixed and current assets and also to meet
promotional and organisational expenses. The total sum required for all these purposes gives
the amount of capitalisation. The cost theory of capitalisation seems to be ideal as it considers
the actual funds to acquire various assets, but it does not consider the earnings capacity of
these assets. If the amount of capitalisation arrived at on this basis includes the cost of
assets acquired at inflated costs or the cost of idle and obsolete assets, the earnings are
bound to be low which will not be able to pay favourable return on the cost of assets and this
will result into over-capitalisation. Similarly, cost theory of capitalisation may not be useful in
case of company with irregular earnings.
Earnings Theory :
Earnings theory of capitalisation considers the amount of capitalisation on the basis of expected
future earnings of the company, by capitalising the future earnings at the appropriate
capitalisation rate. Thus, for determining the amount of capitalisation, it is necessary to take
the following steps:
(a)
To decide future earnings :

Estimations of future earnings may be comparatively an easy task in case of established
concerns as there can be some basis of past data. In case of new concerns, estimating
the future earnings is a difficult task. While estimating future earnings, following factors
should be kept in mind.
212
(i)
Smaller the period, more accurate will be the estimations of future earnings. While
estimating future earnings on the basis of past earnings, weighted average of past
earnings may be considered giving maximum weightage to recent earnings.
(ii)
While considering future earnings on the basis of past earning, care should be
taken to adjust the earnings on account of non-recurring factors. Moreover,
adjustments should be made for known factors in future.
(iii) In case of new concerns, the estimations of future earnings depend upon correct
estimation of future sales (which in turn should be based upon proper sale forecast)
and future costs. Allowance should be made for contingencies.
(b)
To determine Capitalisation rate :

This is the most tricky and delicate issue and is entirely a subjective concept. The
concepts of capitalisation rate may take any of the following forms:
(i)
It is the rate of return that is required to attract investors to the particular organisation.
(ii)
It is the cost of capital.
(iii) It is the rate of earnings of the similar organisations in the same industry.
(c)
To capitalise the future earnings at the decided rate of Capitalisation :
Following example will illustrate the working of earnings theory of capitalisation.

IIIustration :
Expected future earnings of A Ltd. are Rs. 3,00,000. Find out the amount of capitalisation if
rate of return earned by similar types of companies is 15%.
Amount of capitalisation
Rs. 3,00,000 x 100

15
Rs. 20,00,000.
The earnings theory of capitalisation is ideal in the sense that it considers earnings capacity
of the organisation. But it has limitations in the sense that it involves the estimation of two
variables i.e. future earnings and capitalisation rate, which are too difficult to accertain.
As such, in case of established concerns, earnings theory may be useful, whereas new
concerns may prefer cost theory to decide the amount of capitalisation.
OVERCAPITALISATION :
In simple terms, overcapitalisation means existence of excess capital as compared to the
level of activity and requirements. E.g. If a company is earning a profit of Rs. 50,000 and the
normal rate of return applicable for the same industry is 10%, it means that the amount of
shares and debentures should be Rs. 5,00,000. If the amount of shares and debentures
issued by the company is more than Rs. 500,000, then the company will be said to be
overcapitalised.
Capitalisation
213
The term overcapitalisation should not be taken to mean excess funds. There can be situation
of overcapitalisation; still the company may not be having sufficient funds. Similarly, the company
may be having more funds and still may be having a low earning capacity thus resulting into
overcapitalisation.
Causes of overcapitalisation :
The situation of overcapitalisation may arise due to various reasons as stated below:
214
(1)
The assets might have been purchased during the inflationary situations. As such the
real value of the assets is less than the book value of the assets.
(2)
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 the assets.
(3)
The company might have spent huge amounts during its formation stage or might have
spent huge amounts for the purchase of intangible assets like goodwill, patents,
trademarks, copyrights and designs etc. As a result, the earning capacity of the company
may be adversely affected.
(4)
The requirement of funds might not have been properly planned by the company. As a
result, the company may have shortage of capital and to overcome the situation of
shortage of capital, the company may borrow the funds at unremunerative rates of interest,
which in its turn will reduce the earnings of the company.
(5)
The company might have followed the lenient dividend policy without bothering much
about building up the reserves. As a result, the retained profits of the company may be
adversely affected.
(6)
If there is a very high rate of taxation for companies, the company may not be having
sufficient funds left with it for modernisation or renovation programmes. As such, the real
value and the earning capacity of the assets will be lower.
(7)
There may be many instances, where the management of the company may raise large
amounts by issuing securities, irrespective of the fact whether they are really required or
not, in order to take benefit of favourable capital market conditions. As a result, only the
liability of the company increases but not the earning capacity.
(8)
According to the earnings theory of capitalisation, the capitalisation is the amount of

earnings capitalised at a representative rate of return. As such, if the capitalisation rate
is wrong, the amount of capitalisation will be wrong, in such a way that lower the rate of
capitalisation, higher will be amount of capitalisation.
Effects of Overcapitalization :
(1)
On Company :
The real value of the business and its earning capacity reduces with the adverse affect
on market value of shares. Credit standing of the company in the market falls down and
it is difficult to raise further capital. The temporary means like lower amount of depreciation
and maintenance charges are followed to improve the earnings which aggravates the
situation further.
(2)
On Shareholders :
This is the worst affected class. The shares held by them are not having any backing of
tangible assets. Due to the reduced market values, the shares become non-transferable
or are required to be transferred at extremely low prices.
(3)
On Consumers :
To overcome the situation of overcapitalisation and to improve the earnings, the company
may be tempted of increase the selling price, more particulary in monopoly conditions.
Due to this, the quality of the produts may also be affected.
(4)
On Society at Large :
The increasing selling prices and reducing quality cant be continued for a very long time
due to the competition existing in the market. The situation like this means loosing the
backing of the shareholders as well as the consumers. As a result, the company is
dragged towards the winding up which ultimately affects the society at large in the
adverse way in terms of lost industrial production, unemployment generated, unrest
among the workers as a part of society etc.
Remedies Available :
In order to overcome the situation of overcapitalisation, the company may resort to any of the
following remedial measures:
(1)
To reduce the debts by repaying them. But the debts should be repaid out of the own
earnings of the company. There is no point in repaying the debts out of the fresh issue of
shares or debentures, as it does not reduce the amount of capitalisation.
(2)
To redeem the preference shares if they carry too high rate of dividend.
(3)
The persons holding the debentures may be pursuaded to accept new debentures which
carry lower rate of interest.
(4)
The par value of the equity shares may be reduced but this also will have to be done only
after taking the shareholders into confidence.
Capitalisation
215
(5)
The number of equity shares may be reduced but this also will have to be done only after
taking the shareholders into confidence.
UNDERCAPITALISATION
As against the indication of overcapitalisation, the situation of undercapitalisation indicates
the excess of real 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 symptoms of undercapitalisation. As such, undercapitalisation is
an indication of effective and proper utilisation of funds employed in the business. It also
indicates sound financial position and good management of the company. Hence it is said
that undercapitalisation is not an economic problem but a problem in adjusting capital structure.
Causes of Undercapitalisation :
The situation of undercapitalisation may arise due to various reasons as stated below :
(1)
Sometimes, it may so happen that while deciding the amount of shares and debentures
to be issued, the future earnings may be underestimated. As a result, if the actual
earnings turn out to be higher, capitalisation of these earnings may result into
undercapitalisation. Similarly, use of low rate of capitalisation for capitalising the future
earnings may also result in undercapitalisation.
(2)
There may be cases where the earnings of the business come as a windfall. This may
arise during transition from depression to boom. Thus, while recovering from depression,
the companies may find their earnings too high to result into the state of
undercapitalisation.
(3)
Sometimes, the company may follow too conservative policy for paying the dividends
keeping aside more and more profit for making further additions and investments. As a
result, the company may find itself to be in too high profits and thus undercapitalisation.
(4)
The company may be in the position to improve its efficiency through constant
modernisation programmes financed out of its own savings. As such the earnings capacity
of the company may increase to such an extent that the real value of the assets is much
more than the book value which results into the state of undercapitalisation.
Effects of Undercapitalisation :
(1)
On Company : Financial stability and solvency of the company is not affected due to
undercapitalisation, but it still affects the company adversely.
(a)
216
As earnings per share ratio is very high, it increases the competition unduly by
creating a feeling that the line of business is very lucrative.
(b)
Increasing amounts of profits increases the tax liability of the company.
(c)
Marketability of the shares of the company gets restricted due to very high market
prices of shares.
(d)
Very high profitability of the company induces the employees to demand increase
in wages, reduced working hours, more welfare schemes and more social amenities.
(e)
Very high profitability of the company creates a feeling among the customers that
the company is charging very high prices for its products. They try to bring pressure
on the company for reducing the prices of the product.
(f)
Increasing profitability coupled with unrest among the employees as well as

consumers increases the possibility of Government control and intervention over
such companies. This proves to be quite embarrassing for the company.
(2)
On Shareholders : Generally, the shareholders of an undercapitalised concerns are

benefited. Firstly, they get a very high dividend income regularly. Due to the increasing
share prices, the investment of shareholders in the company appreciates considerably
which can be encashed at any time. Secondly, in times of need, the shareholders may
get loans on the security of these shares on easy terms due to high credit standing of
the company in market. However, the shareholders of the undercapitalised concerns
may suffer in the sense that the market for the shares is limited due to very high market
prices of the shares.
(3)
On Society : The effects of undercapitalisation on the society as a whole may not

necessarily be adverse ones. It may encourage new enterpreneurs to start new ventures
or existing ones to expand. This may increase the industrial production and reduce the
unemployment problems. The consumers may get variety of products at the competitive
prices.
However, society may not be benefited if the state of undercapitalisation is not taken into
right spirit. If the feeling is developed among the workers and consumers that they are
being exploited due to ever-increasing profitability of the undercapitalised company, it
may disturb not only the company itself but also the society as a whole. Possibility of
Government intervention and introduction of various control measures (say in the form of
price control, dividend ceiling and dividend freeze) increases.
Remedies Availabe :
The main indications about existence of the situation of undercapitalisation is the ever-increasing
amount of earnings per share. If the situation of undercapitalisation is to be resolved, the
company can take any of the following two measures in order to reduce the amount of earnings
per share.
Capitalisation
217
(1)
Issue of Bonus Shares :

If the company has sufficient amount of reserves and surplus in hand, whole or a part of
reserves and surplus may be capitalised by way of bonus shares. As a result, number of
shares as well as amount of share capital will increase and amount of reserves and
surplus will be reduced. It should be noted that it will affect neither the amount of
capitalisation nor the total income of the shareholders. But it will reduce the amount of
earnings per share.
E.g. Suppose that the present capitalisation of the company comprise of Equity Share
Capital of Rs. 1,00,000 (divided into 1000 Equity Shares of Rs. 100/- each) and reserves
of Rs. 75,000. If the present earnings are Rs. 50,000, the present earnings per share will
Rs. 50 i.e. Rs. 50,000/- : 1000 equity shares. The company decides to issue 500 equity
shares of Rs. 100/- each as bonus shares. As such, the equity share capital will increase
to Rs. 150,000 and reserves will reduce to Rs. 25,000. The earnings of the company will
be considered against total of 1500 equity shares and as such, earnings per share will
reduce to Rs. 33.33 i.e. Rs. 50,000/1500 Equity Shares.
(2)
Splitting the Shares :

To overcome the situation of undercapitalisation, the company may decide to spilt the
shares in order to spread the earnings over a greater number of shares so that the
earnings per share may be reduced.
E.g. Suppose that the present capitalisation of the company consists of equity share
capital of Rs. 1,00,000 (divided into 1000 equity shares of Rs. 100/- each) and its present
earnings are Rs. 50,000. As such, present earning per share will be Rs. 50, i.e. 50,000/
1000 equity shares. The company decided to reduce per value of shares by 50% and
increase the number of shares in the same proportion. As such, now the number of
equity shares will become 2,000 and the earnings of Rs. 50,000 will be distributed over
2,000 equity shares of Rs. 50/-each and earnings per share will reduce to Rs. 25/- i.e.
Rs. 50,000/-2,000 equity shares.
OVERCAPITALISATION VS. UNDERCAPITALISATION :

If effects of both of these situations of overcapitalisation and undercapitalisation are studied
and observed carefully, one will find that both the situations are having bad effects. But the
effects of overcapitalisation are more serious which affect the company, shareholders,
consumers and society at large in an adverse way and the ultimatum involved with this situation
is only the liquidation and winding up of the company, which is a very high cost for the
company to pay. Situation of undercapitalisation increases the competition for the company,
there is discontentment on the part of the employees and the consumers get the feeling that
they are being exploited. But the fact still remains that the shareholders and the society at
218
large are benefited due to the increased prosperity of the company. Naturally, if the choice is
to be made between these two situations, undercapitalisation will be preferable situation. As
such a statement is usually made Both overcapitalisation and undercapitalisation are
undesirable. Of the two, however, overcapitalisation is more fatal and dangerous.
However, ideally the company should try to avoide both the extremes of overcapitalisation as
well as undercapitalisation. It should ideally aim at a fair capitalisation or balanced capitalisation.
WATERED STOCK/WATERED CAPITAL :
When share capital is not represented by the assets of equal value, the situation may mean
introduction of water in the capital or watered capital.
This situation may arise due to following reasons :
(1)
The services of the promoters are valued highly and they are paid usually in the form of
shares of the company. As such, share capital is increased but no assets are created.
(2)
Sometimes, the company pays higher price to the vendors of the assets transferred i.e.,
the price which is more than the worth of the assets.
As such, possibility of the existence of the watered stock or watered capital can be traced to
the intention of the promoters who sell the shares. If the promoters deliberately acquire the
assets at inflated prices, the situation of watered capital may exist.
WATERED CAPITAL VS. OVERCAPITALISATION :
Some times, the terms watered capital and overcapitalisation are confused for each other, but
it is not true. The concept of watered capital is confined to the time of promotion of the
company. Thus, at the time of promotion, the company is expected to acquire the assets at a
price which justifies its real worth. If the assets prove to be worthless or are bought at an
inflated price, the situation of watered capital may exist.
On the other hand, if the company has worked for several years and during these years has
failed to earn sufficient earnings to justify the amount of its capital, the company will be in the
state of overcapitalisation.
Thus, the existence of watered capital may be one of the causes of overcapitalisation, but it is
not inevitably the cause of overcapitalisation as the subsequent earnings may justify the
amount of capitalisation though the capital may remain watered.
The following illustration may make the relationship between watered capital and
overcapitalisation more clear:
Capitalisation
219
Suppose, that a company issues and subscribes for 1000 equity share of Rs. 100 each (i.e.,
total equity share capital is Rs. 1,00,000). This amount has been used to purchase the fixed
assets of the company, the real value of which is only Rs. 75,000. It means that the company
is watered to the tune of Rs. 25,000.
The company operates for six years during which it has earned the average profits of Rs. 16,000.
If the earnings are capitalised at the rate of 5%, the capitalised value of earnings will be
Rs. 3,20,000. It means that the company will be having watered capital but it will not be
overcapitalised.
Now suppose, that the original amount of Rs. 1,00,000 is used by the company to purchase
fixed assets, the real worth of which is really Rs. 1,00,000. It means that there is no watered
capital. However after operating for six years the company is able to earn the average profits
of only Rs. 3,000. If the earnings are capitalised at the rate of 5%, the capitalised value of the
earnings will be Rs. 60,000. It means that at the company has no water in capital but it is
overcapitalised.
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QUESTIONS
1.
As between under and overcapitalisation, the former is the lesser evil of the two but still
both should be discouraged and the ideal should be fair capitalisation. Comment.
2.
What are the causes of overcapitalisation? State the dangers of overcapitalisation to the
society. How will you secure balanced capitalisation?
3.
Discuss the symptoms, causes and remedies of overcapitalisation.
4.
What are the causes of undercapitalisation? State the dangers and disadvantages of
undercapitalisation.
5.
Both overcapitalisation and undercapitalisation are undesirable. Of the two,

overcapitalisation is more fatal and dangerous Discuss.
6.
Write short notes on :

(a)
Balanced Capitalisation
(b)
Undercapitalisation
(c)
Watered Capital
(d)
Earings theory of capitalisation.
(e)
Theories of capitalisation
(f)
Overcapitalisation.
Capitalisation
221
NOTES
222
NOTES
Capitalisation
223
NOTES
224
Chapter 7
SOURCES OF LONG TERM AND
MEDIUM TERM FINANCE
While discussing about capitalisation, we have seen that the amount of long term capital
should not be less than requirement nor it should be more than requirement. There should be
a situation of what can be called as fair capitalization. The next question which arises is what
should be the various sources from which the long term capital may be raised?
The various sources from which a company may meet its long term and medium term
requirement of funds are discussed under the following headings:
a.
Shares
b.
Debentures
c.
Term Loans
d.
Public Deposits
e.
Leasing and Hire Purchase
f.
Retained Earnings
SHARES
A share indicates a smaller unit into which the overall requirement of capital of a company is
subdivided. E.g. If the capital required by a company is Rs. 10 Crores, it can be subdivided
into 1 crore smaller units called as Shares, each one of the units having the value of Rs.10
each, which in technical words is referred to as Face Value or Nominal Value. In the Indian
circumstances, the Face Value or Nominal Value can be decided by the company on its own.
Generally found face value or nominal value is Rs. 10 or Rs. 100 each share.
In the Indian circumstances, a company can raise the long term funds by issuing two types of
shares.
a.
Equity Shares
b.
Preference Shares
225
EQUITY SHARES
These are the corner stones of the financial structure of the company. On the strength of these
shares, the company procures other sources of capital. Equity Shares as a source of long
term funds for the company has the following characteristic features
226
1.
Investors in the equity shares are the real owners of the company. As such, the investors
in equity shares are entitled to the profits earned by the company or the losses incurred
by the company.
2.
Funds raised by the company by way of equity shares are available on permanent basis.
In other words, funds raised by the company by way of equity shares are not required to
be repaid by the company during the lifetime of the company. They are required to be
repaid only at the time of closing down of the company i.e. winding up of the company.
3.
Funds raised by the company by way of equity shares are available to the company on
unsecured basis i.e. the company does not offer any of its assets by way of security to
the investors in equity shares.
4.
Return which the company pays on equity shares is in the form of dividend. The rate of
dividend is not fixed. It generally depends upon the profits earned by the company.
However, a profit making company is under no obligation to pay dividend on equity shares.
5.
Equity shares as a source of raising the long term funds is a risk free source for the
company, as the company does not commit anything on equity shares.
6.
Equity shares as an investment is very risky for the investors. As such, the investors are
granted the voting rights. By exercising the voting rights, the investors can participate in
the affairs regarding the business of the company. These voting rights are generally
proportionate voting rights, in the sense the voting rights of the investors are in proportion
to their investment on the overall capital of the company. However, it should be noted that
due to some recent amendments to the companies Act, 1956, it may be possible for the
companies to issue the equity shares with disproportionate voting rights.
7.
Equity shareholders may not be able to compel the company to pay the dividend, but
they enjoy the right to maintain the proportionate interest in profits, assets and control of
the company. As such, if the company wants to issue additional equity shares, it is
under legal obligation to offer these equity shares to the existing shareholders first,
before going to the open market as a general offer. This right of equity shareholders is
called Pre-emptive Right.
8.
In financial terms, equity shares as a source of raising the funds is a costly source
available to the company. The reasons for this will be discussed in the following
paragraphs.
Advantages of Equity Shares

To the Company
While issuing the equity shares, the company does not accept any obligation of any type. The
company neither offers any security to the investors in the form of assets of the company nor
commits the repayment of these shares during the life time of the company nor commits the
payment of any dividend to the shareholders. This is a total risk free source of capital for the
company.
To the investors
a.
As per the law, the liability of the equity shareholders is restricted only to the extent of
face value of the shares purchased by the investors. The personal properties of the
investors are not at stake even if the company fails to fulfil its contractual obligations.
b.
Possibility of getting higher returns is always there in case of equity shares. The investors
can gain from equity shares in two forms. One, the regular dividend paid by the company
in the form of cash or by way of bonus shares and Second, the capital appreciation
received by the investors by selling the equity shares in the secondary market i.e. stock
exchanges. As such, equity shares is a good investment attracting the risk taking investors.
Disadvantages of Equity Shares

a.
As the investors in equity shares enjoy the voting powers to control the affairs of the
company, the management of the company is always under constant danger of getting
interfered and disturbed in the regular administration.
b.
The cost associated with the equity shares is on the higher side as compared to the
borrowed capital. By issuing more and more equity shares, the company looses the
cost advantage.
c.
Many categories of investors i.e. institutional investors may not be able to invest in the
equity shares due to various statutory restrictions.
d.
The excessive issue of equity shares may result in over capitalization to be realized in
future.
PREFERENCE SHARES
These are the shares which enjoy preferential treatment as compared to the equity shares in
respect of the following factors
a.
Unlike in case of equity shares, the preference shares carry the dividend at a fixed rate
which is payable even before any dividend is paid on equity shares.
b.
In the case of winding up of the company, preference shareholders are paid back their
investment even before the investment of equity shareholders is paid off.
227
Preference Shares as a source of funds for the company involves the following characteristic
features
1.
Investors in preference shares are not the absolute owners of the company.
2.
Funds raised by the company by way of preference shares are required to be repaid
during the existence of the company. As per the provisions of Section 80 of the Companies
Act, the company can issue the preference shares maximum for the duration of 20
years. As such, unlike equity shares, preference shares is not a permanent capital
available for the company.
3.
Like in case of equity shares, funds raised by the company by way of preference shares
are available to the company on unsecured basis i.e. the company does not offer any of
its assets by way of security to the investors in preference shares.
4.
Return which the company pays on preference shares is also in the form of dividend
which is payable by the company out of the profits earned. However, unlike in case of
equity shares, the rate of dividend is prefixed and precommunicated to the investors.
5.
As compared to equity shares, risk on the part of company is more in case of preference
shares.
6.
Preference shares as an investment is comparatively less risky for the investors. As

such, generally, preference shares do not carry any voting rights and hence they do not
have any say in controlling the affairs of the company. However, Companies Act, 1956
provides for voting rights to preference shareholders in the following circumstances.
a.
If any resolution directly affecting the rights of the preference shareholders is discussed
by the equity shareholders (e.g. winding up of the company or reduction of share capital
etc.), the preference shareholders can vote on such resolutions.
b.
If the dividend has not been paid on the preference shares, in case of cumulative preference
shares for an aggregate period of two years and in case of non-cumulative preference
shares, either for a period of two consecutive years or for an aggregate period of three
years out of the six preceding years, then the preference shareholders can vote on all
the matters placed before the company in the meeting of the equity shareholders.
Types of Preference Shares

If the company wants to issue the preference shares, they can be of different varieties.
1.
Convertible Vs. Non-convertible

Convertible Preference Shares are those which can be converted in the equity shares at
a later date, the terms of conversion (i.e. when the conversion will take place, at what
rate it will take place etc.) being known to the investors in the beginning only.
228
Non-convertible Preference Shares are those which can not be converted in the form of
equity shares. They are issued as preference shares and they remain the preference
shares.
2.
Cumulative Vs. Non-cumulative

Preference Shares are to be paid dividend at a fixed rate. However, dividend is payable
only if there are profits. The question arises as to what happens if the company is unable
to pay dividend as there are no profits earned by the company. It depends upon the types
of preference shares.
If the preference shares are cumulative preference shares and the company is unable to
pay the dividend in a certain year due to non-availability of profits, the arrears of dividend
go on accumulating till the company earns the profits and once the company earns the
profits, the arrears of preference dividend are required to be paid first, then only the
dividend can be paid on equity shares.
If the preference shares are non-cumulative preference shares and the company is unable
to pay the dividend in a certain year due to non-availability of profits, the arrears of
preference dividend do not accumulate. The dividend lapses in the year of loss.
DEBENTURES
In simple words, Debenture means a document containing an acknowledgement of indebtedness
issued by a company and giving an undertaking to repay the debt at a specified date or at the
option of the company and in the meantime to pay the interest at a fixed rate and at the
intervals stated in the debenture.
The above description of debentures indicates the following characteristic features of debentures.
1.
Investors who invest in the debentures of the company are not the owners of the company.
They are the creditors of the company or in other words, the company borrows the
money from them.
2.
Funds raised by the company by way of debentures are required to be repaid during the
life time of the company at the time stipulated by the company. As such, debentures is
not a source of permanent capital. It can be considered to be a long term source.
3.
In practical circumstances, debentures are generally secured i.e. the company offers
some of the assets as security to the investors in debentures.
4.
Return paid by the company is in the form of interest. Rate of interest is predetermined,
but the same can be freely decided by the company. The interest on debenture is payable
even if the company does not earn the profits.
229
5.
Debentures as a source of raising long term funds is very risky from companys point of
view. The risk accepted by the company in case of debentures is twofold. One, to pay
the interest at the predecided rate and at predecided time intervals irrespective of nonavailability of profits and Second, to repay the principal amount of debentures during the
life time of the company.
6.
Risk on the part of investors is very less in case of debentures. The investors in debentures
being the creditors of the company, they can not control the affairs of the company. As
such, the debentures do not carry any voting rights. However, in the event of non-payment
of interest or principal amount, they can interfere in the operations of the company by
taking legal action.
7.
In financial terms, debentures prove to be a cheap source of funds from the companys
point of view. The reasons for this will be discussed in the following paragraphs.
Types of Debentures
A Company can issue debentures of different varieties as described below
a.
Registered Vs. Bearer

Registered Debentures are those the holders of which are registered in the company as
debenture holders and those can be transferred to another person only through the
company. Holders of bearer debentures are not registered with the company and can be
transferred to anybody by mere delivery.
b.
Convertible Vs. Non-Convertible

Convertible Debentures are the debentures which have the right to get converted into the
equity shares of the company. Non-Convertible Debentures do not enjoy such right.
Based upon the conversion criteria, debentures can be classified as below
a.
Fully Convertible Debentures (FCD)
b.
Partly Convertible Debentures (PCD)
c.
Non-Convertible Debentures (NCD)
d.
Optionally Convertible Debentures
FCDs are the debentures which are entirely convertible in the form of equity shares of the
company. E.g. the terms of issue may provide that the face value of the debenture is Rs.
100. At the end of 5 years, the investors will get 1 equity share of the company. This is
the case of FCD.
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PCDs are the debentures which are partly convertible in the form of equity shares of the
company. E.g. the terms of issue may provide that the face value of the debenture is Rs.
200. At the end of 5 years, the investors will get one equity share of Rs. 100 each while
the remaining amount of Rs. 100 will be repaid at the end of 7 years. This is the case of
PCD.
NCDs are the debentures which are not convertible in the equity shares of the company.
They are issued as debentures, they are repaid as debentures.
In case of optionally convertible debentures, the investors are given the option to convert
their investment in the form of equity shares of the company.
Advantages of Debentures
To the company
a.
By issuing the debentures, the controlling position of the existing equity shareholders
does not get affected as the debentures do not carry any voting rights.
b.
Cost associated with debentures is comparatively less than the cost associated with
the equity shares. As such, it is economical for the company to issue debentures.
c.
During the period of depression when the investors are not prepared to take much of the
risk, the company may be compelled to issue debentures as a source of raising long
term capital.
d.
The company might have borrowed various small amount of debts of short duration which
may prove to be costly and burdensome for the company. All these small debts may be
converted into a single issue of debentures which may prove to be less costly for the
company.
To the investors
Debentures prove to be a good investment option for the conservative investors as well as the
institutional investors, mainly due to following two reasons
a.
Fixed rate of interest payable by the company irrespective of non-availability of profits.
b.
Security available for the investment.
Disadvantages of Debentures
a.
By issuing the debentures, the company accepts the risk of two types. One to pay the
interest at a fixed rate, irrespective of the non-availability of profits and Second, repayment
of principal amount at the predecided time. If earnings of the company are not stable or
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if the demand for the products of the company is highly elastic, debentures prove to be
a very risky proposition for the company. Any adverse change in the earnings or demand
may prove to be fatal for the company.
b.
Debentures is usually a secured source for raising the long term requirements of funds
and usually the security offered to the investors is the fixed assets of the company. A
company which requires less investment in fixed assets, viz. A trading company, may
find debentures as a wrong source for raising the long term requirement of funds as it
does not have sufficient fixed assets to offer as security.
Protection of interests of Debentureholders

Recent amendments to Companies Act, 1956 have made some provisions with the intention
to protect the interests of the debentureholders.
a.
b.
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A Company accepting the funds from debentureholders shall appoint one or more
debenture trustees and in Prospectus or the Letter of Offer, the company should state
that the debenture trustee or trustees have given their consent to the company to act in
the same capacity. The debenture trustee will be primarily responsible to ensure that the
interests of the debentureholders are protected (including the creation of security) and
the grievances of the debentureholders are effectively redressed. To be more specific,
the debenture trustee should take following effective steps
i)
To ensure that the assets of the company and of the guarantors are sufficient to
discharge the principal amount at all times. If it is concluded that the assets of the
company are insufficient to discharge the principal amount, the trustees may file a
petition before the Company Law Board who, after hearing both the parties, may
impose restrictions on the incurring of any further liabilities by the company.
ii)
To satisfy himself that the prospectus or the letter of offer does not contain any
matter inconsistent with the terms of debentures or with the trust deed.
iii)
To ensure that the company does not commit any breach of the provisions of the
trust deed.
iv)
To take steps to remedy any breach of the provisions of trust deed or terms of issue
of debentures.
v)
To take steps to call meeting of the debentureholders as and when required.
The trust deed for securing the issue of debentures should be executed in the prescribed
form and within stipulated period. This trust deed shall be open for inspection by any
member or debentureholder of the company and he can take the copies of the same on
the payment of prescribed fees. If the trust deed is not made available to the member or
the debentureholder, the company and every responsible officer shall be punishable with
a fine which may extend to Rs. 500 per day during which the offence continues.
c.
A company issuing debentures is required to create debenture redemption reserve for

the redemption of debentures and every year adequate amount should be credited to this
reserve out of the profits until such debentures are redeemed. The amount standing to
the credit of debenture redemption reserve shall be available only for the redemption of
debentures. If the company fails to redeem the debentures on the date of maturity, on
the application of any or all the debentureholders, the Company Law Board can order the
company to pay the principal amount of debentures and the interest thereon. In case of
any default in complying with the order of Company Law Board, every responsible officer
shall be punishable with a fine which may extend to Rs. 500 per day during which the
offence continues.
TERM LOANS
Term Loans indicate liabilities accepted by the company which are for the purpose of purchasing
the fixed assets and are repayable over a period of 3 to 10 years. The term loans may be
granted by the Banks (nationalized, cooperative, rural etc.) or the Financial Institutions like
Industrial Development Bank of India (IDBI), Industrial Credit and Investment Corporation of
India (ICICI), Industrial Finance Corporation of India (IFCI) etc.
Features of Term Loans
1.
Banks or Financial Institutions granting the term loans are not at all the owners of the
company. They are creditors of the company. They lend the funds to the company.
2.
Term Loans are required to be repaid during the life time of the company at the predecided
intervals say monthly, quarterly, yearly etc. The initial gap after which the repayment of
term loan starts (technically referred to as the morotorium period) also depends upon the
agreement between the borrowing company and the lending bank or financial institution.
3.
The term loans may be secured or unsecured, though normally all the term loans are
secured. The security which is offered for the term loans is the hypothecation or mortgage
of the fixed assets purchased with the help of term loans.
4.
Return payable by the company on term loans is in the form of interest which may be
calculated on monthly or quarterly or half yearly basis at a predecided rate on the
outstanding balance of the term loan. The interest on term loan is payable despite the
non-availability of profits.
5.
Term Loans as a source of raising long term funds is very risky from companys point of
view. The risk accepted by the company in case of term loans is twofold. One, to pay the
interest at the predecided rate and at predecided time intervals irrespective of non-availabilty
of profits and Second, to repay the principal amount of term loans.
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6.
Risk on the part of lending bank or financial institution is very less in case of term loans.
The banks or financial institutions being the creditors of the company, they can not
control the affairs of the company. As such, they do not have any voting rights. However,
in the event of non-payment of interest or principal amount, they can interfere in the
operations of the company by taking legal action.
7.
In financial terms, as in case of debentures, term loans also prove to be a cheap source
of funds from the companys point of view. The reasons for this will be discussed in the
following paragraphs.
Operational Formalities
Term Loans is a contract between the borrowing company and lending bank or financial
institution. This contract is a written contract referred to as term loan agreement. The term
loan agreement stipulates the various terms and conditions on which the relationship between
the borrowing company and lending bank or financial institution is regulated. Term Loan
agreement has various clauses.
1.
Amount of loan and the period of repayment
2.
Rate of interest payable and the method of payment of interest
3.
Nature of security offered
In addition to the general security offered for the term loan, the agreement may provide for
certain additional covenants in order to protect the interests of the lender. These covenants
may take various forms, some of which are stated below -
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1.
That the borrowing company will submit the copy of Annual Accounts to the lender, soon
after they are finalised.
2.
That the assets purchased with the help of term loans will be properly maintained and
insured by the borrowing company.
3.
That the lender may have a representative on the Board of Directors of the company ( viz.
Nominee Director) if the loan amount is sizeable.
4.
The lender will like to ensure that the borrowing company has the liquid resources in its
hands whenever the interest or the installments of the term loans are due. As such, the
lender will like to confirm that the liquid resources of the company are not blocked for
unnecessary purposes. Hence, the agreement may stipulate that
a.
The company will not pay dividend without the consent of the lender.
b.
The company will not make long term loans to directors/officers.
c.
The company will not invest in outside corporate securities.
d.
The company will not redeem the debt before maturity.

PUBLIC DEPOSITS
In the recent past, Public Deposits has become one of the most important sources available
to the companies for meeting the medium term requirement of funds. The companies find
public deposits as an attractive source mainly due to following reasons
a.
Raising the funds in the form of public deposits is more convenient than borrowing the
funds from banks and financial institutions. Borrowing the funds from banks or financial
institutions is a tedious job involving the compliance with many procedural requirements
like margin money stipulations, security requirements, submission of periodical
statements etc. None of these procedural requirements are required to be complied with
in case of public deposits.
b.
The rate of interest which the company is required to pay on public deposits is
comparatively less than the rate of interest payable on the funds borrowed from banks or
financial institutions.
c.
Public Deposits are unsecured borrowings for the company.
d.
The company can raise the funds in the form of public deposits which can be used for
any purposes. The end use of the funds raised in the form of public deposits is not
committed by the company.
e.
In the situations of credit squeeze introduced by the banks, public deposits plays a very
important role.
Control over Public Deposits

The phenomenal growth of public deposits as a source of funds for the companies was an
issue of concern for the Government, as it distorted the interest pattern and it encouraged the
non-priority sectors to grow. As such, the deposits of the Governments owned agencies like
banks, UTI, LIC etc. were diverted to public deposits. Hence, it was thought necessary to
exercise control over the growth of public deposits as a source of funds for the companies.
This came into application by the introduction of Section 58A and 58B to the Companies Act,
1956 vide Amendment Act, 1974 and the announcement of Companies (Acceptance of Deposits)
Rules, 1975 which applies to the companies which are not Non-Banking Finance Companies
(NBFCs). The main provisions of these regulations are discussed below
Applicability :
In the word deposits, all types of loans and deposits are covered, however the following
deposits are excluded.
a.
Any amount received from Government, Local Authority and Foreign Government/Citizens/
Authority/Person and any amount whose repayment is guaranteed by Government.
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b.
Any loans from Banks/Financial Institutions.
c.
Amount received by a company from another company.
d.
Security deposits from employees.
e.
Advance for purchase or sales.
f.
Amounts received for subscribing to shares/debentures pending allotment.
g.
Amounts received in trust or amounts in transit.
h.
Amounts received from directors or from shareholders of a Private Limited Company.
Acceptance of deposits :
While accepting the deposits, the company will have to comply with following requirements.
a)
No company shall accept any deposit which is repayable on demand.
b)
Minimum period for which any deposit can be accepted will be 6 months and the maximum
period will be 36 months.
Note : A company, may, for the purpose of meeting its short term requirement of funds,
accept the deposits for a period of less than 6 months but not less than 3 months, but
their amount should not exceed 10% of paid up share capital and free reserves.
c)
The maximum amount of deposits which a company may accept will be 25% of the
aggregate of paid up share capital and free reserves out of which not more than 10%
should be from a shareholder of non-private limited companies or should be guaranteed
by any director.
d)
The maximum interest which a company may pay on the deposits will be 12.5% at
monthly rests. If the interest is paid at shorter rests, the amount of interest shall be
discounted so as not to exceed the interest calculated at monthly rests.
e)
The maximum amount of brokerage which a company may pay on deposits accepted
will be following percentage of deposits :
1% for deposits upto one year.
1.5% for deposits upto two years.
2% for deposits upto three years.
Notes : Free reserves as mentioned above will include capital redemption reserve and
share premium but will not include,
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i)
Accumulated loss amount, deferred revenue expenses, and other intangible assets.
ii)
Revaluation reserve.
iii)
Depreciation reserve or bad debts reserve.

Maintenance of liquid assets :

Every company, before 30th day of April every year should deposit or invest, a sum equal to
atleast 15% of the deposits maturing during the year ending on 31st March next following in
the form of:
(i)
Current or other deposit account with any scheduled Bank.
(ii)
Central or State Government Securities.
(iii) Bonds issued by Housing Development Finance Corporation Limited.

The amount so deposited or invested shall not be utilised for any purpose other than repayment
of deposits maturing during the year.
Advertisement :
If a company decides to invite the public deposits, it should publish an advertisement in a
leading English newspaper and in one local newspaper circulating in the state in which
registered office of the company is situated. Such advertisement should be issued on the
authority and in the name of the Board of Directors of the company and should contain a
reference to the date on which the Board of Directors has approved the text of the advertisement.
The advertisement should contain the following details :
a)
Name of the company
b)
Date of incorporation of the company
c)
Business carried on by the company and its subsidiaries with the details of its branches
or units, if any.
d)
Brief particulars of management of the company.
e)
Names, addresses and occupations of the Directors
f)
Profits before tax and profits after tax, for the three financial years immediately preceding
the date of advertisement.
g)
Summarised financial Position of the company (in the form prescribed by Schedule VI of
the Companies Act, 1956) as in the two audited balance sheets immediately preceding
the date of advertisement.
h)
The amount of deposits which can be raised by the company and the aggregate of
deposits actually held on the last day of the immediately preceding financial year.
i)
A statement to the effect that on the date of advertisement, the company has no overdue
deposits other than the unclaimed deposits or a statement showing the amount of such
overdue deposits.
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j)
A declaration to the effect

i)
That the company has complied with the provisions of these rules.
ii)
That the compliance with these rules does not imply that repayment of deposits is
guaranteed by the Central Government.
iii)
That the deposits accepted by the company are unsecured and rank pari passu
with the other unsecured liabilities.
iv)
That the company is not in default in the repayments of deposits and interest
thereupon in accordance with the terms and conditions of such deposits.
Before the advertisement is issued, a copy of the same, signed by a majority of the Directors,
should be delivered to the Registrar of Companies.
The advertisement so issued shall be valid until the expiry of six months from the date of
closure of the financial year in which it is issued or the date on which balance sheet is laid
before the company in general meeting, and if the Annual General Meeting has not been held,
the latest day on which the meeting should have been held, whichever is earlier.
If a company wants to accept the deposits without making public invitation, before accepting
the deposits it should deliver a statement in lieu of advertisement to the Registrar of Companies.
Such statement in lieu of advertisement attracts the same provisions as applicable to the
advertisement as to the contents and the validity.
Application form :
A Company can accept or renew deposits, only on application being made by the intending
depositor. Such application form shall be accompanied by a statement made by the company
containing all the particulars stated under the head Advertisement as stated above.
Deposit Receipt :
After accepting the deposits, every company should furnish to the depositor, within the period
of 8 weeks from the date of receipt of money or realisation of cheques, the deposit receipt
containing the following particulars.
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i)
Date of deposit
ii)
Name and address of depositor
iii)
Amount of deposit.
iv)
Rate of interest.
v)
Date of maturity.
Deposit Register :
Every company accepting the deposits should maintain registers, at the registered office,
showing the following particulars.
i)
Name and address of depositor
ii)
Date and amount of deposit.
iii)
Duration of deposit.
iv)
Date of repayment.
v)
Rate of interest.
vi)
Date or dates on which interest is payable.
vii)
Any other particulars.
Prepayment of deposits :
If a deposit is repaid after 6 months from the date of deposit but before its expiry, the rate of
interest on such deposit shall be reduced by 1% from the rate which the company would have
paid had the deposit been accepted for the period for which such deposit had run.
Annual Returns :
The companies to whom these rules apply, are required to file with Registrar of Companies, a
return in prescribed form, on or before 30th June every year and the return should contain
information of deposits as on 31st March of that year. Such return should be duly certified by
the auditor of the company. A copy of this return is required to be sent to Reserve Bank of
India.
Protection of interests of depositors :
Section 58-A of the Companies Act, 1956, makes the provision for the protection of interests
of depositors. The said section provides that if a company fails to repay any deposit or any
part thereof as per its terms and conditions, the Company Law Board has been empowered to
order the company to make the repayment of such deposit or the part thereof forthwith or
within such time and subject to such conditions as may be prescribed. Such action can be
taken by Company Law Board on its own motion or on the application of the depositors.
However, before making the order, company Law Board should give reasonable opportunity of
being heard to the company and other interested persons.
It is further provided that whosoever fails to comply with the order of Company Law Board Shall
be punishable with imprisonment which may extend to three years and shall also be liable to
a fine of not less than Rs. 500 per day during which such non-compliance continues.
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Provisions to protect the interests of small depositors :

Companies Amendment Act, 2000 has made certain provisions to protect the interests of
small depositors. A small depositor means a depositor who has deposited in a financial year
a sum not exceeding Rs. 20,000 in a company.
The provisions are stated below :
a.
Every company accepting deposits from the small depositors shall inform the Company
Law Board of any default made by it in respect of repayment of deposit or interest
thereon.
b.
A Company shall not accept any further deposit from the small depositor unless each
small depositor whose deposit has matured has been paid the amount of his deposit and
interest thereon.
c.
Every company who has defaulted in the repayment of deposit or the payment of interest
thereon to a small depositor, shall state, in every further advertisement and application
form inviting deposits from the public, the total number of small depositors and the
amount due to them in respect of which default has been made.
d.
If any interest accrued on the deposits of small depositors has been waived, the fact of
such waiver shall be mentioned by the company in every advertisement and application
form inviting deposits issued after such waiver.
e.
Every application form issued by the company to small depositor shall contain a statement
stating that the applicant has been appraised of
f.
1.
Every past default of the company in the repayment of deposit or interest thereon,
if any such default has taken place.
2.
The waiver of interest if any and reasons therefor.
If anybody knowingly fails to comply with the above requirements or fails to comply with
any order of Company Law Board, he shall be punishable with the imprisonment upto
three years and shall be liable to pay fine of not less than Rs. 500 per day during which
default continues.
Point to be noted here is that the above provisions apply only in case of small depositors and
not in case of large depositors.
LEASE FINANCING
In the recent years, the lease financing has emerged as one of the most important sources of
long term financing. Under the leasing agreements, the company acquires the right to use the
asset without holding the title to it. Thus, it is the written agreement between the owner of the
assets, called the lessor, and the user of the assets, called the lessee whereby the lessor
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permits the lessee to economically use the asset for a specified period of time but the title of
the asset is retained by the lessor. This economical use of the asset is permitted by the
lessor on the payment of periodical amount which is in the form of lease rent.
Lease Agreement or Lease Deed :
Lease agreement/deed is the most important document in any leasing activity as it starts the
legal relationship between the lessor and lessee.
The usual contents of the lease agreement/deed are as stated below.
1)
Description and cost of equipment to be acquired.
2)
Commencement date for lease contract.
3)
Amount of lease rentals and mode of payments.
4)
Fixed period of lease, renewal options and the terms during secondary period as to the
amount of lease rentals or purchase option.
Note : After the fixed period of lease, the lease is usually given the option either to renew
the lease from time to time at a nominal lease rental or to purchase the asset at a price
which is reasonably lower than the fair value of asset.
5)
Guarantee for payment of lease rental by lessee.
6)
Variation of lease rentals.
7)
Termination of the lease agreement in the event of certain occurrences.
8)
In order to protect the interests of the lessor and lessee, certain covenants as stated
below may also be incorporated as a part of lease deed.
i)
That lessee will maintain the asset in good working condition and pay all taxes, insurance
etc.
ii)
That lessee will not sell or mortgage or charge the land or building on which equipment
is installed without notifying to lessor.
iii)
That lessee will not claim any grant or relief available to the lessor.
iv)
That lessee will not alter or modify equipment without lessors knowledge.
v)
That lessee will accept the lessors right to inspect the equipment.
Advantages of Leasing for the lessee :

1)
Risks of ownership : Leasing facilitates lessee to avoid the risks attached with the ownership
of the equipments, say risk of obsolescence in the area of everchanging technologies.
2)
Saving of capital outlay : Leasing enables lessee to make full use of the asset without
making immediate payments of the purchase price which otherwise would be payable
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by him. Some lessors may also finance to the extent of 100% of the cost of the equipment
where lessee is not required to make any provision for asset acquisition.
3)
Tax advantages : Under the leasing propositions, the payment of lease rents is the tax
deductible expenditure. On the other hand, if the company decides to own the same
asset by resorting to the borrowing, the expenses which are available for deduction for
tax purposes are in the form of depreciation and interest on borrowing.
4)
Structuring of lease rents : Lessor may structure the payments of lease rents in such
a way that it matches the revenue expectations of the lessee from the equipments,
which may not be possible if lessee resorts to borrowing for owning the asset.
5)
No effect on borrowing power : As the obligations accepted by the lessee under the
lease deed appear nowhere on the balance sheet as debt, the borrowing power of the
lessee still remains unaffected. The lessee may still resort to debt capital provided equity
base of the company permits further borrowing.
6)
Convenience : Leasing is the quickest method of financing the requirements of long

term capital and lessee is relieved from the rigid and time consuming procedures and
terms and conditions involved in other forms of term borrowings say term loans.
Evaluation of lease financing :

The alternative of leasing can be evaluated under the following headings:
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a)
Does leasing increase borrowing capacity of a firm. The answer to this question is yes,
E.g. suppose that at present a company is having the fixed assets the cost of which is
Rs. 200 lakhs which are financed by way of equity shares of Rs. 100 lakhs and Rs. 100
lakhs by way of debentures. As such the present debt equity ratio is 1:1. Now, if the
company wants to acquire further fixed assets worth Rs. 100 lakhs, it can purchase it
outright by financing the same out of debt capital in which case, the debt equity ratio will
be 2:1 which will inevitably mean reduced borrowing capacity. If the company decides to
take these assets on lease, its debt equity ratio will remain unaffected as it gets only the
right to use the assets and not the ownership of the assets. As such, due to lease
transactions, the debt equity ratio of the company remains unaffected which indicates
increased borrowing capacity. However, with greater sophistication in financial appraisal
and improved financial disclosure practices, leases are likely to be viewed as debts.
b)
Does leasing release the firm from bad investment. An investment may turn out to be
bad if the basic purpose for which it is made is defeated. E.g. Investment made by a
company in a machine may turn out to be bad if the machine becomes obsolete or nonuseable in terms of the rapid technological development. Under these circumstances it
can be said that leasing releases a firm from bad investment as in case of leasing, the
risk of obsolescence is transferred to the lessor i.e. the owner of the asset, and the
funds of the firm may be used for more profitable purposes.
However, this argument may not be valid under all the circumstances. Lessor, if aware.of
the risk of obsolescence, may charge the lessee for bearing the risk and it will be in the
form of higher amount of lease rentals. In that case, lessee will not be really released
from the risk of bad investment unless the risk of obsolescence on the assets is greater
than as estimated by the lessor and as recovered by way of lease rentals
Hire Purchasing :
Nowdays, in addition to Lease Financing, Hire Purchasing is also emerging as a popular
source of long term financing whereby the company can acquire long term infrastructural
facilities, say fixed assets. It will be pertinent to note here the relationship between lease
financing and hire purchasing.
Hire purchase indicates an agreement between the owner of goods, called as the hiree and the
user of the goods, called as the hirer whereby the hiree deliver the goods to the hirer but the
ownership of the goods remains with the hiree. In return, the hirer makes the periodical payments
of hire charges which are partly against the capital repayment and partly against the interest
payable. For accounting and tax purposes, only the interest is treated as revenue expenditure
and is considered to be a tax deductible expenditure. The hirer capitalises the asset purchased
under the hire purchase agreement though he is not the owner of the assets. Depreciation is
considered by the hirer as an expenditure, debiting the same to profit and loss account and
hence becomes the tax deductible expenditure. The further hire purchase installments towards
capital which are not yet due are shown as liability on the Balance Sheet.
After the hire charges are paid by the hirer in full, he gets an option of purchasing the asset
entirely in which case the installments paid earlier are converted into the purchase price and
the ownership of the asset is transferred to the hirer. If the hirer fails to pay any installment,
hiree can take the possession of the asset without refunding any installment paid earlier. It is
the duty of the hirer to keep the asset in good condition. As such, the hiree may stipulate that
the assets should be properly insured, the premium being paid by the hirer. Further, it may
also be stipulated that the hirer will not sell or exchange the asset till he becomes the owner
of the asset. The hirer has a right to put an end to the agreement before the last installment is
paid, but the installments paid by him previously are not refunded to him.
Accounting for Leasing and Hire Purchase :
It can be seen from the above discussion that leasing and hire purchase are similar to each
other in certain respects. In both the cases, right to use the asset is available to the lessee or
hirer but ownership of the asset remains with the lessor or hiree.
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Accounting of lease transactions :

a)
Entire amount of lease rentals paid by the lessee to the lessor are considered to be
revenue expenditure for the lessee hence are debited to the Profit & Loss Account,
reducing the profits or increasing the losses. Lease rentals paid by the lessee are
considered to be tax deductible expenditure for the lessee.
b)
Asset which is taken on lease by the lessee is not capitalised by the lessee and as
such, lessee is not able to claim depreciation on the asset. Similarly, the liability for the
future lease rentals is also not shown in the balance sheet of the lessee as a liability.
Thus, in case of lease transactions, neither the assets side nor the liabilities side of the
balance sheet of lessee gets affected. This means that borrowing capacity of the lessee
or the debt equity ratio of the lessee remains intact in case of lease transactions. Hence,
leasing is referred to as off the balance sheet mode of financing for the lessee.
Accounting of hire purchase transactions :

a)
Entire amount of hire charges paid by the hirer to the hiree are not considered to be
revenue expenditure in the books of hirer. The hire charges paid by the hirer are split as
the payment against capital repayment and the payment against the interest. The
component of interest payment only is debited to Profit & Loss account, whereas the
payment against the capital repayment reduces liability for the hirer.
b)
Asset taken by the hirer on hire is capitalised in the books of hirer, though the ownership
does not transfer to the hirer till the last installment of hire charges is paid by him. Only
the payment against interest payment is a tax deductible expenditure for the hirer. Similarly,
liability for the future hire charges is also disclosed as the liability on the balance sheet
of the hirer. Hirer claims the depreciation on the asset taken by him on hire purchase and
the same is treated as a tax deductible expenditure for the hirer. Thus, unlike in case of
leasing transactions, hire purchase is not a off the balance sheet mode of financing for
the hirer.
Types of Leases
a)
Financial Lease :
In this type of lease, the lessor acts as a financier. Lessee selects the asset and bears the
cost of repairs, maintenance and insurance of the asset. Lessor reserves the right to confiscate
the asset in the event of any default on the part of lessee. The lessor recovers a major part of
the cost of asset by way of lease rent during the lease period, the lessor agrees to transfer the
ownership of the asset to the lessee by paying a nominal price which is referred to as repurchase
Price. This type of lease is also referred to as capital lease.
244
b)
Operating Lease :
In this type of lease, the lessee gets a limited right to use the asset. Lessor selects and
purchases the asset and leases the same to the lessee. Lessor bears the cost of repairs,
maintenance and insurance of the asset. Operating lease is for a smaller duration of time and
imposes no long term obligation either on the lessor or on the lessee. The lease rent paid by
the lessee does not contain any part towards the cost of the asset. After the lease period is
over, the possession of the asset reverts back to the lessor who can lease out the asset to
another party. The lease deed is cancellable at the option of the lessor or the lessee after
giving specific notice.
c)
Sale and Lease Back :
In this type of lease, the lessee purchases the asset of his own choice and then sells the
same to the lessor. On the sale of asset to the lessor, the ownership of the asset gets
transferred to the lessor. Lessor then leases out the same asset to the lessee. After this
stage, it becomes a routine lease transaction both for the lessor as well as for the lessee. In
practical circumstances, this type of lease is very regularly found in case of some old asset
which is used by an organisation for a certain duration of time. To explain the concept of sale
and lease back, let us take an example.
Company A has purchased an equipment 10 years back for an amount of Rs. 5,00,000 and
has been using the same since then. After providing for depreciation for the last 10 years,
written down value of the equipment in the books of the company is only Rs. 15,000. This
equipment is sold by the company to a leasing company for an amount of Rs. 5,00,000.
Leasing company pays the purchase consideration of Rs. 5,00,000 to the company and
leases back the same equipment to the company. In this arrangement, both the company as
well as the lessor are benefited. The company gets benefited as the company receives an
amount of Rs. 5,00,000 for an equipment which is 10 year old equipment, without parting with
the equipment. For lessor, it is a business proposition. Being a lease transaction, the lessor
can claim the depreciation on the asset leased out by him. Under ideal circumstances, lessor
should be able to claim the depreciation on Rs. 5,00,000 being the consideration paid by the
lessor to the company. However, in the light of recent amendments made to the Income Tax
Act, 1961, the lessor can claim the depreciation on Rs. 15,000 only which is the written down
value of the asset in the books of company at the time of transfer of the asset to the lessor.
245
RETAINED EARNINGS
Retained earnings or ploughed back profits is one of the best source of raising long term funds
for the company. It indicates that whatever profits are earned by the company are not distributed
by it by way of dividend but are kept aside for being used in future for expansion or other
purposes. If the company follows a regular policy of ploughing back of profits i.e. keeping
aside profits without distributing them, the shareholders may resent this policy. As such,
while deciding the amount of profits to be retained, the company has to be very careful, about
its consequences on the expectations of shareholders and also on the prices of the shares.
246
QUESTIONS
1)
Examine critically Debentures as a source of corporation finance.
2)
Examine the comparative merits and demerits of the following methods of raising additional
finance required by a joint stock company.
(i)
Redeemable Preference Shares
(ii)
Debentures
(iii) Public Deposits

3)
Critically appraise the preference shares as a source of finance in Indian corporate sector.
4)
Does leasing increase a firms borrowing capacity? Does it release the firm from bad
investment and freeing of funds for more profitable uses?
5)
Account for the growing amount of public deposits with corporate organisations. Explain
the control and regulations of public deposits.
6)
What is meant by lease financing? State and explain different types of lease.
7)
Write short notes :

a)
Public deposits
b)
Regulation of public deposits
c)
Convertible Debentures
d)
Lease financing
247
NOTES
248
capital. However, if the company introduces more and more doses of debt capital in the
overall capital structure, it makes the investment in the company a risky proposition. As
such, the expectations of the investors in terms of return on their investment may increase
and share prices of the company may decrease. These increased expectations of the
investors or the decreased share prices may be considered to be implicit cost of debt
capital.
IMPORTANCE OF COST OF CAPITAL
The term cost of capital is important for a company basically for following purposes :
(1)
The concept of cost of capital is used as a tool for screening the investment proposals.
(The various methods for appraising investment proposals are discussed in details in the
following chapters.) E.g. In case of the net present value method, the cost of capital is
used as the discounting rate for discounting the future inflow of funds. Any project resulting
into positive net present value only will be accepted. All other projects will be rejected.
Similarly, in case of Internal Rate of Return Method (IRR), the resultant IRR is compared
with the cost of capital. It is expected, that if a project is to be accepted, IRR resulting
from the same should be more than cost of capital. If project generates IRR which is less
than cost of capital, the project will be rejected.
(2)
The cost of capital is used as the capitalisation rate to decide the amount of capitalisation
in case of a new concern.
(3)
The concept of cost of capital provides useful guidelines for determining the optimal
capital structure (This concept is discussed in details in the following pages). Optimal
capital structure is the one where overall cost of capital is minimum and the overall
valuation of the firm is maximum.
MEASUREMENT OF COST OF CAPITAL

(a)
256
Cost of Debt : The debts may be either short term debts or long term debts. Very
naturally, the cost of capital in the form of debt is the interest which the company has to
pay. But this is not the real cost attached with debt capital. The real cost is something
less than the rate of interest which the company has to pay. This is due to the fact that
the interest on debt is a tax deductible expenditure. If the amount of interest is considered
as a part of expenses, the tax liability of the company reduces proportionately. As such,
while computing the cost of debt, adjustments are required to be made for its tax impact.
E.g. Suppose a company issues the debentures having the face value of Rs. 100 and
bearing the rate of interest of 10% p.a. If the tax rate applicable to the company is 50%,
the cost of debentures is not 10% which is the rate of interest, but it is to be duly
reduced by the tax benefit available for this interest. The tax benefit is 50% of 10%,
hence the cost of debentures is only 5%. Further, the interest payable on the debentures
has to be viewed from the angle of the amount actually received on their issue. E.g. A
company issues 1000 debentures of Rs. 100 each bearing interest @8% p.a. Company
incurres the expenses in connection with the issue of debentures to the extent of Rs.
10,000 (These expenses may be in the form of discount allowed, underwriting commission,
advertisement etc.) Thus, the company will have to pay the annual interest of Rs. 8,000
on the net amount received to the extent of only Rs. 90,000 (i.e. Rs. 1,00,000 minus Rs.
10,000). Cost of debentures in this case works out to around 8.89% and assuming that
the tax rate applicable is 50%, the tax benefit makes the cost of debentures equal to
4.45%. However, the debt capital has a hidden cost also. If the debt content in the
capital structure of a company exceeds the optimum level, the investors start considering
company as too risky and their expectations from equity shares increase. This is the
hidden cost of debt.
(b)
Cost of Preference Shares : The cost of capital preference shares is the dividend rate
payable on them. As in case of debentures, the cost capital is adjusted for the amount
excess or less received on the issue of preference shares. Eg. Suppose, a company
issues 1,000 preference shares of Rs. 100 each at the value of Rs. 105 each. Rate of
dividend is 10% and the expenses involved with the issue of preference shares amount
to Rs. 10,000. Thus the net amount received works out to Rs. 95,000 whereas the
amount of the dividend is Rs. 10,000. Here, the cost of capital works out to
Rs. 10,000
x 100 = 10.52%
Rs. 95,000
As the amount of dividend payable on preference shares is not a tax deductible
expenditure, there is no question of further adjustment for the tax benefit.
(c)
Cost of Equity Shares : Computation of cost of equity shares is the most complex
procedure. It is due to the fact that unlike preference shares or debentures, equity shares
do not have either the interest or dividend to be paid at a fixed rate. The cost of equity
shares basically depends upon the expectations of the equity shareholders. There are
following approaches to compute the cost of equity shares.
(1)
D/P Approach : According to this approach, before an investor pays certain price for
purchasing equity shares of the company, he expects certain return on the investment
which is in the form of the dividend. The expected rate of dividend is the cost of equity
shares. This means, that the investor calculates the market price of the shares by
capitalising the present dividend rate which is expected to be same for all times to come
at a given level. E.g. If the market price of Equity shares of a company (Face value
Rs. 10) is Rs. 15 and if the company at present is paying the dividend @ 20% which is
expected to be continued in future also, the cost of Equity Shares will be :
Capital Structure
257
20% x
Rs. 10
= 13.3%
Rs. 15
However, it can also be argued that the cost of equity shares may be 20%, because on
the expectation of rate of dividend at 20%, market price of the shares is Rs. 15.
This approach is objected on certain grounds. Firstly, this presupposes that an investor
looks forward only to receive dividend on equity shares. This may not always be correct.
He may also look forward to capital appreciation in the value of his shares. Secondly,
this approach assumes that the company will not earn on its retained earnings and that
the retained earnings will not result in either appreciation of the market price or increase
in dividends. This assumption can be a wrong assumption which may lead to wrong
conclusions.
(2)
E/P Approach : According to this approach, the cost of equity shares is based upon the
stream of unchanged earnings earned by a company. This approach holds that each
investor expects a certain amount of earnings whether distributed by way of dividend or
not, from the company in whose shares he invests.
Thus, if an investor expects that the company in which he is investing should have at
least 20% rate of earnings, cost of equity shares will be calculated on that basis. If a
company is expected to earn 30%, he will be prepared to pay Rs. 150 for one share of
Rs. 100 each.
This approach can be objected on the following grounds. Firstly, it wrongly assumes that
the earnings per share will remain constant in future. Secondly, the market prices of the
shares will not remain constant as the shareholders will expect capital gains as a result
of reinvestment of retained earnings. Thirdly, all the earnings may not be distributed
among the shareholders by way of dividend.
(3)
D/P + G Approach : According to this approach, the investor is prepared to pay the
market price of the shares as he expects not only the payment of the dividend but also
expects a growth in the dividend rate at a uniform rate perpetually.
Thus, the cost of equity shares can be calculated as
D
+ G where
P
D = Expected dividend per share
P = Market price per share
G = Growth in expected dividends.
258
E.g. If the dividend per share is Re. 1 per share with the expected growth of 6% per year
perpetually, the cost of equity shares, with the assumed market price of the share of Rs.
25, will be
Re. 1
Rs. 25
+ 0.06
= 0.04 + 0.06
= 10%
This approach involves the difficulty of determining the growth rate.

(4)
Realised Yield Approach : According to this approach, the cost of equity shares may
be decided on the basis of yields actually realised over the period of past few years
which may be expected to be continued in future also. This approach basically consider
D/P + G approach, but instead of considering the future expectations of dividends and
growth factor, the actual yields in past are considered.
(d)
Cost of Retained Earnings : Many a times, it is argued that the retained earnings do
not cost anything to the company. This is argued like this as there is no obligation, either
formal or implied, to pay return on retained earnings even though they constitute one of
the major sources of funds for the company. In case of debt, the company has fixed
obligation to pay interest on it. Almost similar obligation exists in case of preference
share also. In case of equity shares, though there is no legal obligation, the expectations
of the shareholders at least provides a starting point for computing the cost of equity
shares. The retained earnings do not involved any of such obligations, either, formal or
implied. As such, it may be felt that retained earnings involve no cost as they are not
raised from outside source. But this contention is not correct. Retained earnings involve
cost and this cost is in the form of the opportunity cost in terms of dividend foregone by
or withheld from the equity shareholders.
E.g. Assuming that the profits earned by the company are not retained but are distributed
among shareholders by way of dividend. These amounts of dividends which would have
been received by the shareholders, after due adjustments for tax deducted at source,
could have been invested by the shareholders elsewhere to earn some return. The
company, by retaining the profits, prohibits the shareholder from earnings these returns.
As such, the company is required to earn on the retained earnings atleast equal to the
rate which would have been earned by the shareholders if they were distributed to them.
This is the cost of retained earnings.
COMPOSITE COST OF CAPITAL

After ascertaining the cost of each source of the capital constituting the capital structure, the
Capital Structure
259
next step is to compute the composite cost of capital which is defined as the weighted
average of the cost of each specific type of capital. The reason behind considering weighted
average and not the simple average is to give consideration to the proportion of various sources
of funds in the capital structure of the company. Thus, the process of computing the composite
cost of capital is carried on by following the steps stated below.
(1)
Assign weights to various sources of funds. It may be stated here that the weights may
be in the form of book value of funds or market value of funds.
(2)
Multiply the cost of each source of funds by the weights assigned.
(3)
Calculate the composite cost by dividing total weighted cost by the total weights.
The above process can be explained with the help of following illustrations.
Illustration I :
The capital structure of a company and the cost of specific sources of funds is as below :
Sources of funds
Book value
(weights) Rs.
Specific
Cost
Weighted cost
Rs.
3 (1 x 2)
1,50,000
5%
7,500
50,000
9%
4,500
Equity shares
2,00,000
15%
30,000
Retained earnings
1,00,000
8%
8,000
Debentures
Preference shares
5,00,000
Composite cost of capital
Total weighted costs
50,000
x 100
Total weights
=
50,000
x 100
5,00,000
10%
Illustration II :
From the information given below, calculate the weighted cost of capital (before tax) for Z Ltd.
260
Rs. in Lakhs
1.
Shareholders' funds
Share Capital
Equity
500
Preference
100
Retained Earnings
2.
300
Loan Funds
Secured Loans
800
Unsecured Loans (Incl. intercorporate deposit)
700
2,400
(a)
Normal yield on Equity shareholders' fund anticipated at 15%.
(b)
Dividend rate on preference shares - 12%.
(c)
Tax rate for Z Ltd. - 60%.
(d)
Interest on secured loans - 16.25%.
(e)
Interest on unsecured loans - 20%.
Solution :
Computation of after tax cost of capital
Source
Book value
(weights)
2
Tax Adjusted
Cost
3
Weighted Cost
Equity shares
500
15%
75
Preference shares
100
12%
12
Retained Earnings
300
15%
45
Secured Loans
800
6.50% i.e.
52
4 i.e. 2 x 3
40% of 16.25%
Unsecured loans
700
8% i.e.
56
40% of 20%
2400
Capital Structure
240
261
Weighted Average Cost

After tax
= Weighted cost
x 100
Total weights
=
240
x 100
2,400
= 10%
Computation of before tax cost of capital :
= After tax cost of capital
(100% Tax rate)
=
10%
(100% 60%)
= 10%
40%
= 25%
262
PART III LEVERAGES

Before we go ahead with discussing the concept of Leverages, consider the following example
Let us assume that there are two companies A and B which are exactly similar to each other
in terms of nature of business, size, extent of turnover etc. As such, the amount of capitalization
is also the same for both the companies which is assumed to be Rs. 10,000. However,
strategies for raising the capital are different from each other. Assuming that the required
capital can be raised either by way of equity or debt, following particulars are available :
Company A
Company B
(Each Share of Rs. 10 each)
1,000
9,000
10% Debentures
9,000
1,000
10,000
10,000
Equity Share capital
Profitability statements of both the companies when the sales are Rs. 20,000 and Rs. 18,000
are as below Company A
Company B
Sales
Less : Variable Cost
20,000
10,000
18,000
9,000
20,000
10,000
18,000
9,000
Contribution
Less : Fixed Cost
10,000
5,000
9,000
5,000
10,000
5,000
9,000
5,000
PBIT
Less : Interest
5,000
900
4,000
900
5,000
100
4,000
100
PBT
Less : Income Tax @50%
4,100
2,050
3,100
1,550
4,900
2,450
3,900
1,950
PAT
2,050
1,550
2,450
1,950
Number of Equity Shares

Earnings per share
100
20.50
100
15.50
900
2.72
900
2.16
It can be noted from the above example that A Ltd. is able to earn more amount per equity
share because in its capital structure, the amount of debentures is more and also because
the interest paid on debentures is tax deductible expenditure and amount of tax is less in
case of A Ltd.
It can also be noted from the above example that a 10% reduction in sales in case of A Ltd.
reduces the earnings per share by around 24% while the same percentage of reduction in
Capital Structure
263
sales in case of B Ltd. reduces the earnings per share by around 20%. It happens so because
the risk of reduction in sales and earnings gets distributed among less number of equity
shares in case of company A Ltd., while the said risk gets distributed among more number of
equity shares in case of company B Ltd.
Explanations Operating costs incurred by a company can be classified into three categories
a.
Variable Cost
b.
Fixed Cost
c.
Semi-variable Cost
Fixed Cost is the cost which remains constant irrespective of changes in the sales revenue, at
least over a shorter span of time.
Variable Cost is the cost which varies in direct proportion to the sales revenue.
Semi-variable Cost lies in between the two extremes of fixed cost and variable cost. Such
costs remain constant upto a certain sales revenue and increase if the sales revenue increases
beyond a certain point. There may be some statistical or mathematical techniques available
whereby the semi-variable cost can be segregated into the fixed cost component and variable
cost component. Hence, let us assume that the costs can be either fixed costs or variable
costs.
Difference between the sales revenue and variable cost is referred to as contribution or marginal
contribution. Significance of the term contribution is that it is equated with the term profits over
a shorter period of time, as the fixed cost remains the same at all levels of activities. As such,
sales revenue generated by the company after deducting the variable cost incurred for the
same contributes towards the profits which is technically referred to as contribution. The
operating profit earned by the company is in the form of contribution duly reduced by the fixed
operating cost.
As such, using the above referred terms, the operating statement of a company can be
presented as below -
Less :
Sales Revenue
Variable Operating Cost
Less :
Contribution
Fixed Operating Cost
Operating Profit
264
Break even point is that level of sales revenue at which there is no profit or no loss. Till the
sales revenue reaches the break even point, the company incurres the losses. It is only after
crossing the break even point that the profit generating capacity of the company starts. As
such, it is the intention of every company to reach the break even point as early as possible.
The essential implication of high fixed cost in the cost structure is that the break even point is
high which indicates that the amount of sales revenue a company is required to generate to be
in a no profit no loss situation is very high which makes the company a very risky proposition.
The operating profit earned by a company is also referred to as Profit Before Interest and
Taxes (PBIT) in financial terms. After the level of operating profit, the company is contractually
required to pay the interest on the long term borrowed capital like debentures, term loans etc.
The amount of profit earned after recovering the interest on long term sources of capital is
referred to as Profit Before Taxes (PBT). The company is required to pay the taxes as per the
provision of Income Tax Act, 1961 after the amount of profit before taxes is arrived at. Profit
remaining after the payment of income tax is referred to as Profit After Taxes (PAT). This profit
can be distributed among the owners of the company by way of dividend.
We have already seen that before the company can pay the dividend on Equity Shares, it is
bound to pay the dividend on Preference Shares. After paying the dividend on preference
shares, remaining profits can be distributed among the equity shareholders by way of dividend
and hence are referred to as distributable profits.
In financial terms, Profit Before Interest and Taxes (PBIT) can be referred as Earnings Before
Interest and Taxes (EBIT) and Profit After Tax (PAT) can be referred to as Earnings After Tax (EAT).
Using the above terms, the profitability statement of a company takes the following form -
Less :
Profit before Interest & Taxes (PBIT)

Interest on long term borrowings
Less :
Profit before Taxes (PBT)

Taxes
Less :
Profit after Taxes (PAT)

Preference Dividend
Distributable Profits for Equity
If both the calculations are merged together, following relationship emerges.
Less :
Sales Revenue
Variable Operating Cost
Contribution
Capital Structure
265
Less :
Fixed Operating Cost

Profit before Interest & Taxes (PBIT)
Less :
Interest on Long term borrowings
Less :
Profit before Taxes (PBT)

Taxes
Less :
Profit after Taxes (PAT)

Preference Dividend
Distributable Profits for Equity
In continuation of these calculations, following two calculations are made very frequently in
practical situations Earnings Per Share (EPS)
Earnings Per Share is a very widely used ratio to measure the profits available to the equity
shareholders on a per share basis.
EPS is calculated as Profit after Tax - Preference Dividend
No. of Equity Shares
EPS is calculated on the basis of current profits and not on the basis of retained profits. EPS
does not indicate the amount of profits distributed among the owners by way of dividend and
also the amount of profits retained in the business.
This calculation is very significant for an investor in equity shares as higher EPS indicates
higher amount of profits available to him.
Price Earning Ratio (P/E Ratio)
Price Earning Ratio indicates the price currently being paid in the stock market for every one
rupee of EPS.
P/E Ratio is calculated as Market Price Per Share
Earnings Per Share
P/E Ratio is of great significance to an operator on the stock exchange buying and selling the
266
shares. An ideal investor makes an comparison between the current market price and future
EPS as the market value of shares depends upon the future EPS also.
Leverages :
In very simple words, the term leverage measures relationship between two variables. In financial
analysis, the term leverage represents the influence of one financial variable over some other
financial variable. In financial analysis generally three types of leverages may be computed.
1.
Operating Leverage
2.
Financial Leverage
3.
Combined Leverage
1.
Operating Leverage
It measures the effect of change in sales quantity on Earnings Before Interest and Taxes
(EBIT)
It is computed as :
Sales - Variable Cost (i.e. Contribution)
Earnings before interest and tax
Indications :
A high degree of operating leverage means that the component of fixed cost is too high in the
overall cost structure. A low degree of operating average means that the component of fixed
cost is less in the overall cost structure. In other words, operating leverage measures the
impact of percentage increase or decrease in sales on earnings before interest and taxes.
E.g. In the example cited above, when sales are Rs. 20,000 contribution is Rs. 10,000 and
earnings before interest and taxes are Rs. 5,000. As such operating leverage can be calculated
as :
Contribution
EBIT
Rs. 10,000
Rs. 5,000
= 2
It means that every 1% increase in contribution will increase the EBIT by 2% and vice versa.
As such, when contribution is Rs. 9,000 instead of Rs. 10,000 i.e. the contribution is reduced
by 10%, the EBIT is reduced by 20% i.e. the EBIT has become Rs. 4,000 instead of Rs. 5,000.
Capital Structure
267
2.
Financial Leverage :
It indicates the firm's ability to use fixed financial charges to magnify the effects of changes in
EBIT on the firm's EPS. It indicates the extent to which the Earnings Per Share (EPS) will be
affected with the change in Earnings Before Interest and Tax (EBIT). It is computed as :
EBIT
EBIT - Interest
Indications :
A high degree of financial leverage indicates high use of fixed income bearings securities in
the capital structure of the company. A low degree of financial leverage indicates less use of
fixed income bearing securities in the capital structure of the company.
E.g. In the example cited above, in case of A Ltd., the EBIT is Rs. 5,000 and interest on
debentures is Rs. 900, when sales are Rs. 20,000 whereas in case of B Ltd., the EBIT is Rs.
5,000 and interest on debentures is Rs. 100 when sales are Rs. 20,000. As such, the degree
of financial leverage can be computed as
EBIT
EBIT - Interest
A Ltd.
Financial leverage
Rs. 5,000
B Ltd.
=
Rs. 5,000 - Rs. 900

=
Rs. 5,000
Rs. 5,000 - Rs. 100

=
Rs. 4,100
=
1.22
Rs. 5,000
Rs. 5,000
Rs. 4,900
1.02
High degree of financial leverage is supported by the knowledge of the fact that in the capital
structure of A Ltd, 90% is the debt capital component, whereas in case of B Ltd, 10% is the
debt capital component.
It means that in case of A Ltd. every 1% increase in EBIT will increase EPS by 1.22% and vice
versa.
As such, when EBIT is reduced from Rs. 5,000 to Rs. 4,000 (i.e. 20% reduction), EPS of A
Ltd. gets reduced from Rs. 20.50 to Rs. 15.50 (i.e. 24.40% reduction) and EPS of B Ltd. gets
reduced from Rs. 2.72 to Rs. 2.16 (i.e. 20.40% reduction).
Uses of Financial Leverage :
The degree of financial leverage gives an indication regarding the extent to which EPS may be
268
affected due to every change in EBIT. As the use of debt capital in the capital structure
increases the EPS, the company may like to use more and more debt capital in its capital
structure by using the financial leverage.
As explained in the example cited above, EPS in case of A Ltd. is Rs. 20.50 when sales are
Rs. 20,000, as 90% of its capital is debt capital. But in case of B Ltd. EPS is only Rs. 2.72
when sales are Rs. 20,000, as only 10% of its total capital is debt capital. As such, the
phrase is often used that financial leverage magnifies both profits and losses'.
However, though financial leverage magnifies the profits as well as EPS, the use of debt
capital beyond a certain limit will not necessarily give a favourable impact. Use of financial
leverage is useful as long as debt capital costs less than what it earns. It reduces profits or
EPS if it costs more than what it earns. As such, financial leverage also acts as a guideline in
setting maximum limit upto which the company should use the debt capital.
However, the technique of financial leverage suffers from some limitations.
Limitations :
1.
It ignores implicit cost of debt. It assumes that the use of debt capital may be useful so
long as the company is able to earn more than the cost of debt, i.e. interest. But it is not
always correct. Increasing use of debt capital makes the investment in the company a
risky proposition, as such the market price of the shares may decline, which may not be
maximizing the shareholders' wealth. Before considering the capital structure, the implicit
cost of debt should be considered.
2.
It assumes that cost of debt remains constant regardless of degree of leverage which is
not true. With every increase in debt capital, the interest rate goes on increasing due to
the increased risk involved with the same.
3.
Combined Leverage :
The combined effect of operating leverage and financial leverage measures the impact of
charge in contribution on EPS.
It is computed as :
Operating Leverage x Financial Leverage
=
Sales - Variable Cost

EBIT
EBIT
EBIT - Interest
Sales - Variable Cost

EBIT - Interest
EG. In the example cited above, in case of both A Ltd. and B Ltd., when sales are Rs. 20,000,
contribution is Rs. 10,000 but earnings after interest and before tax are Rs. 4,100 and
Capital Structure
269
Rs. 4,900 respectively. As such combined leverage can be computed as :

Sales - Variable cost (i.e. contribution)
EBIT - Interest
A Ltd.
=
Rs. 10,000
Rs. 4,100
2.44
B Ltd.
= Rs. 10,000
Rs. 4,900
= 2.04
It means that in case of A Ltd. every 1% increase in contribution will increase EPS by 2.44%
and vice versa, while in case of B Ltd. every 1% increase in contribution, will increase EPS by
2.04%. As such when contribution gets reduced from Rs. 10,000 to Rs. 9,000 i.e. 10%
reduction, EPS of A Ltd. gets reduced from Rs. 20.50 to Rs. 15.50 (i.e. 24.4% reduction) and
EPS of B Ltd. gets reduced from Rs. 2.72 to Rs. 2.16 (i.e. 20.4 reduction).
Indications :
The indications given by the combined effect of operating and financial leverages may be
studied under the following possible situations.
1.
High Operating Leverage, High Financial Leverage :

It indicates very very risky situation as a slight decrease in sales and/or contribution
may affect the EPS to a very great extent. As far as possible, this situation should be
avoided.
2.
High Operating Leverage, Low Financial Leverage :

It indicates that a slight decrease in sales and/or contribution may affect EBIT to a very
great extent due to existence of high fixed cost but this possibility is already taken care
of by low proportion of debt capital in the overall capital structure.
3.
Low Operating Leverage, High Financial Leverage :

It indicates that the decrease in sales/contribution will not affect EBIT to a very great
extent as the component of fixed cost is negligible in the overall cost structure. As such,
the company has accepted the risk of borrowing more debt capital in order to increase
EPS to the maximum possible extent. This may be considered to be an ideal situation.
4.
Low Operating Leverage, Low Financial Leverage :

It indicates that the decrease in sales/contribution will not affect EBIT to a very great
extent as the component of fixed cost is negligible in the overall cost structure. But still,
the company has not accepted the risk of having large component of debt capital in its
capital structure. It may indicate very very cautious policy followed by the management
which need not be necessary, as it will not maximise the shareholders' wealth. At the
same time, it may also indicate that the company is not utilising its borrowing capacity
properly and fully.
270
PART IV THEORIES OF CAPITAL STRUCTURE
CAPITAL STRUCTURE AND COST OF CAPITAL

In the previous pages we have seen that the introduction of debt capital in the capital structure
increases the earning per share of equity shareholders. We have also seen that the introduction
of debt capital increases the risk also which is the risk of insolvency due to non-availability of
cash and variability of earnings available to equity shareholders. As such, increasing the debt
component beyond a certain limit will not increase the earnings per share. If debt component
crosses a particular limit, the expectations of the lenders of money also increase due to the
risk factor involved. Similarly, the share holders also will demand a higher rate of return on their
investment to compensate for the risk arising out of additional amount of debt capital in the
capital structure. As such, introduction of a heavy amount of debt capital in the capital structure
will not only reduce the valuation of the firm but will also increase the cost of capital.
However, this view is not universally accepted. It is not an accepted principle that the valuation
of a firm and its cost of capital may be affected by the change in financing mix. Different views
have been expressed in this context. We will classify these views in the form of following four
theories of capital structure.
(1)
Net Income Approach
(2)
Net Operating Income Approach
(3)
Traditional Approach
(4)
Modigliani - Miller Approach
For this purpose, following assumptions have been made.

(1)
Firms use only long term debt capital or equity share capital to raise funds.
(2)
Corporate Income Tax does not exist.
(3)
Firms follow policy of paying 100% of its earnings by way of dividend.
(4)
Operating earnings are not expected to grow.
Following definitions and symbols are also used.

S
Market Value of equity shares
Market Value of debt
Total Market Value of firm
NOI =
Net Operating Income i.e. EBIT
Total Interest Payments
NI
Net Income available to equity shareholders.

i.e. EBIT - I
Overall cost of capital = EBIT

V
Capital Structure
271
a)
Net Income Approach :
According to this approach as proposed by Durand, there exists a direct relationship between
the capital structure and valuation of the firm and cost of capital. By the introduction of additional
debt capital in the capital structure, the valuation of the firm can be increased and cost of
capital can be reduced and vice versa.
To explain the approach more precisely, we will consider the following example :
Present
Position
Rs.
50% Increase
in Debt Capital
Rs.
50% Decrease
in Debt Capital
Rs.
8% Debentures
6,00,000
9,00,000
3,00,000
NOI i.e EBIT
1,50,000
1,50,000
1,50,000
48,000
72,000
24,000
1,02,000
78,000
1,26,000
10%
10%
10%
10,20,000
7,80,000
12,60,000
6,00,000
9,00,000
3,00,000
16,20,000
16,80,000
15,60,000
9.26%
8.93%
9.62%
I
NI
Equity Capitalisation Rate
Market value of Equity Shares (S)
Market value of Debentures (B)
Total value of firm V = S + B
Overall cost of capital
It can be seen from above, that by the increase in debentures, the total value of the firm
increases and cost of capital reduces and vice versa. However, this will hold good only if the
cost of debentures i.e. rate of interest is less than the equity capitalisation rate.
b)
Net Operating Income Approach :
According to this approach, also proposed by Durand, the valuation of the firm and its cost of
capital is independent of its capital structure. Any change in the capital structure does not
affect the value of the firm or cost of capital, though the further introduction of debt capital may
increase equity capitalisation rate and vice versa.
To explain the approach, more precisely, we will consider the following example.
272
Present
Position
Rs.
50% Increase
in Debt Capital
Rs.
50% Decrease
in Debt Capital
Rs.
6,00,000
9,00,000
3,00,000
10%
10%
10%
1,50,000
1,50,000
1,50,000
Total value of firm (V)
15,00,000
15,00,000
15,00,000
1,50,000
1,50,000
1,50,000
15,00,000
15,00,000
15,00,000
10%
10%
10%
6,00,000
9,00,000
3,00,000
Market value of Equity shares (S) i.e. V-B
9,00,000
6,00,000
12,00,000
48,000
72,000
24,000
EBIT - I
1,02,000
78,000
1,26,000
V-B
9,00,000
6,00,000
12,00,000
11.3%
13%
10.5%
8% Debentures
Overall Capitalisation Rate
EBIT
EBIT/V
I
It can be seen from the above that the market value of the firm remains unaffected by change
in the capital structure. However, the introduction of additional debentures increases the equity
capitalisation rate and vice versa.
c)
Traditional Approach :
This is the mean between two extreme approaches of net income approach on one hand and
net operating income on another. It believes the existence of what may be called 'Optimal
Capital Structure'. It believes that upto a certain point, additional introduction of debt capital,
inspite of increase in cost of debt capital and equity capitalisation rate individually, the overall
cost of capital will reduce and total value of the firm will increase. Beyond the point, the overall
cost of capital will tend to rise and total value of the firm will tend to reduce. Thus, for the
judicious mix of debt and equity capital, it is possible for the firm to minimize overall cost of
capital and maximize total value of the firm. Such a capital structure where overall cost of
capital is minimum and total value of the firm is maximum is called :Optimal Capital Structure".
Capital Structure
273
To explain this approach, more precisely, we will consider the following example :
No Debt 5% Debentures 8% Debentures
Rs. 3,00,000
Rs. 6,00,000
EBIT
1,50,000
1,50,000
1,50,000
15,000
48,000
1,50,000
1,35,000
1,02,000
10%
11%
12%
15,00,000
12,27,273
8,50,000
3,00,000
6,00,000
15,00,000
15,27,273
14,50,000
10%
9.82%
10.34%
Less :
Interest on debentures
NI
Cost of Equity Capital
Market value of Equity Shares (S)
Total value of firm i.e. V = S + B
Overall capital cost
i.e. EBIT
V
It can be seen from the above neither the no-debentures position nor the position where
debentures are issued to the extent of Rs. 6,00,000 minimize the overall cost of capital or
maximize the toal value of the firm. It is when debentures are issued to the extent of Rs.
3,00,000 that the overall cost of capital is minimum and total value of the firm is maximum,
hence that is the Optimal Capital Structure.
d)
Modigliani - Miller (M and M) Approach :
This approach closely resembles net operating income approach. According to this approach,
value of the firm and its cost of capital are independent of its capital structure. It argues, that
overall cost of capital is the weighted average of cost of debt capital and cost of equity capital.
Cost of equity capital depends upon shareholders' expectations. Now, if shareholders expect
10% from a certain company, they already take into consideration debt capital in the capital
structure. For every increase in debt capital the expectations of the shareholders also increase
as in the eyes of shareholders, risk in the company also increases. Thus, each change in the
mix of debt capital and equity capital is automatically offset by change in the expectations of
the shareholders which in turn is attributable to change in risk element. As such, they argue
that, leverage i.e. mix in debt capital and equity capital, has nothing to do with overall cost of
capital and overall cost of capital is equal to the capitalisation rate of pure equity stream of a
risk class. Hence, leverage has no impact on share market prices or cost of capital.
274
Illustrative Problems
(1)
Assuming no taxes and given the earnings before interest and taxes (EBIT), interest (I),
at 10% and equity capitalisation rate (K), below, calculate the total market value of each
firm :
Firms
EBIT
Rs.
I
Rs.
2,00,000
20,000
12,0%
3,00,000
60,000
16,0%
5,00,000
2,00,000
15,0%
6,00,000
2,40,000
18,0%
Also determine the weighted average cost of capital for each firm.
Firm X
Firm Y
Firm Z
Firm W
EBIT
Rs.
2,00,000
3,00,000
5,00,000
6,00,000
Rs.
20,000
60,000
2,00,000
2,40,000
NI (Net Income available to

the shareholders)
Rs.
1,80,000
2,40,000
3,00,000
3,60,000
12%
16%
15%
18%
Market value of Equity Shares (S) Rs. 15,00,000
15,00,000
20,00,000 20,00,000
Market value of debt (B)*
Rs.
2,00,000
6,00,000
20,00,000 24,00,000
Total value of the firm V = S + B
Rs. 17,00,000
21,00,000
40,00,000 44,00,000
10.59%
11.43%

i.e. EBIT/V
7.50%
8.18%
*Note : As the rate of interest i.e. 10% and the amount of interest is known, the amount of
debt capital can be calculated as :
Amount of interest x 100
10
(2)
In considering the most desirable capital for a company, the following estimates of the
cost of debt and equity capital (after tax) have been made at various levels of debt-equity
mix.
Capital Structure
275
Debt as % of total
capital employed
Cost of debt
%
Cost of equity
%
7.0
15.0
10
7.0
15.0
20
7.0
15.5
30
7.5
16.0
40
8.0
17.0
50
8.5
19.0
60
9.5
20.0
You are required to determine the optimal debt equity mix for the company by calculating
composite cost of capital.
Solution :
Calculation of composite cost of capital
Debt as % of total
capital employed
Cost of
debt
Cost of
equity
Composite cost of capital

%
7.0
15.0
7.0 x 0.1 + 15.0 x 1.0 = 15.00
10
7.0
15.0
7.0 x 0.1 + 15.0 x 0.9 = 14.20
20
7.0
15.5
7.0 x 0.2 + 15.5 x 0.8 = 13.80
30
7.5
16.0
7.5 x 0.3 + 16.0 x 0.7 = 13.45
40
8.0
17.0
8.0 x 0.4 + 17.0 x 0.6 = 13.40
50
8.5
19.0
8.5 x 0.5 + 19.0 x 0.5 = 13.75
60
9.5
20.0
9.5 x 0.6 + 20.0 x 0.4 = 13.70
It can be seen from the above that composite cost of capital is minimum i.e. 13.40% when
capital structure is as below
40% debt
60% equity
100%
Hence, that is the optimal debt-equity mix.
(3)
276
Following items have been extracted from the liabilities side of XYZ company as at 31st
December 1986
Rs.
Paid-up Capital
4,00,000 Equity shares of Rs. 10 each
40,00,000
60,00,000
Loans
15% Non-convertible Debentures
20,00,000
14% Institutional Loans
60,00,000
Other information about the company as relevant is given below :

Year ended
31st Dec.
Dividend
per share
Rs.
Earnings
per share
Rs.
Average market
price per share
Rs.
1986
4.00
7.50
50.00
1985
3.00
6.00
40.00
1984
4.00
4.50
30.00
You are required to calculate the weighted average cost of capital, using book values as the
weights and Earnings/Price (E/P) ratio as the basis of cost of equity.
Solution :
Calculation of Cost of Capital
Sources of Funds
Book Value
(Weights)
Tax Adjusted
Cost
Weighted
Cost
Equity Shares
40,00,000
15%
6,00,000
Reserves & Surplus
60,00,000
15%
9,00,000
Non-convertible Debentures
20,00,000
7.5%
1,50,000
Institutional Loans
60,00,000
7%
4,20,000
1,80,00,000
20,70,000
Weighted average cost of capital

20,70,000
x 100
1,80,00,000
= 11.5%
Capital Structure
277
Working Notes :
(a)
It is assumed that the company is subjected to tax rate of 50%.
(b)
Cost of equity shares is calculated on E/P basis.

Average EPS
Average Market Price
i.e.
Rs. 6.00
x 100
Rs. 40.00
= 15%
(4)
A company needs Rs. 5,00,000 for the construction of a new plant. Following alternative
capital structures are under consideration
a.
The company may issue 50,000 Equity Shares of Rs. 10 per share at par.
b.
The company may issue 2,500 debentures of Rs. 100 per debenture carrying the rate of
interest of 12% p.a. and balance by way of Equity Shares of Rs. 10 per share issued at
par.
c.
The company may issue 2,500 Preference Shares of Rs. 100 per share at par carrying
the rate of dividend of 10% and balance by way of Equity Shares of Rs. 10 per share
issued at par.
If the company's Profit Before Interest and Tax is Rs. 60,000 or Rs. 80,000 or Rs. 1,00,000
what will be the Earning Per Share under each of the above capital structures? If the objective
of the company is to maximize the EPS, which of the capital structures will be recommended?
Assume 50% as the corporate tax rate.
Solution :
It is assumed that the following three plans are possible for the company :
278
Plan 1 -
Only Equity Shares
Plan 2 -
Equity Shares and Debentures
Plan 3 -
Equity Shares and Preference Shares
a.
When Profit Before Interest and Tax is Rs. 60,000

Plan 1
Plan 2
Plan 3
60,000
60,000
60,000
30,000
Profit Before Tax
60,000
30,000
60,000
Tax
30,000
15,000
30,000
Profit After Tax
30,000
15,000
30,000
25,000
Distributable Profit
30,000
15,000
5,000
50,000
25,000
25,000
Re. 0.60
Re. 0.60
Rs. 0.20
Plan 1
Plan 2
Plan 3
80,000
80,000
80,000
30,000
Profit Before Tax
80,000
50,000
80,000
Tax
40,000
25,000
40,000
Profit After Tax
40,000
25,000
40,000
25,000
40,000
25,000
15,000
50,000
25,000
25,000
Re. 0.80
Rs. 1.00
Re. 0.40
Plan 1
Plan 2
Plan 3
100,000
100,000
100,000
30,000
100,000
70,000
100,000
Tax
50,000
35,000
50,000
Profit After Tax
50,000
35,000
50,000
25,000
50,000
35,000
25,000
50,000
25,000
25,000
Re. 1.00
Rs. 1.20
Re. 1.00
Profit Before Interest & Tax

Interest
Preference Dividend
Earnings Per Share
b. When Profit Before Interest and Tax is Rs. 80,000

Interest
Preference Dividend
Earning Per Share
c. When Profit Before Interest and Tax is Rs. 1,00,000

Interest
Profit Before Tax
Preference Dividend
Earning Per Share
Capital Structure
279
(5)
A company needs Rs. 12 lakhs for the installation of a new factory which would yield an
annual EBIT of Rs. 2,00,000. The company has the objective of maximising the EPS. It
is considering the possibility of issuing equity shares plus raising a debt of Rs. 2,00,000,
Rs. 6,00,000 or Rs. 10,00,000. The current market price per share is Rs. 40 which is
expected to drop to Rs. 25 per share if the market borrowings were to exceed Rs.
7,50,000. Cost of borrowings are indicated as under.
Upto Rs. 2,50,000
10% p.a.
Between Rs. 2,50,001 and Rs. 6,25,000
14% p.a.
Between Rs. 6,25,001 and Rs. 10,00,000
16% p.a.
Assuming a tax rate of 50%, work out the EPS and the scheme which would meet the
objective of the management.
Solution :
On the basis of the information available, following are the alternative capital structures possible.
Equity
Debt
Plan 1
Plan 2
Plan 3
2,00,000
6,00,000
10,00,000
10,00,000
6,00,000
2,00,000
12,00,000
12,00,000
12,00,000
Following is the calculation of EPS under each of the above capital structures
Calculation of EPS
Earnings Before Interest & Tax
2,00,000
2,00,000
2,00,000
20,000
84,000
1,60,000
1,80,000
1,16,000
40,000
Tax
90,000
58,000
20,000
Earnings After Tax
90,000
58,000
20,000
25,000
15,000
8,000
3.60
3.95
2.50
Interest
Earnings Before Tax
Earnings Per Share
As Earnings Per Share is maximum in Plan 2, the company will go for the said plan.
Notes :
It is assumed that the company can issue the Equity Shares at the prevailing market price.
The assumption will not be a valid assumption as the issue price will have to be lower than the
market price. However, if we continue with the assumption, number of equity shares will be as
below :
280
Plan 1 - Rs. 10,00,000 by Equity / Rs. 40 per share as issue price

Plan 2 - Rs. 6,00,000 by Equity / Rs. 40 per share as issue price
Plan 3 - Rs. 2,00,000 by Equity / Rs. 25 per share as issue price.
(6)
Operating Leverage and Combined Leverage of a company is 2 and 3 respectively at the

present level of sales of 10,000 units. The selling price per unit is Rs. 12 while its variable
cost is Rs. 6. The company has no preference share capital. Applicable corporate income
tax rate can be assumed to be 50%. The rate of interest on company's debt is 16% p.a.
What is the amount of debt in the capital structure of the company?
Solution :
As Sales are Rs. 1,20,000 and Variable Cost is Rs. 60,000, Contribution is known to be
Rs. 60,000.
As Operating Leverage is 2, Contribution / PBIT = 2
Hence, PBIT = Contribution / 2 i.e. Rs. 30,000
As Combined Leverage is 3, Contribution / PBT = 3
Hence, PBT = Contribution / 3 = i.e. Rs. 20,000.
As PBIT is Rs. 30,000 and PBT is Rs. 20,000, Interest will be Rs. 10,000.
Rate of Interest is known to be 16%. Hence, the amount of debt capital in the capital structures
will be
10,000
x 100 = 62,500
16
(7)
The Capital Structure of a company is as below :

(Each Share of Rs. 10)
Rs. 60,000
10% Debentures
Rs. 80,000
Retained Earnings
Rs. 20,000
Sales of the company are Rs. 6,00,000. Its variable operating cost is 40% of sales and fixed
operating cost is Rs. 1,00,000. Assuming the income tax rate of 50%.
i.
Calculate different types of leverages
ii.
Determine the likely level of PBIT if EPS is (a) Re.1 (b) Rs. 3 and (c) Rs. 0.
Capital Structure
281
Profitability structure of the company will be as below :
Sales
Rs. 6,00,000
Variable Cost
Rs. 2,40,000
Contribution
Rs. 3,60,000
Fixed Cost
Rs. 1,00,000
EBIT
Rs. 2,60,000
Interest
Rs.
EBT
Rs. 2,52,000
Taxes
Rs. 1,26,000
Profit After Tax
Rs. 1,26,000
8,000
Calculation of Leverages :
(a)
Operating Leverage :
Contribution
EBIT
(b)
= 1.38
2,60,000
Financial Leverage :
EBIT
EBT
(c)
3,60,000
2,60,000
= 1.03
2,52,000
Combined Leverage :
Contribution
EBT
3,60,000
= 1.43
2,52,000
Calculation of EBIT
We know that,
50% of (EBIT - Interest)
= EPS
We further know that

Interest
No. of Equity shares
282
= Rs. 8,000
= 6000
(a)
(b)
.
..
.
..
.
..
.
..
(c)
.
..
.
..
.
..
.
..
(8)
50% (EBIT - 8000)

6000
= 1
50% (EBIT - 8000)
= 6000
1/2 EBIT - 4000
= 6000
1/2 EBIT
= 10,000
EBIT
= 20,000
50% (EBIT - 8000)

6000
= 3
50% (EBIT - 8000)
= 18000
1/2 EBIT - 4000
= 18000
1/2 EBIT
= 22000
EBIT
= 44000
50% (EBIT - 8000)

6000
= 0
50% (EBIT - 8000)
= 0
1/2 EBIT - 4000
= 0
1/2 EBIT
= 4000
EBIT
= 8000
The following figures of Krish Ltd. are presented to you.

Rs.
EBIT
Less :
23,00,000
Debenture interest @ 8%
Long Term Loan interest @ 11%
80,000
2,20,000
3,00,000
20,00,000
Less : Income Tax
10,00,000
Earnings After Tax
10,00,000
No. of Equity Shares of Rs. 10 each

EPS
Market Price of Shares
P/E Ratio
Capital Structure
5,00,000
Rs. 2
Rs. 20
10
283
The company has undistributed reserves and surplus of Rs. 20 lakhs. It is in need of Rs. 30
lakhs to pay the debentures and modernise its plant. It seeks your advice on the following
alternative models of raising finance.
Alternative I : Raising entire amount as term loan from banks @12%.
Alternative II : Raising part of the funds by issue of 1,00,000 shares of Rs. 10 each at par and
the rest by term loan @ 12%.
The company expects to improve its rate of return on capital employed by 2% as a result of
modernisation, but P/E ratio is likely to go down to 8 if the entire amount is raised as term
loan.
(a)
Advice the company on the financial plan to be selected.
(b)
If it is assumed that there will be no change in the P/E ratio, if either of the two alternatives
are adopted, would your advice still hold good ?
Solution :
Present Capital Employed
Rs.
50,00,000
Reserves & Surplus
20,00,000
8% Debentures
10,00,000
11% Term Loan

.
. . Capital Employed
20,00,000
100,00,000
EBIT
23,00,000
Rate of EBIT on Capital Employed
23%
Alternative I : Term Loan Only
Rs.
EBIT
Less :
30,00,000
Interest
11% Term Loan
2,20,000
12% Term Loan
3,60,000
EBIT
24,20,000
Taxes @ 50%
12,10,000
Profit After Taxes
12,10,000
E.P.S.
P/E Ratio
Market Price of the share
284
5,80,000
2.42
8
19.36
Alternative II : Term Loan and Equity Shares

EBIT
Less :
30,00,000
Interest
11% Term Loan
2,20,000
12% Term Loan
1,20,000
3,40,000
EBT
26,60,000
Taxes @ 50%
13,30,000
Profit After Taxes
13,30,000
E.P.S.
2.22
P/E Ratio
10
Market Price of the share
22.20
Conclusion :
(a)
As the market price of the share in the second alternative is going to be more, the
company will select that financial plan.
(b)
If it is assumed that there will be no chance in P/E ratio in either of these alternatives, the
first alternative will be preferred as the market price of the share is going to be Rs. 24.20
in that situation.
(9)
The existing capital structure of XYZ Ltd. is as under :

Equity shares of Rs. 100 each
Rs. 40,00,000
Retained Earnings
Rs. 10,00,000
9% Preference Shares
Rs. 25,00,000
7% Debentures
Rs. 25,00,000
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. 25,00,000 to finance its expansion programme for
which it is considering the following alternatives :
(i)
Issue of 20,000 equity shares at a premium of Rs. 25 per shares.
(ii)
Issue of 10% preference shares.
(iii) Issue of 8% debentures.

If it is estimated that the P/E ratios in the case of equity, preference and debenture financing
would be 20, 17 and 16 respectively.
Which of the above alternatives would you consider to be the best if objective of the company
is to maximise market price of the shares.
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Chapter 9
CAPITAL MARKET
CAPITAL MARKET
In simple words, Capital Market refers to the market available to the company for raising the
long term requirement of funds. Last decade of the twentieth century has witnessed various
liberalization measures and reforms taking place in various sectors of the economy. Capital
Market is no exception to the rule. The changes which have taken place in the capital market
are basically in two formsa.
Repeal of Capital Issues (Control) Act, 1947 and abolition of the office of Controller of
Capital Issues. This came into effect from 29th May, 1992.
b.
Enactment of the Securities and Exchange Board of India Act, 1992 and formation of
Securities and Exchange Board of India (SEBI).
As a result of this, the market for the long term securities of the companies has become more
free and companies are now able to raise the funds in the market in a free manner. However,
in order to protect the interests of investors, SEBI has been empowered to issue the directions
from time to time. As such, at present, the only regulatory framework applicable to the
companies trying to raise the funds by issuing their securities in the market is in the form of
guidelines issued by SEBI from time to time for disclosure and investors protection. The
extract of these SEBI guidelines are discussed in the following paragraphs.
In the Capital Market (in technical words it is referred to as Primary Market), a company can
raise the funds in following three mannersa.
Public Issue
b.
Rights Issue
c.
Private Placement of Securities
Public Issue indicates the sale of securities to the members of general public.
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According to the provisions of Section 81 of the Companies Act, 1956, if a Public Limited
Company wants to raise further capital by way of issuing additional shares, they are required
to be offered to the existing equity shareholders first in the similar proportion. This is technically
called as Rights Issue of shares. However, the existing shareholders are not compelled to
buy those shares. The existing shareholder can buy those shares himself or he can renounce
the right in favour of any other person.
Private placement of Securities, as the name indicates, is the private placement made by the
company to a selected few investors.
SEBI guidelines for Public Issue and Rights Issue
If the company wishes to collect the funds by making Public Issue or Rights issue of the
Securities, following requirements of SEBI guidelines are required to be complied with by the
company.
Filling of Prospects or Letters of Offer
A company cannot make the public issue of Equity Shares unless a draft prospects is filed
with SEBI, through an eligible Merchant Banker, at least 21 days before it is filed with the
Registrar of Companies (ROC). Contents of the prospectus are also prescribed in the guidelines.
A listed company cannot make the rights issue of Equity Shares where aggregate value
exceeds Rs. 50 Lakhs, unless the letter of offer is filed with SEBI, through an eligible Merchant
Banker, at least 21 days before it is filed with the Regional Stock Exchange. Contents of the
offer letter are also prescribed in the guidelines.
Listing on Stock Exchange
A company cannot make the public issue of Equity Shares unless it has made an application
for listing of these equity shares in the stock exchange (s).
Eligibility for an unlisted company for making public issue
An unlisted company cannot make the public issue of equity shares unless the company
has
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a.
a track record of distributable profits for at least three years out of immediately preceding
five years and
b.
a pre-issue net worth of more than Rs. 1 Crore in three out of preceding five years, with
the minimum net worth to be met during immediately preceding two years and
c.
the issue size not exceeding 5 times its net-worth.
If the unlisted company does not satisfy any of the above conditions, it can make the public
issue only through the Book Building process. In the Book Building process, the company
has to compulsorily allot at least 60% of the issue size to the Qualified Institutional Buyers,
failing which the full subscription amount will have to be refunded.
Eligibility for a listed company for making public issue
A listed company can make the public issue if the issue size is less than 5 times its pre-issue
net worth.
If the issue size is more than or equal to 5 times of pre-issue net worth, the company has to
take the route of Book Building and has to allot at least 60% of the issue size to the Qualified
Institutional Buyers, failing which the full subscription amount will have to be refunded.
Partly paid shares
No company can make the pubic issue of Equity Shares unless all the partly paid shares have
been fully paid up.
Pricing of the issue
A listed company can freely price its equity shares offered through the public issue or rights
issue. An unlisted company making the Public Issue of Equity Shares and desirous of getting
the shares listed on the stock exchange can freely price its equity shares. However, the
company is required to give the justification of the price in the offer document.
Any unlisted company or a listed company making issue of equity shares can issue them to
applicants in the firm allotment category at a price different from the price at which offer is
made to the public provided that the price at which the security is offered to the applicants in
firm allotment category is higher than the price at which the security is offered to the public.
Denomination of the shares
Denomination of the equity shares in the public issue or rights issue can be freely decided by
the company.
Promoters Contribution
In a public issue by an unlisted company, the promoters shall contribute not less than 20% of
the post-issue capital. In a public issue by a listed company, the promoters shall participate
to the extent of 20% of the proposed issue or ensure post-issue holding to the extent of 20%
of the post-issue capital. Promoters shall bring full amount of the promoter contribution at
least one day before the issue opens for public.
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Lock-in period
The lock-in period for the promoter contribution shall be three years from the date of commercial
production or the date of allotment of shares whichever is later.
If an unlisted company making the public issue of equity shares and desirous of getting the
shares listed on the stock exchange has issued the shares to any person within six months
prior to the opening of issue for the public at a price lower than the price at which shares are
offered to the public, the entire share capital (except the shares of venture capitalist and
employees of the company) shall have lock-in period of six months from the date of trading of
shares on the stock exchange.
Minimum application
If the equity shares are being issued at par, the minimum number of shares for which an
application is to be made is 200 shares of the face value of Rs. 10 per share. In other words,
the minimum application money payable by the applicant shall not be less than Rs. 2,000.
Minimum application money payable by the applicant along with the application shall not be
less than 25% of the issue price.
Tradable Lots
Minimum tradable lot in case of shares having the face value of Rs. 10 per share can be
decided by the company on the basis of offer price as stated below Offer Price per share
Up to Rs. 100
Minimum tradable lot

100 shares
Rs. 101- Rs. 400
50 shares
More than Rs. 400
10 shares
However, minimum tradable lot shall not be more than 100 shares.
Subscription List
A public issue of shares shall be kept open for minimum three working days and not more
than ten working days.
Rights issue shall be kept open for at least 30 days and not more than 60 days.
Underwriting
Underwriting of the public issue of shares is at the option of the company making the issue.
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Minimum Subscription
If the company receives less than 90% of the issued amount from the public plus the shares
taken over by the underwriters, the company must refund the subscription amount in full within
60 days from the date of closure of the issue.
Utilization of funds
The company can utilize the funds collected by way of rights issue after satisfying the stock
exchange that minimum 90% subscription has been received.
Retention of over subscription
The quantum of issue shall not exceed the amount specified in the prospectus or the letter of
offer. However, an oversubscription to the extent of 10% is permissible for the purpose of
rounding off to the nearer multiple of 100 while finalising the allotment.
SEBI GUIDELINES FOR THE ISSUE OF DEBT INSTRUMENTS
Basic
The company can not issue FCDs having a conversion period of more than 36 months unless
conversion is made optional with put and call option.
If the conversions take place after 18 months but before 36 months from the date of allotment
of debentures, any conversion in part or in whole shall be optional at the hands of debentureholders.
Rate of Interest, premium and period of conversion
The rate of interest for the debentures can be freely decided by the company. The amount of
premium on redemption and the period of conversion can be decided by the company and
disclosed in the offer document.
Credit Rating
The company can not make the public issue of the FCDs/PCDs/NCDs unless credit rating is
obtained from a credit rating agency and disclosed in the offer document. If the size of the
issue is greater than Rs. 100 crores, two ratings from two different credit rating agencies are
required to be obtained. When the rating is obtained from more than one credit rating agency,
all the credit ratings, including the unacceptable ratings, shall be disclosed by the company.
All the credit ratings obtained during the three preceding years for any listed securities of the
company are required to be disclosed.
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Debenture Trustees
If the issue of debentures is having the maturity period of more than 18 months, the company
shall appoint a Debenture Trustee. The name of the Debenture Trustee shall be disclosed in
the offer document. A Trust Deed shall be executed by the company in favour of the Debenture
Trustees within six months from the date of closure of the issue. The Debenture Trustee shall
have the requisite powers for protecting the interests of the debenture holders including the
right to appoint a nominee director.
Debenture Redemption Reserve (DRR)
If the company issues the debentures with the maturity of more than 18 months, it has to
create DRR. DRR should be created out of the post-tax profits earned by the company. The
company shall create the DRR to the extent of at least 50% of the amount of debenture issue
before debenture redemption commences. Drawl from DRR is permissible only after 10% of
the debenture liability has actually been redeemed by the company. DRR will be treated as
free reserve while issuing the bonus shares.
Security
The company shall create the security within six months from the date of issue of debentures.
INTERMEDIARIES IN CAPITAL MARKET
If a company wants to raise the funds from various sources, services given by various
intermediaries become essential in the process. Among all these intermediaries, probably the
most important and significant intermediary is the Merchant Banker. In the area of Capital
Markets, it is basic responsibility of the Merchant Banker to ensure that the issue is a success.
To be more particular, Merchant Banker performs the following functions-
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a.
Advise the company about the structuring of the issue after taking into consideration the
overall economic conditions, expectations of the investors etc.
b.
Assist in getting the various statutory approvals.
c.
Drafting of the Prospectus and the Offer Document in consultation with the solicitors and
others.
d.
Assist the company in the appointment of other intermediaries like underwriters, brokers,
bankers, registrars, advertising agencies, printers etc.
e.
Develop the strategies for marketing the issue properly through the various techniques
like advertisements, mailers, press conferences, investors conferences, broker
conferences etc.
f.
Coordinate the efforts of all the intermediaries for the success of the issue.
g.
Monitor the issue during the period of subscription.

h.
Assist in finalising the basis of allotment.
i.
Assist in securing the stock exchange listing
In addition to the Merchant Bankers, following intermediaries play a significant role in the
process of raising the funds in Capital Market.
Underwriters
Underwriters provide a protection to the company in the situation of investors not fully subscribing
to the issue of the securities. Thus, underwriting is a contract where the underwriter agrees to
subscribe directly or to procure subscription for that portion of the issue which is not taken up
by the pubic. As a result, when the issue is underwritten, the company making the issue is
assured of getting the total requirement of funds, either from the investors or from the
underwriters. The return received by the underwriters is in the form of underwriting commission
which is based upon the amount underwritten by the underwriter.
It has already been stated, that as per the SEBI regulations, underwriting is not obligatory.
However, in case of every underwritten issue, the Lead Merchant Banker shall accept the
minimum underwriting obligation of 5% of the total underwriting commitment or Rs. 25 Lakhs
whichever is less.
Bankers to the Issue
Bankers to the issue collect the application money on behalf of the company. Bankers to the
issue are the banks who provide the term finance or working capital finance to the company
and who underwrite the issue.
Registrars to the Issue
Registrars to the Issue typically performs the following tasks
Collecton of applications from the banks after the issue is closed.
Scrutiny of the application forms.
Classification and tabulation of information for allotment.
Finalisation of basis of allotment.
Preparation and dispatch of allotment letters, share certificates, debentures certificates

and refund orders.
RECENT TRENDS IN CAPITAL MARKET

We will study the recent trends in Capital Market mainly under the following headingsa.
Innovative instruments in Capital Market
b.
Credit Rating
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303
c.
Buy Back of Shares
d.
Venture Capital
INNOVATIVE INSTRUMENTS IN CAPITAL MARKET

During the last few years, the companies have entered the capital market with various innovative
instruments to raise the funds from the public. We will discuss the following innovative
instruments used by the companies.
a.
Equity Warrants
b.
Floating Rate Bonds
c.
Zero Coupon Bonds
d.
Deep Discount Bonds
e.
Secured Premium Notes
Equity Warrants
The holders of the warrants are entitled to purchase the equity shares at a specific price
during the specified period (technically referred to as exercise period). However, the holder of
the equity warrants has a right but not the obligations to purchase the equity shares. Naturally,
the holder of the equity warrant will exercise the option to buy the equity shares if the prevailing
market price of the equity shares is more than the specified price during the exercise period.
The equity warrants are generally issued along with some other instrument with the intention
to make the issue of that other instrument more attractive. Equity Warrants can be either
detachable or non-detachable. Detachable Equity Warrants can be detached from the underlying
instruments and can be traded independently. Non-detachable Equity Warrants can not be
detached from the underlying instrument.
Advantages of Equity Warrants
The issuing company gets benefited with the help of Equity Warrants particularly when the
requirement of funds of the company is staggered over a period of time. The company can
decide the exercise period taking into consideration its requirement of funds.
Risks associated with Equity Warrants
If the market price of the equity shares is less than the exercise price during the exercise
period, the company may not get the subscription for the shares. Once the exercise period is
over, equity warrants are of no use to the company.
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Floating Rate Bonds

In case of floating rate bonds, the rate of interest paid by the company is not fixed. The rate of
interest is tied up with some base rate say bank rate and the variations in base rate decide the
actual rate of interest payable by the company on the bonds. E.g. State Bank of India issued
the Floating Rate Bonds of the Face Value of Rs. 1,000 carrying the rate of interest of 3% over
the maximum interest payable by the bank on the term deposits. If the rate of interest payable
on the term deposits increases, the rate of interests on the floating rate bonds will increase
and vice versa.
At the same time, the company may prescribe some rate as the Floor Rate (indicating the
minimum rate of interest payable by the company on the bonds even if the base rate falls
below a certain limit) and as the Cap Rate (which indicates the maximum rate of interest
payable by the company even if the base rate increases beyond a certain limit).
Advantages of Floating Rate Bonds
The Floating Rate Bonds avoid the risk of interest rate fluctuations in the economy both for the
issuing company as well as for the investors.
ZERO COUPON BONDS (ZCB)
Zero Coupon Bonds do not have any explicit or coupon rate of interest payable by the company.
E.g. ZCB can be issued on the following termsFace value
Rs. 100 per ZCB
Redemption Value
Rs. 125 per ZCB
Redemption Period
3 years
Difference between the redemption value and the face value is the gain to the investor.
Advantages of ZCB
The company does not require any periodical outflow of funds to service the borrowing during
the currency of the borrowing.
DEEP DISCOUNT BONDS (DDB)
Deep Discount Bonds were issued by Industrial Development Bank of India (IDBI) in 1992 for
the first time. The terms on which IDBI issued the DDB were as belowFace Value
Rs. 1,00,000
Issue Price
Rs. 2,700
Maturity Period
25 years
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The investors were given the option to quit investment at the end of every 5 years period. E.g.
the investors will be paid Rs. 5,700 after the end of 5 years and Rs. 50,000 at the end of 20
years etc.
Advantages of DDB
Risks associated with DDB
The redemption period is usually very long and hence, the investors accept the risk of nonpayment at the time of maturity.
SECURED PREMIUM NOTES (SPN)
Secured Premium Note was issued by TISCO in 1992 for the first time. The terms on which
TISCO issued the SPN were as belowa.
Face Value of the SPN was Rs. 300 per SPN.
b.
SPN will not carry any interest during the first three years.
c.
Commencing from year 4, the investors were to be paid Rs. 75 towards the principal and
another Rs. 75 towards the interest and redemption premium. The investors were given
the following three options to choose the following mixes of the low interest/high premium
or high interest/low premium.
d.
i)
Interest Rs. 37.50 and Redemption Premium Rs. 37.50.
ii)
Interest Rs. 50 and Redemption Premium Rs. 25
iii)
Interest Rs. 25 and Redemption Premium Rs. 50
Each SPN was attached with the warrant whereby the investor could buy one equity
share of TISCO for Rs. 100 during the exercise period of one year to one and half years
after the allotment of the SPN.
Advantages of SPN
CREDIT RATING
After 1990, Indian capital market saw a lot of companies entering the capital market with the
intention of raising the funds by issuing the shares and / or debentures. It is expected that
306
before an investor makes the investment in the instruments issued by the company, he should
satisfy himself about the financial credentials of the company. While investing in the equity
shares of a company, the investor is assumed to be knowing about the risk involved with the
investment. However, in case of the debt instruments, the investors are expected to make the
investment in these instruments after making the study of the various factors relating to the
investment. However a small investor is not sufficiently equipped to make such a study. As
such, the financial service in the form of credit rating has emerged as a tool to help the investor
evaluate his investment portfolio.
What is credit rating?
Credit Rating is the expression of opinion, with the help of symbols, given by an independent
credit rating agency, about the ability of the issuer of a debt instrument to make timely payments
of principal and interest at the specified dates.
The above description of credit rating reveals the following features of credit rating.
a.
Credit rating is with respect to a particular instrument issued by the company. In other
words, credit rating indicates the safety associated with the particular instrument issued
by the company. It does not indicate the financial health of the company as a whole.
b.
Credit rating is not a recommendation for buying, selling or holding a security. Acutal
investment made by the investor depends upon the other important factors like expectation
of returns, risk taking capacity of the investor etc.
c.
For the purpose of deciding the rating about the particular instrument, the rating agency
may use the various types of information. This information may be made available to the
rating agency either by the company itself or it may be available to the agency from any
other source. However, the rating agency does not perform the audit function. In the
sense, the rating agency does not certify that the information available to it is true and
correct.
d.
Credit Rating does not create any legal relationship between the rating agency and the
investor. If an investor invests in particular security on the basis of high credit rating given
by rating agency and the said investment turns out to be bad investment subsequently,
the investor cannot hold rating agency responsible for the bad investment.
e.
The Credit rating once given is not a one-time phenomenon applicable during the entire
tenure of the security. With the changing risk characteristics of the company, the credit
rating should be reviewed and upgraded or downgraded accordingly.
Is credit rating obligatory?

In the Indian circumstances, credit rating is not obligatory in case of equity shares. It is
obligatory only in case of the debt instruments. To be more precise, credit rating is obligatory
in case of the following debt instruments.
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307
a.
Convertible or Non-convertible Debentures/ Bonds irrespective of the period of maturity

or redemption.
b.
Fixed Deposits issued by non-banking financial companies.
c.
Commercial Paper.
Recently amended SEBI guidelines provide that if the size of issue is more than Rs. 100
crores, the issue is required to be rated by at least two credit rating agencies.
It should be noted that the requirement of credit rating in respect of the above instruments is
not a part of any particular law or statute. It is included in the various guidelines applicable for
the issue of above instruments.
Who can do the credit rating?
Presently there are four approved credit rating agencies who can do the credit rating of the
various instruments. These agencies are :
a.
Credit Rating and Information Services of India Ltd. (CRISIL)
b.
Investment Information and Credit Rating Agency (IICRA)
c.
Credit Analysis and Research Limited (CARE)
d.
FITCH Rating India Private Limited.
Advantages of credit rating
308
a.
In the developing capital market conditions, credit rating provides the investor with the
reliable and superior information from an independent and professional source, about the
company at no cost. This facilitates the investment on the part of investors on conscious
basis instead of on some ad-hoc basis.
b.
With a satisfactory credit rating, it is comparatively easy for a company to market the
instrument at less cost. Similarly, with a satisfactory credit rating, it is possible for the
company to approach a wide audience of the investors.
c.
Credit rating provides a motivation to the companies to improve their performance. A

company with a low credit rating with respect to a particular instrument, always strives
to improve its performance.
d.
With the help of credit rating the investible funds of the investors are directed towards
more productive investment portfolios. The possibility of investment failing is comparatively
less.
Methodology of Credit Rating

For this purpose, we will take into consideration the rating methodology followed by CRISIL.
The rating procedure followed by CRISIL may be based upon the information available to it
either directly from the company or from any other source. During this process, CRISIL considers
the following aspects about the company.
a.
b.
Business Analysis
i)
Industry Risk This indicates the overall demand/supply position in the industry as
a whole, the existing as well as the potential competitors in the industry, various
government policies affecting the industry etc.
ii)
Market Position This indicates the market position of the company vis--vis that
of the competitors in the industry in terms of the market share, competitive
advantages and disadvantages, selling and distribution arrangements etc.
iii)
Operating efficiency This involves the consideration of manufacturing process

and operating efficiency of the company in relation to those of the competitors,
availability of various infrastructural facilities, modernisation/expansion/diversification
plans etc
Financial Analysis
This involves the consideration of the various factors like accounting policies followed by the
company, analysis of the financial statements, adequacy of cash flows for fixed capital and
working capital needs, ability to raise funds from the market etc.
C.
Management Evaluation
This involves the consideration of the various factors like track record of the management,
capacity to overcome the adverse business conditions, management targets/ objectives/
strategies etc..
Credit Rating Symbols
CRISIL
IICRA
CARE
Highest Safety
AAA
LAAA
CARE AAA
High Safety
AA
LAA
CARE AA
Adequate Safety
LA
CARE A
Moderate Safety
BBB
LBBB
CARE BBB
Long Term (Debentures/Bonds)
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309
Inadequate Safety
BB
LBB
CARE BB
High Risk
LB
CARE B
Substantial Risk
LC
Care C
Default
LD
Care D
Highest Safety
FAAA
MAAA
CARE AAA (FD)
High Safety
FAA
MAA
CARE AA (FD)
Adequate Safety
FA
MA
CARE A (FD)
Inadequate Safety
FB
MB
CARE B (FD)
High Risk
FC
MC
CARE C (FD)
Default
FD
MD
CARE D (FD)
Highest Safety
P1
A1
PR1
High Safety
P2
A2
PR2
Adequate Safety
P3
A3
PR3
Inadequate Safety
P4
A4
PR4
Default
P5
A5
PR5
Medium Term (Fixed Deposits) :
Short Term (Commercial Paper) :
Note :
a.
The above table indicates the comparison between the symbols used by the various
rating agencies. The basic description for the use of symbols is as used by CRISIL. The
exact description used by the remaining two rating agencies varies slightly from the
description used by CRISIL.
b.
The rating agencies may add + or - signs to indicate the degree of variation.,
The Credit Rating Symbols used by Fitch Rating India Pvt. Ltd. are as below
For Long Term (12 months and more)
AAA (ind)
AA + (ind), AA (ind), AA-(ind)
A+ (ind), A(ind), A- (Ind)
BBB+(ind), BBB (ind), BBB- (ind)
BB+ (ind), BB(ind), BB-(ind)
B+(ind), B(ind), B-(ind)
C(ind)
D(ind)
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Highest Credit Quality

High Credit Quality
Adequate Credit Quality
Moderate Credit Quality
Speculative
Highly Speculative
High Default Risk
Default
Public Deposits
tAAA (ind)
tAA+(Ind), tAA(ind), tA-(ind)
tA_(ind), tA(ind), tA-(ind)
tBBB+(ind), tBBB(ind), tBBB-(ind)
tBB+(ind), tBB(ind), tBB-((ind)
tB+(ind), tB(ind), tB-(ind)
tC (ind)
tD(ind)

High Credit Quality
Adequate Credit Quality
Moderate Credit Quality
Speculative
Highly Speculative
High Default Risk
Default
For Short Term (Less than 12 months)

F1+(ind), F1(ind)
F2+(ind), F2(ind)
F3(ind)
F4(ind)
F5(ind)

Good Credit Quality
Fair Credit Quality
Speculative
Default
Limitations of Credit Rating

a.
b.
c.
d.
e.
Credit Rating is based upon the evaluation made by the agencies which is essentially a
subjective evaluation which may vary depending upon the experience, knowledge and
the individual opinion of the rators which may be biased in some cases.
The various guidelines issued for regulating the various types of instruments for which
credit rating is required, require the companies to get the credit rating done. However,
these guidelines do not require the companies to publish these ratings. As such, in
certain cases the companies may not publish the ratings, particularly when the ratings
are not favourable to the companies. This defeats the basic purpose of credit rating.
The approved credit rating agencies prevailing in the country are promoted by the
government controlled organisations. This may involve its own consequences.
It is usually observed that the ratings given by the credit rating agencies is primarily
based upon the past performance of the companies, whereas the future prospects of the
companies should be given more importance while deciding the credit rating. Moreover,
if a particular company or a particular industry is passing through the temporary adverse
conditions, it may get a low credit rating if judged on temporary basis.
Multiplicity of the rating agencies can be considered to be the limitation of the credit
rating. If a company is not satisfied with the rating given by one agency, the company
can approach another rating agency with the hope to get better rating from that agency.
The recently introduced guidelines issued by SEBI provide that if the company has
approached more than one rating agency, it is required that the ratings given by all the
agencies are made known to the investors. If there is a vast difference between the
ratings awarded by the different agencies, it may be a point of concern for the investor.
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311
f.
In the recent past, some cases were observed that the ratings given by the agencies
were either upgraded or downgraded within comparatively a very short span of time. The
question arises what went wrong to such an extent that the ratings were required to be
upgraded or downgraded to such an extent. In the whole process, the basic rating given
by the agencies gets challenged. Effectively, the credibility of the agency is at stake.
BUY BACK OF SHARES

As per the provisions of Companies (Amendment) Act, 1999, the company is now authorised
to buy back its own shares. This is one of the exceptions to the rule that no company can
reduce the amount of its share capital during its life time. The provisions in respect of buy
back of own shares are contained in Section 77A of the Companies Act, 1956 which are as
below:
a.
Articles of Association of the company should authorise the company to buy back its
own shares. If there is no authorisation in the Articles of Association, they need to be
amended first.
b.
The buy back of the shares should be approved by passing a special resolution in the
general meeting of the Company. The explanatory statement enclosed to such notice
should contain the details like disclosure of all material facts, necessity for buy back,
the class of shares proposed to be bought back, amount required for such buy back of
shares and time required for completion of buy back. After the special resolution is
passed but before the buy back of shares, the company shall file with the Registrar of
Companies of the respective state and with SEBI, if shares of the Company are listed on
a recognized stock exchange, a declaration that the company is capable of meeting its
liabilities and will not be insolvent within a period of one year from such declaration. Such
declaration shall be signed by atleast two directors, one of whom should be the managing
director. This special resolution should be filed with the Registrar of Companies of the
respective state in Form No. 23. The procedure of buy back should be completed within
12 months from passing such special resolution.
c.
The shares can be bought back out of the following amounts:

i)
Free Reserves of the company.
ii)
Share Premium Account of the company.
iii)
Proceeds of issue of any shares or other specified securitites.

However, proceeds of earlier issue of shares or other specified securities can not
be used for buy back of shares.
312
Similarly, the shares can be bought backi)
From the open market.
ii)
Form the existing shareholders on a proportionate basis.
iii)
By purchasing the shares issued to the employees under the employees stock
option scheme or issued to them as sweat equity.
d.
The amount of shares bought back should not be more than 25% of total paid-up capital
of the company and its free reserves. A company may be able to buy back its own
shares every year, however, the amount of shares bought back in any financial year shall
not be more than 25% of its paid up equity capital in that financial year.
e.
The debt equity ratio of the company after such buy back of shares should not be more
than 2:1 except where the Central Government allows a higher ratio in case of certain
companies.
f.
The shares which are proposed to be bought back should be fully paid up shares.
g.
When the company buys back its own shares, it shall extinguish and physically destroy
securities so bought back within a period of 7 days from the last date of completion of
buy back.
h.
If the company buys back its own shares, it shall not make further issue of same kind of
shares (including rights shares) within a period of 24 months. However, this provision
shall not apply toi)
Issue of bonus shares.
ii)
Conversion of preference shares/debentures into the equity shares.
iii)
Fulfillment of obligations in respect of conversion of equity warrants, employees

stock options or sweat equity.
i.
After the process of buy back of shares is complete, the company shall file necessary
particulars with Registrar of Companies of the respective state and with SEBI if shares of
the company are listed on a recognized stock exchange.
j.
Where a company buys back its own shares, it shall maintain a registrar of the shares
so bought back, consideration paid for such shares bought back, date of cancellation of
these shares, date of extinguishing/ physical destruction of these shares etc.
Capital Market
313
VENTURE CAPITAL
In the recent past, Ventures Capital has become one of the best possible sources for raising
the funds for the companies involving more amount of business risks and for whom the normal
avenues for raising the funds are unavailable as the common investors are unwilling to invest
their funds into such ventures. Venture capital as a source of funds has become a necessity
for the organizations who have good growth opportunities. Venture Capitalist or Venture Capital
Fund (VCF) is interested in investing in these projects (i.e. Venture Capital Undertaking) as
his investment is likely to generate huge amount of returns. These returns may not be in the
form of recurring returns like dividend, but also in the form of capital gains over a longer span
of time.
A venture capitalist investing in the project is aware of the fact that the project is in the
untested area, involving more amount of risk. He is also aware that the projects are likely to
involve larger gestation period. As such, a venture capitalist is not worried about the failure of
the project in which he invests his funds. This is because of the fact that he knows that the
project which succeeds will give huge returns which will compensate for the losses incurred
by other projects. This is the reason why the venture capitalist is not only the investor of funds
or the lender of the funds. A conventional lender of funds is not directly involved in the operations
and management of the company. He keeps away from managing the company and is bothered
about the safety of the funds lent by him, A conventional investor only trades in the shares of
the company without any relationship with the management of the company.
As against this, before investing in the project, Venture Capital Company or Venture Capital
Fund scrutinizes the project carefully and studies the merits of the project. He takes active
participation in the management of the project providing the benefit of his expertise and
experience to the Venture Capital Undertaking.
Before investing in the project, Venture Capitalist is interested in ensuring thata.
The project is technically feasible.
b.
The project is commercially viable.
c.
The entrepreneurs are technically competent.
d.
The project has a competitive advantage over a longer span of time.
Types of Venture Capital Financing

The venture capital funding can be either in the form of equity financing or debt financing.
However, equity financing is more preferred route for venture capital funding. This is due to the
following facts
314
a.
Projects for venture capital financing are more risky in nature and involve larger gestation
period. Hence, the project will require the long term funds on which it may not be able to
pay the returns during the initial period. At the same time, venture capitalist is not
interested in interfering in the project. Hence, the investment of the venture capitalist
does not exceed 49% so that the effective control of the project remains with the
entrepreneur.
b.
Venture capitalist is not interested in keeping his investment in the project on a permanent
basis. He wishes to quit his investment as early as possible. He can do so when the
project becomes successful and profitable and he is able to sell off his equity shares.
Exit Routes available to VCF

As stated earlier, the VCF is not interested in remaining associated with the Venture Capital
Undertaking on a permanent basis. He is interested in quitting his investment at a suitable
point of time. In the Indian circumstances, following two options may be available to VCF for
the purpose of quitting his investment.
a.
Purchase of VCF stake by the promoters
b.
Initial Public Offering (IPO)
Purchase of VCF stake by the promoters

This exit route is very popular in the Indian circumstances where the promoters of the Venture
Capital Undertaking purchase the equity stake of VCF within the agreed period at a pre
decided price. This enable the promoters to maintain their stake in the Ventures Capital
Undertaking intact. The limitation of this exit route lies in the fixation of the price which the
promoters will be required to pay to the VCF for buying the equity stake of the VCF.
Initial Public Offering (IPO)
The first public offering of equity shares of company to be followed by listing of the shares on
stock exchange is known as Initial Public Offering (IPO). Once the Venture Capital Undertaking
becomes profitable, it can make the public issue of its shares. After the abolition of the office
of Controller of Capital Issues, it is possible for the companies to decide the premium on the
issue of its shares. After the shares of the company are listed on the stock exchange, the
VCF can sell its stake on the stock exchange earning the capital appreciation in return. The
limitation of this exit route is the restricted scope of IPO for the Venture Capital Undertaking
as the venture promoted by comparatively unknown promoters may be viewed as an unattractive
proposition by the investors. Further, complexities in getting the securities listed on the stock
exchange and the efficiency of the secondary markets in India restrict the scope of this exit
route available to the VCFs.
Capital Market
315
Ventures Capital in India

The history of venture capital in India can be traced back to the establishment of Technology
Development Fund (TDF) in the year 1987-88, through the levy of cess on all technology
import payments. TDF was for providing financial assistance to innovative and high risk projects
through Industrial Development Bank of India (IDBI). In 1988, Industrial Credit and Investment
Corporation of India (ICICI) promoted Technology Development and information Company of
India (TDICI) as the first venture capital company under the Companies Act, 1956.
In 1996, Securities and Exchange Board of India issued the guidelines for the operations of
Venture Capitalists to carry out their operations in India. This has made the entry of foreign
venture capital funds more easy in the Indian situations
At present, the venture capital funds (VCFs) operating in India can be classified in the following
categories.
a.
VCFs promoted by All India Development Financial Institutions like IDBI, ICICI and IFCI.
E.g. TDICI promoted by ICICI.
b.
VCFs promoted by State level Financial Institutions. E.g. Gujrat Venture Finance Company
Limited or Andhra Pradesh Venture Capital Limited.
c.
VCFs promoted by the Commercial Banks. Eg. Can Bank Venture Capital Fund or State
Bank Venture Capital Fund etc.
d.
Private Sector Venture Capital Funds. Eg. Indus Venture Fund, 20th Century Venture
Capital Company, Infrastructure Leasing and Financial Services Limited etc.
In order to promote the venture capital, Section 10 (23FB) was inserted in Income Tax Act,
1961 which provides that any income earned by a VCF will be exempt from tax. To get this
exemption, following two conditions are required to be satisfied.
a.
Venture Capital Company or Venture Capital Fund should have been given the certificate
of registration by SEBI and such Venture Capital Company or Venture Capital Fund
should have fulfilled all the conditions as specified by SEBI.
b.
Venture Capital Company or Venture Capital Fund is set up to raise the funds for
investment in a Venture Capital Undertaking which essentially means a company whose
shares are not listed in a recognised stock exchange.
If the above conditions are satisfied, any income of such Venture Capital Company or Venture
Capital Fund will be exempt from income tax even if the shares of such company are
subsequently listed in recognized stock exchange.
316
QUESTIONS
1.
State the guidelines for the public issue and rights issue of shares.
2.
Write a short note on various intermediaries in capital market.
3.
Write a short note on various innovative instruments used by the companies for raising
the funds in capital market.
4.
Write short notes on a)
Credit Rating
b)
Venture Capital
c)
Buy Back of shares
Capital Market
317
NOTES
318
Chapter 10
CAPITAL BUDGETING
As discussed in the earlier chapters, the finance function has to deal with one of the most
important decisions regarding the amount to be invested in fixed assets and the decision is
technically in the form of Capital Budgeting. Thus, the capital budgeting decisions are decisions
as to whether or not money should be invested in long term projects. It includes analysis of
various proposals regarding capital expenditure to evaluate their impact on the financial situation
of the company and to choose the best out of the various alternatives. The function of finance
in this area is to enable the management to take a proper capital budgeting decision.
IMPORTANCE OF CAPITAL BUDGETING
Capital budgeting decisions are the most crucial and critical decisions for a business to take.
This is the fact due to the various reasons.
(1)
Capital budgeting decisions have long term implications on the operations of the
business.A wrong decision may affect the long term survival of the Company. The
investment in fixed assets more than required, may increase the operating costs of the
Company. The inadequate investment in fixed assets may make it difficult for the Company
to compete and may affect its market share.
(2)
Capital budgeting decisions involve large amount of the funds. As such, it is necessary
to take the decision very very carefully and to make the arrangement of the funds for the
procurement of these assets.
(3)
The capital budgeting decisions are irreversible due to the fact that it is difficult to find the
market for such capital goods. The only alternative is to scrap these assets which involves
huge losses.
(4)
Capital budgeting decisions are difficult to make because it involves the assessment of
future events which are difficult to ascertain. The investments are required to be made
immediately but the returns are expected over a number of years.
Capital Budgeting
319
THE PROCESS OF CAPITAL BUDGETING

The process of capital budgeting involves generally the following steps.
(1)
Project Generation : The generation of the proposals may fall under any of the following
categories.
(a)
Additions to the present product line.
(b)
Expansion of the capacity of the existing product line.
(c)
Proposals to reduce costs of the existing product line without affecting the scale of
operations.
The generation of the projects may take place at the levels of top management or at the
level of workers also. E.g. Proposal to replace on old machine or to improve the production
techniques may originate at the workers level also.
(2)
Project Evaluation : As in case of any types of decision makings, the capital budgeting
decisions also have two faces. Firstly, estimation of the benefits and costs measured in
terms of cash flows and Secondly, selection of an appropriated criterian to judge the
desirability of the projects. It is necessary that the evaluation of the projects is done by
impartial group and experts in the field. Care must be taken to choose the criteria to
judge the desirability of the projects and it should be consistent with the companys
basic objective to maximize the wealth.
(3)
Project Selection : There is no fixed and laid down procedure to select the final criteria
among the various available alternatives. Generally, the selection of the final project is
done by the top management though it may be scrutinized at various levels. In many
cases, top management may delegate the authority to approve certain projects to lower
management also.
(4)
Project Execution : After the final selection of the project is made, the funds are
appropriated and the execution of the project is carried on. However, there has to be a
proper system to check that the execution of the project is being made as per the
predecided plans and scheldules.
EVALUATION OF THE PROJECTS

As discussed earlier, the process of evaluation of the projects necessarily involves the cost
benefit analysis. This cost benefit analysis will generally be made in financial terms, though in
some cases non-financial considerations may also come into play. E.g. Some times a project
may be undertaken to get established in the market or to satisfy certain legal requirements or
for some social welfare benefits or just for some emotional reasons. However financial cost
benefit analysis will be the basic evaluation criteria.
320
There are many techniques and tools to evaluate the various investment proposal. But before
going into the details of these various techniques, one most important aspect of the evaluation
has to be studied and that is how to compute the cash flows?
HOW TO COMPUTE THE CASH FLOWS?
As the estimation of cash flows both outflows as well as inflows is the crux for evaluating
the projects, this estimation should be made as carefully as possible. The following stages
should be considered for this purpose.
(1)
Following items constitute the cash outflow.

(i)
Cost of new equipment.
(ii)
Cost for demolition of old equipment (similarly, if there is some scrap value receivable
from the disposal of the old equipment, the outflow on account of the new equipment
should be suitably adjusted.)
(iii) Cost of preparing site and installation charges incurred with respect to the new
equipment.
Following factors should also be taken into consideration.
(i)
If the cost of the new equipment is not to be incurred in one single instalment, but
is to be paid over a period of years, it will involve the cash outflow not only in the first
year but in the subsequent years also. Similarly, if the cost of the equipment/
project is met by raising the term borrowing, the cash outflow will come into
consideration as and when the instalment of term borrowings and interest on the
same are paid.
(ii)
If the new equipment/project brings certain scrap value after the useful life is over,
the amount realised as scrap value will constitute the cash inflow, but in relation to
the year in which the amount is actually received.
(iii) In some cases, implementation of the project may involve investment in the form of
additional working capital due to increased inventory, increased debtors etc. This
additional investment in working capital constitutes cash outflow. Similarly, after
the useful life of the project is over, this investment in the working capital is released
and hence should be considered as inflow but only with respect to the year in which
it is so released. Further, if the company resorts to some outside source of funds
for financing working capital requirements, the cash outflow on account of investment
in working capital will be the amount invested by the company itself. The amount
received from the outside source of working capital finance constitute the cash
inflow.
Capital Budgeting
321
(iv)
(2)
If a new asset is intended to be purchased in order to replace an existing asset, the

sale proceeds of the old asset should be considered as the cash inflow and the
cash outflow required to purchase new asset should be adjusted accordingly.
Following factors should be considered while computing cash inflows.

(i)
Computation of cash inflows highly depends upon correct estimation of production

and sales. On the basis of the additional production units which can be sold and
the price at which they can be sold, the gross revenue from the project can be
worked out. However, while doing so, the possibility of reduction in selling price,
introduction of a cheaper product by competitiors, etc. should also be considered.
(ii)
Second stage in deciding the cash inflows is to estimate the costs attached to the
project. These costs may be in the form of fixed costs or variable costs or
depreciation.
(iii)
The difference between the gross revenue and the costs give the result of the net
revenue which should be adjusted for taxation factor for computation of cash inflows
as it involves the actual payment of cash. However, the amount of depreciation, if it
is already included in the cost to consider the taxation factor should be added back
while computing the cash inflow as depreciation does not involve the cash outflow.
In simple words, the cash inflows should be computed in the following stages.
Sales Revenue
Less :
Costs (including depreciation)

Net Revenue
Less :
Tax Liability
Revenue after taxes.
Add :
Depreciation
Net cash inflow
322
(iv)
Care should be taken not to include the cost of interest and dividends while
considering the costs attached to the project. This is due to the fact that for evaluating
the proposals if cost of capital is considered as the discounting factor (as discussed
in details later), the amounts of interest and dividend are already given due
consideration while computing the cost of capital.
(v)
Sometimes the cash inflows may be considered in terms of net savings in costs
rather than in terms of excess of sales over the additional cost. Thus, for computing
the cash inflows these savings in costs will be the starting point which will have to
be adjusted further for taxation and depreciation factor. The cash inflows will be
computed as below.
Saving in costs
(Other than Depreciation)
Less :
Depreciation
Net Savings in costs.
Less :
Tax liability
Savings after tax
Add :
Depreciation
Net cash inflows.
TIME VALUE OF MONEY

It has already been discussed that the evaluation of capital expenditure proposals involves the
comparison between cash outflows and cash inflows. The peculiarity of evaluation of capital
expenditure proposals is that it involves the decisions to be taken today whereas the flow of
funds, either outflow or inflow, may be spread over a number of years. It goes without saying
that for a meaningful comparison between the cash outflows and cash inflows, both the variables
should be on comparable basis. As such, the question which arises is that is the value of
flows arising in future the same in terms of today? E.g. If a proposal involves the cash inflow
of Rs. 10,000 after one year, is the value of this cash inflow really Rs. 10,000 as on today when
the capital expenditure proposal is to be evaluated? The ideal reply to this question is no.
The value of Rs. 10,000 received after one year is less than Rs. 10,000 if received today.
The reasons for this can be stated as below:
(1)
There is always an element of uncertainty attached with the future cash flows.
(2)
The purchasing power of cash inflows received after the year may be less than that of
equivalent sum if received today.
(3)
There may be investment opportunities available if the amount is received today which
cannot be exploited if the equivalent sum is received after one year.
E.g. If Mr. X is given the option that he can receive an amount of Rs. 10,000 either today or
after one year, he will most obviously select the first option. Why? Because, if he receives
Rs. 10,000 today he can always invest the same say in the fixed deposits with a bank
carrying the interest of say 10% p.a. As such, if the choice is given to him, he will like to
receive Rs. 10,000 today or Rs. 11,000 (i.e. Rs. 10,000 plus interest @ 10% p.a. on
Rs. 10,000) after one year. If he has to receive Rs. 10,000 only after one year, the real value of
the same in terms of today is not Rs. 10,000 but something less than that. This concept is
called time value of money.
Capital Budgeting
323
In the capital budgeting decisions, if there has to be a meaningful comparison between the
cash outflows and cash inflows which may arise in future at different points of time whereas
the evaluation is required to be done as on today, both the future cash outflows and cash
inflows are required to be expressed in terms of today.
There are two techniques available for this.
(a)
Compounding
(b)
Discounting
(a)
Compounding :
In this technique, the interest is compounded and becomes a part of initial principal at the end
of compounding period.
E.g. If Mr. X invests Rs. 10,000 in fixed deposit carrying interest @ 10% p.a. compounded
annually, at the end of first year, Rs. 10,000 will be worth Rs. 11,000 (i.e. Rs. 10,000 + interest
on Rs. 10,000 @ 10% p.a.). If Rs. 11,000 are reinvested in the same fixed deposit, at the end
of second year Rs, 11,000 will be worth Rs. 12,100 (i.e. Rs. 11,000 + interest on Rs. 11,000
@ 10% p.a.) In other words, the value of todays Rs. 10,000 if received after two years becomes
Rs. 12,100.
The compounding of interest can be calculated with the help of following equation.
A
P (1 + i)n where
Amount at the end of the period.
Amount of principal at the beginning of the period.
Rate of interest
Number of years
E.g. In the above example, after two years, the value of todays Rs. 10,000 if invested in the
investment carrying the interest of 10% p.a. can be computed as
A
(b)
10,000 x (1 + 0.10)2
10,000 x 1.21
Rs. 12,100
Discounting :
These techniques involve the process which is exactly opposite to that involved in the technique
of compounding. This technique tries to find out the present value of Re. 1 if received or spent
after n years, provided that the interest rate of i can be earned on investment. The present
value is calculated with the help of following equation.
324
where,
Present value of sum received or spent
Sum received or spent in future
Rate of interest
Number of years.
(1 + i)
E.g. If Mr. X is given the opportunity to receive Rs. 10,000 after two years, when he can earn
interest of 10% p.a. on his investment, what should be the amount which he should invest
today so that he may be able to receive Rs. 10,000 after two years.
It can be computed as :
P
=
=
A
(1 + i)n
10,000
(1 + 0.10)2
Rs. 8,264.46
In other words, if Mr. X invests Rs. 8,264.46 today in the investment carrying interest rate of
10% p.a. he may be able to receive Rs. 10,000 after two years or the present value or Rs.
10,000 if received after two years is only Rs. 8,264.46 as on today if investment opportunities
are available to earn the interest of 10% p.a.
PRESENT VALUE TABLES
To simplify the computation of present value, use can be made of Table A given in the Appendix
which gives the present value of rupee one for the various interest rates (i) and years (n) for
computing the present value of a future lump sum, the said sum can be multiplied by choosing
the interest factor/discounting factor/present value factor for the relevant combination of i and n.
E.g. To find out the present value of Rs. 4,000 received after 7 years, assuming interest rate to
be 15%, we ascertain the present value factor to be 0.513. We ascertain the present value to be
Rs. 4000 x 0.513
= Rs. 2,052.
PRESENT VALUE OF SERIES OF CASH FLOWS
In capital budgeting decisions, the cash flows, either cash outflow or cash inflow, may occur
at various points of time. For finding out the present value of this series of cashflows, it is
necessary to find out the present value of each future cash flow and then aggregate them.
Capital Budgeting
325
Illustration I
A project involves cash inflows as below.
Year Cash
Inflows Rs.
10,000
12,000
15,000
20,000
Assuming interest rate to be 15%, find out the present value of cash inflows.
Solution : Calculation of present value of cash inflows.
Year
Cash inflows
Rs.
Present Value
Factor 15%
Total Present Value

Rs.
10,000
0.870
8,700
12,000
0.756
9,072
15,000
0.658
9,870
20,000
0.572
11,440
39,082
Illustration II :
A machine costing Rs. 1,00,000 is to be purchased as below :
Rs. 20,000
Down payment out of own contribution.
Rs. 80,000
Borrowing by way of term loan. To be paid in 4 equal annual instalment

along with the interest @ 15% p.a. The interest being computed on opening
outstanding balance.
Calculate present value of the cash outflow.
326
Solution :
Calculation of present value of cash outflows
Year
Principal sum/
Own
Contribution Rs.
Interest Total outflow

Rs.
Rs.
PV. Factor
15%
Total PV
Rs.
20,000
20,000
1.000
20,000
20,000
12,000
32,000
0.870
27,840
20,000
9,000
29,000
0.756
21,924
20,000
6,000
26,000
0.658
17,108
20,000
3,000
23,000
0.572
13,156
1,00,028
If a project involves uniform cashflows, the present value of the cashflows can be calculated by
a short cut method. Instead of calculating present value for each cashflow and then summing
up the present values, the discounting factors (interest factor or present value factors) themselves
can be summed up to find out the Accumulated Discounting Factor for the various interest
rates (i) and years (n) and the multiplication of Accumulated Discounting Factor and cashflow
will give present value of cashflow.
Illustration III
A project involves the cash inflow of Rs. 20,000 per year for 4 years. Assuming interest rate of
15%, find out the present value of cash inflows.
Accumulated Discounting factor at 15% for 4 years is 2.855.
Present value of cash inflows Rs. 20,000 x 2.855
=
Rs. 57,100.
RELEVANCE IN CAPITAL BUDGETING DECISIONS

As discussed earlier, to make the value of cash outflows and cash inflows comparable, it is
necessary to reduce future cash outflows or cash inflows to their present value by discounting
them by proper discounting factor or interest factor or present value factor. Usually, weighted
average cost of capital is considered as the discounting factor in capital budgeting decisions.
Capital Budgeting
327
TECHNIQUES FOR EVALUATION OF CAPITAL EXPENDITURE PROPOSALS

Various techniques are available for evaluation of capital expenditure proposals. They can be
broadly catagorised under two heads.
(a)
Techniques not considering time value of money.
(b)
Techniques considering time value of money.
(a)
Techniques not considering time value of money :
(1)
Pay back period :
Pay back period indicates the period within which the cost of the project will be completely
recovered. In other words, it indicates the period within which the total cash inflows equal to
the total cash outflows. Thus,
Pay back period
Cash outlay
Annual cash inflow
Illustration I :
A project requires an outlay of Rs. 5,00,000 and earns, an annual cash inflow of Rs. 1,00,000
for 8 years. Calculate pay back period.
Pay back period for the project is
Rs. 5,00,000
= 5 years
Rs. 1,00,000
If the project involves unequal cash inflows, the payback period can be computed by adding up
the cash inflow till the total is equal to cash outlay.
Illustration II
A project requires an outlay of Rs. 1,00,000 and earns, the annual cash inflow or Rs. 25,000,
Rs. 30,000, Rs. 20,000 and Rs. 50,000. Calculate pay back period.
If we add up cash inflows, we find that in the first 3 years, an amount of Rs. 75,000 of the cash
outlay is recovered. Fourth year generates the cash inflow of Rs. 50,000, whereas the amount
of Rs. 25,000 only remains to be recovered. Assuming that the cash inflows occur evenly
during the year, the time which will be required to recover Rs. 25,000 will be
Rs. 25,000
x 12 months = 6 months.
Rs. 50,000
328
Thus, the pay back period is 3 years and 6 months.

Acceptance Rule :
Payback period method can be used as an accept or reject criteria or as a method of ranking
the project. If the payback period computed for a project is more than maximum pay back
period estimated by the management it would be rejected or vice versa. As a ranking method,
the projects having shortest pay back period will be ranked highest.
Advantages :
(1)
It is quite simple to calculate and easy to understand. It makes it quite clear that there
are no profits on a project unless pay back period is over.
(2)
It costs less.
(3)
It may be a suitable technique where risk of absolescence is high. In such cases,

projects with shorter pay back period may be preferred as the changes in technology
may make other projects obsolete before their costs are recovered.
Disadvantages :
(1)
It does not consider the returns from a project after its pay back period is over. Thus, one
project A may have a pay back period of 5 years while another project B may have a pay
back period of 3 years, thus making project B more preferable. But it is quite possible
that project A may generate good cash inflows after 5 years till the end of 10 years, while
project B may stop generating cash inflows after 3 years only. In such cases, project A
may prove to be more advantageous.
(2)
It may not be a suitable method to evaluate the projects if they involve uneven cash
inflows.
(3)
It ignores time value of money.
(4)
To decide the acceptable payback period is a difficult task. There is no rational basis for
deciding the maximum payback period. It is a subjective decision.
(2)
Accounting Rate of Return :
Accounting rate of return (ARR) computes the average annual yield on the net investment in
the project. ARR is computed by dividing the average profits after depreciation and taxes by
net investments in the project. Thus ARR can be computed as.
Total Profits
x 100
Net investment in project x No. of years of profits
Capital Budgeting
329
Illustration :
A project involves the investment of Rs. 5,00,000 which yields profits after depreciation and
tax as stated below.
Years
Profits after depreciation and tax
Rs.
25,000
Rs.
37,500
Rs.
62,500
Rs.
65,000
Rs.
40,000
Rs. 2,30,000
At the end of 5 years, the machineries in the project can be sold for Rs. 40,000. Find the ARR.
The total profits after depreciation and taxes are Rs. 2,30,000.
The net investment in the project will be Original cost Less salvage value i.e. Rs. 5,00,000
Rs. 40,000 = Rs. 4,60,000
ARR will be
Rs. 2,30,000
x 100 = 10%
Rs. 4,60,000 X 5 years
Acceptance Rule :
As pay back period method, ARR also can be used as accept or reject criteria or as a method
for ranking the projects. As accept or reject criteria, the projects having the ARR more than
minimum rate prescribed by the management will be accepted and vice versa. As a ranking
method, the projects having maximum ARR will be ranked highest.
Advantages :
330
(1)
It is simple to calculate and easy to understand.
(2)
It considers the profits from the project throughout its life.
(3)
It can be calculated from the accounting data.
DISADVANTAGES :
(1)
It uses profits after depreciation and taxes and not the cash inflows for evaluating the
projects.
(2)
It ignores time value of money.
(b)
Techniques considering time value of money
(1)
Discounted Pay back period :
This is an improvement over the pay back period method in the sense that it considers time
value of money. Thus, discounted pay back period indicates that period within which the
discounted cash inflows equal to the discounted cash outflows involved in a project.
Illustration :
A project requires an outlay of Rs. 1,00,000 and earns the annual cash inflows of Rs. 35,000,
Rs. 40,000, Rs. 30,000 and Rs, 50,000. Calculate discounted pay back assuming the
discounting rate of 15%.
Years
Cash inflows
Rs.
Discounting
Factor
@15%
Discounted
Cash Inflow
Rs.
Cummulative Discounted
Cash inflows
Rs.
35,000
0.870
30,450
30,450
40,000
0.756
30,240
60,690
30,000
0.658
19,740
80,430
50,000
0.572
28,600
1,09,030
Thus, pay back period is after 3 years but before 4 years. Assuming that cash inflows accrue
evenly during year, Pay Back Period will be 3 years 8 months (Approx.).
Acceptance rule, advantages and disadvantages
They are the same as in case of pay back period method except the fact that it considers time
value of money
(2)
Net Present Value :
Net present Value (NPV) is a method of calculating present value of cash inflows and cash
outflows in an investment project, by using cost of capital as the discounting rate, and finding
out net present value by subtracting present value of cash outflows from present value of cash
inflows. Thus,
Capital Budgeting
331
NPV =
cash
{ Discounted
}
Inflows
Less
Discounted Cash
{ Outflows
}
Illustration :
Calculate net present value of a project involving initial cash outflow Rs.1,00,000 and generating
annual cash inflows of Rs. 35,000, Rs. 40,000 Rs, 30,000 and Rs. 50,000 Discounting rate
is 15%.
Years
Cash inflows
Rs.
Discounting factor
15%
Present Value of cash

inflows Rs.
35,000
0.870
30,450
2.
40,000
0.756
30,240
3.
30,000
0.658
19,740
4.
50,000
0.572
28,600
1,09,030
Less :Investment outlay

Net Present Value (NPV)
1,00,000
9,030
Accceptance Rule :
As accept or reject criteria, all the projects which involve positive NPV i.e. NPV > 0 will be
accepted and vice versa.
As a ranking method, the projects having maximum positive NPV, will be ranked highest.
Advantages :
(1)
It considers time value of money.
(2)
It considers cash inflows from the project throughout its life.
Disadvantages :
332
(1)
It is difficult to use, calculate and understand.
(2)
It presupposes that the discounting rate, i.e. cost of capital is known. But cost of capital
is difficult to measure in practice.
(3)
It may give dissatisfactory results if the alternative projects involve varying investment
outlay. A project involving maximum positive NPV may not be desirable if it involves huge
investment.
(4)
(3)
It presupposes that the cash inflows can be reinvested immediately to yield the return
equivalent to the discounting rate, which may not be possible always.
Internal Rate of Return :
Internal Rate of Return (IRR) is that rate at which the discounted cash inflows match with
discounted cash outflows. The indication given by IRR is that this is the maximum rate at
which the company will be able to pay towards the interest on amounts borrowed for investing
in the projects, without loosing anything. Thus, IRR may be called as the break even rate of
borrowing for the company.
In simple words, IRR indicates that discounting rate at which NPV is zero. If by applying 10%
as the discounting rate, the resultant NPV is positive, while by applying 12% discounting rate,
the resultant NPV is negative, it means that IRR, i.e. the discounting rate at which NPV is
zero, falls between 10% and 12%. Thus, by applying the trial and error method, one can find
out the discounting rate at which NPV is zero. The process to compute IRR will be to select
any discounting rate and compute NPV. If NPV is negative, a lower discounting rate should be
tried and the process should be repeated till the NPV becomes zero. Following illustration
explains the process to calculate IRR.
Illustration :
A project cost Rs. 1,00,000 and generates annual cash flows of Rs 35,000, Rs. 40,000,
Rs. 30,000 and Rs. 50,000 over its life of 4 years. Calculate the Internal Rate of Return.
Using 15% as discounting rate, the present value of cash inflows can be calculated as below.
Year
Cash inflows Rs.
PV factor 15%
Total PV Rs.
1
2
3
4
35,000
40,000
30,000
50,000
0.870
0.756
0.658
0.572
30,450
30,240
19,740
28,600
1,09,030
Using 18% as discounting rate, the present value of cash inflows can be calculated as below :
Year
Cash inflows Rs
PV factor 18%
Total PV Rs.
1
2
3
4
35,000
40,000
30,000
50,000
0.847
0.718
0.609
0.516
29,645
28,720
18,270
25,800
1,02,435
Capital Budgeting
333
Using 20% as discounting rate, the present value of cash inflows can be calculated as below.
Year
Cash inflows Rs
PV factor 20%
Total PV Rs.
1
2
3
4
35,000
40,000
30,000
50,000
0.833
0.694
0.579
0.482
29,155
27,760
17,370
24,100
98,385
Thus, at 18% discounting rate, NPV, is Rs. 2,435 and at 20% discounting rate, NPV is (-)
Rs. 1615. Hence, IRR is between 18% and 20%, i.e. more than 18% but less than 20%.
Difference between PV at 18% and 20% is Rs. 4050 (i.e. Rs. 1,02,435 Rs. 98,385) and the
negative NPV of Rs. 1615 has to be covered by this amount to arrive as IRR.
Thus IRR will be
20%
1615 X 2
4050
= 19.2% (Appr.)
Acceptance Rule :
The computed IRR will be compared with the cost of capital. If the IRR is more than or at least
equal to the cost of capital the project may be accepted (IRR > Cost of Capital Accept).
If the IRR is less than cost of capital, the project may be rejected. (IRR < Cost of Capital
Reject)
Advantages :
(1)
It considers time value of money.
(2)
It considers cash inflows from the project throughout its life.
(3)
It can be computed even in the absence of the knowledge about the firms cost of capital.
But in order to draw the final conclusion, the comparison with the cost of capital is a
must.
Disadvantages :
334
(1)
It is difficult to use, calculate and understand.
(2)
It presupposes that the cash inflows can be reinvested immediately to yield the return
equivalent to the IRR. NPV method, on the other hand, presupposes that the cash
inflows can be reinvested to yield the return equivalent to the cost of capital, which is
more realistic.
(4)
Profitability Index (PI)/Benefit Cost Ratio (B/C Ratio)
It is the ratio between total discounted cash inflows and total discounted cash outflows. Thus
the Profitability Index can be computed as :
PI =
Discounted cash inflows

Discounted cash outflows
PI can be computed as gross one as stated above or as net one which means gross minus
one.
Illustration
A project requires an outlay of Rs. 1,00,000 and earns the annual cash inflows of Rs. 35,000
Rs. 40,000, Rs. 30,000 and Rs. 50,000. Calculate, Profitability Index assuming the discounting
rate of 15%.
Year
Cash flows
Rs.
Discounting factor
@15%
Discounted Cash Inflows

Rs.
35,000
0.870
30,450
40,000
0.756
30,420
30,000
0.658
19,740
50,000
0.572
28,600
1,09,030
Profitability Index can be calculated as :

= Discounted cash inflows
Discounted cash outflows
Rs. 1,09,030
Thus, PI (Gross)
= 1.09
Rs. 1,00,000
PI (Net)
1.09 1.00
= 0.09
Acceptance Rule :
As accept or reject criteria, the projects having the Profitability Index of more than one will be
accepted and vice versa. As a ranking method, the projects having highest profitability index
will be ranked highest.
Capital Budgeting
335
FINAL CHOICE OF EVALUATION METHOD

Between the basic two types of techniques as described above, the techniques considering
time value of money are generally preferred for the obvious reasons. However, the choice of the
evaluation technique depends upon the objective of the management in the investment decisions.
The objective is naturally in the form of maximization of wealth of the shareholders. As such,
only those projects will be in the interest of the shareholders which can earn more rate of
return than other alternative investment opportunities.
LIMITATIONS OF CAPITAL BUDGETING
The basic limitation of the capital budgeting process lies in this fact that it involves various
estimations . These estimations are specifically in respect of (a)
Cash outflow.
(b)
Revenues / Saving and costs attached with projects.
(c)
Life of the projects.
Whereas the cash outflows can be estimated with a reasonable accuracy, the cash inflows
and life of the projects cant be estimated accurately. Further, the changes in fiscal and
taxation policies of the Government also have the impact on determination of cash inflows. If
the techniques use the discounted flows to evaluate the projects, the cost of capital is used
as discounting rate. Difficulties in deciding the cost of capital, prove to be the limitation of
capital budgeting process.
EVALUATION CRITERIA IN CERTAIN TYPICAL SITUATIONS
(a) In certain cases, the capital expenditure may not involve any specific inflow of funds, but
only outflow of funds. E.g. If a machine manufactures such products which themselves cannot
be marketed, there may not be any specific inflow of funds associated with such machines.
Under such situations, if the company is required to make the choice between two machines,
the company should choose that machine which involves less amount of present value of
outflow of funds.
Illustration :
A company has to make a choice between buying of two machines. Machine A would cost
Rs. 1,00,000 and require cash running expenses of Rs. 32,000 p.a. Machine B would cost
Rs. 1,50,000 and its cash running expenses would amount to Rs. 20,000 p.a. Both the
machines have a life of 10 years with zero salvage value. The company follows straight line
depreciation and is subject to 50% tax on its income. The companys required rate of return is
10%. Which machine should it buy?
336
Note : Present value of Re. 1 p.a. for 10% discount rate is Rs. 6.1446.
Solution :
Machine A
Particulars
Cost of Machine
Running Expenses
Depreciation
Pre-tax
Amt.
Post-tax
Amt.
Years
PV factor
@10%
Total PV
1,00,000
32,000
(-)10,000
1,00,000
16,000
(-) 5,000
0
1-10
1-10
1.0000
6.1446
6.1446
1,00,000
98,314
(-) 30,723
1,67,591
Machine B
Particulars
Pre-tax
Amt. Rs.
Post tax
Amt. Rs.
Years
PV factor
@10%
Total PV
Rs.
Cost of Machine
1,50,000
1,50,000
1.0000
1,50,000
20,000
10,000
1-10
6.1446
61,446
(-) 15,000
(-) 7,500
1-10
6.1446
(-) 46,085
Running Expenses
Depreciation
1,65,361
As the PV of net outflow of funds is less in case of Machine B, investment in Machine B will
be accepted.
(b) In certain cases, the capital expenditure may involve replacement of an existing machinery
or equipments which is likely to result into the savings of costs. As such, under such situations,
the inflow of funds is in the form of savings arising from the investment which will be required
to be considered in the light of costs and benefits associated with new proposal vis--vis the
costs and benefits associated with existing proposal which will not be available in future.
Illustration :
Shree Prakash Co. has been using a machine costing Rs. 15,000 for the past 5 years. The
machine has 15 years of life. The current salvage value would be Rs. 2,000 and the company
has been paying 50% of its profits as taxes (i.e. it is subjected to 50% flat tax rate)
Now, the management desires to replace it by new machine costing Rs. 10,000 with salvage
value of Rs. 2000. The new machine has life of 10 years. Cost of capital is 10% and the
expected savings are likely to be Rs. 3,000 per annum.
Capital Budgeting
337
(a)
Should be company go for a new machines?
(b)
What would be your advice if expected savings increase by 50% per annum and expected
life descreases by 5 years?
Solution :
Part A :
Calculation of Cash Outflow :
Rs.
Purchase Price of new Machine
10,000
Less : Salvage value of old machine
2,000
Less : Tax saving @ 50% on the loss on sale of old machine
4,000
Net Cash Outflow
4,000
Note : Loss on the sale of old machine is calculated as below :

Cost of Old machine
15,000
Less : Depreciation for 5 years
5,000
Written down value (WDV)
10,000
Less : Salvage value
2,000
Loss on sale of old machine
8,000
Calculation of Cash Inflows :

Particulars
Savings
Difference in amount
of depreciation
Salvage value
pre-tax
Amt. Rs.
Post-tax
Amt. Rs.
Years
PV factor
@10%
Total PV
Rs.
3,000
1,500
1-10
6.145
9,218
(-) 200
(-) 100
1-10
6.145
(-) 615
2,000
2,000
10
0.386
772
9,375
Hence NPV i.e. Rs. 9375 Rs. 4,000
5,375
As NPV is positive, the company should go for new machine.

Note : Assuming that the depreciation is calculated on straight line basis which is acceptable
for income tax purposes and that the slavage value of old machine at the end of its life was Rs.
Nil, difference in the amount of depreciation is calculated as below :
338
Old Machine (Rs.)

Cost price
Less : Salvage value
Life in years
Annual depreciation
New Machine (Rs.)
15,000
10,000
2,000
15,000
8,000
15
10
1,000
800
Hence, amount of depreciation will be reduced by Rs. 200 if new machine is purchased.
Part B
Calculation of cash outflow will remain the same.
Calculation of cash inflows :
Particulars
Pre-tax
Amt. Rs.
Post-tax
Amt. Rs.
Years
PV factor
@10%
Total PV
Rs.
4,500
2,250
1-5
3.791
8,530
Depreciation on
new machine
1600
800
1-5
3.791
3,033
Depreciation on
old machine
(-) 1,000
(-) 500
1-10
6.145
(-) 3,073
2,000
2,000
0.621
1,242
Savings
Salvage value
9,732
Hence NPV is Rs. 9732- Rs. 4,000
5,732
As NPV is positive, the company should go for new machine in the second case also.
PLANNING, ORGANIZATION AND CONTROL OF CAPITAL EXPENDITURE
It has already been discussed that the various proposals for incurring capital expenditure may
be generated either at top management level or even at lower management level though latter
is the rare possibility. The various proposals generated are evaluated with the help of various
techniques as discussed above. The ultimate selection for proposals depends upon the
evaluation made by these techniques, however the factors like urgency or availability of funds
may also play important role.
The ultimate power to reject or accept various capital expenditure proposals rests with the top
management which may be in the form of Board of Directors or Executive Committee or
Management Committee. In some cases, the power may rest with the Chairman or Managing
Capital Budgeting
339
Director. The proposals involving the outlay to a certain extent may fall within the powers of
chief executive also and the proposals involving the outlay beyond that extent will have to be
referred to top management as described above. If the actual implementation of the selected
proposals involve the arrangement of funds from the financial institutions or require certain
Government approvals, it is the responsibility of middle management to arrange for the same.
If it is intended to exercise proper control on the capital budgeting process, an organization
may be required to take the following steps.
340
(1)
Planning : The capital expenditure has to be planned properly taking into consideration
the present and future needs of the business. It should be planned in such a way as to
ensure the balanced development of all the sections of the organization individually as
well as of the organisation as a whole. Usually, the plans in respect of capital expenditure
are prepared in the form of capital expenditure budget. Care should be taken to select
the period for which capital expenditure budget should be prepared. Too long a period
may not be useful.
(2)
Evaluation : Utmost care should be taken while evaluating the capital expenditure
proposals. As the capital expenditure proposals involve long term and irreversible
decisions, a wrong decision may disturb the entire financial structure of the organization.
The evaluation of various proposals should be done as rationally as possible. Proper
weightage should be given to the elements of risk and uncertainly.
(3)
Control over progress : Usually, the implementation of capital expenditure proposals

are spread over more than one year. As such proper control is required to be exercised
over issue of work orders/purchase orders, acquisition of material, labour force and other
assets, supply of funds etc.
(4)
Periodic and post completion audit : These are required to be conducted in order to
confirm whether the proposal has been implemented as per the original plan or not. If
some faults are pointed out regarding planning process, they may be corrected while
considering future projects. If some faults are pointed out during mid-term review of the
projects, corrective actions may be taken during the remaining period of implementation.
(5)
Forms and procedures : In order to ensure proper control over capital expenditure,
certain forms and procedures may be prescribed. Care should be taken that the said
forms are used and procedures are followed at each and every stage of implementation
of the capital expenditure proposals.
APPENDIX - I
CAPITAL RATIONING
The various techniques available with the company for evaluating the capital expenditure
proposals facilitate the company to decide which of the projects may be accepted. If the
company has sufficient funds to invest in all the acceptable projects, the problem is very
simple. However, it may not be the situation in practice. The company may not have enough
funds to invest in all the acceptable projects. Or the company may not be willing to acquire
necessary funds to invest in all acceptable projects due to the external or internal reasons
(E.g. Fixed budget for capital expenditure). Thus, capital rationing refers to a situation where
the company has more acceptable proposals requiring a greater amount of funds than is
available with the company. As such, under capital rationing, it is not only necessary to
decide profitable investments, but it is also necessary to rank the acceptable proposals
according to their relative profitabilities. With limited funds, the company must obtain the
optimum combination of acceptable investment proposals.
The normal process which may be followed under the capital rationing situations may be
(1)
To rank the projects according to some measure of profitability.
(2)
To select projects in the descending order of profitability till the available funds are
exhausted.
However, the situation of capital rationing may involve the consideration of other problems
also.
(1) Project Indivisibility : There may be some projects which cannot be divided while
execution. They can be either accepted or rejected in its entirety. These projects cannot be
undertaken partially or in pieces.
Consider the following situation.
The company has the following four acceptable proposals ranked according to Profitability
Index Method with the ultimate capital expenditure budget ceiling of Rs. 10,00,000.
Project
Projet Cost Rs.
Profitability Index
Ranking
5,00,000
1.25
3,50,000
1.20
2,50,000
1.18
1,00,000
1.15
Capital Budgeting
341
According to capital rationing process, projects A and B can be executed completely. Project
C is costing Rs. 2,50,000 whereas funds available after the execution of projects A and B is
only Rs. 1,50,000. if project C can be either accepted or rejected completely, the problem is
how to face such situation?
(2) Avoidance of smaller projects : If the process of capital rationing is strictly followed it
may result into the exclusion of various smaller projects by larger projects though the smaller
projects may be competitively profitable when compared with the larger projects. Consider the
following situation.
The company has the following four acceptable proposals ranked according to Profitability
Index Method with the ultimate capital expenditure budget ceiling of Rs. 10,00,000
Project
Projet Cost Rs.
Profitability Index
Ranking
6,50,000
1.26
3,50,000
1.25
50,000
1.24
40,000
1.23
If capital rationing process is to be applied strictly, projects A and B will be selected for
execution, whereas projects C and D will be rejected though they are equally profitable like
projects A and B.
(3) Mutually Dependent Project : The projects available before the company may be
basically of two types. Firstly, projects may be mutually exclusive i.e. the execution of one
project rules out the possibility of execution of other projects e.g. Five different machines are
available for a company to carry out a job. If the company decide to purchase one machine,
the possibility of purchasing other four machines is ruled out. Secondly, projects may be
mutually dependent i.e. the execution of one project depends upon the execution of another
project.
Now under the capital rationing situation, if sufficient funds are available to invest only in
machine A but not in B when investment in both the machines is mutually dependent, then the
problem is how to face such situation?
(4) Multi Period Projects : There may some projects the execution of which cannot be
completed in one accounting period, but their execution is spread over in various accounting
periods. In such situations, the constraints of capital rationing are required to be considered
over all the subsequent periods also which are required for the execution of the project.
342
APPENDIX II
CAPITAL BUDGETING AND RISK
The various techniques, as discussed above, for evaluating the capital expenditure proposals
may be ideally applied in a riskless situation which is a rare possibility. As stated above, the
capital budgeting process involves the estimation of various future aspects regarding future
cash inflows, life of the project etc. The accuracy of these estimates and hence reliability of
investment decisions mainly depends upon the precision in the forecasting of these aspects.
Howsoever carefully these aspects are forecast, there is always the possibility that the actual
situations may not correspond with these estimates. As such, the term risk with reference to
investment decisions may be defined as the variability in the actual returns emanating from a
project in future over its working life in relation to the estimated return as forecast at the time
of the initial capital budgeting decision.
Several mathematical and non-mathematical methods have been developed to consider the
risk in capital budgeting decisions. We will consider mainly three methods which are commonly
used.
(1)
Informal Method :
This method does not follow any mathematical or statistical model to consider the risk factor.
This is surely an informal or subjective method, which depends on the knowledge and experience
of the evaluator. The standard fixed to consider a project to be risky is strictly internal and is
not specified.
Illustration :
A company has under consideration two mutually exclusive projects for increasing its plant
capacity, the management has developed pessimistic, most likely and optimistic estimates
of the annual cash flows associated with each project. The estimates are as follows :
Project A
(Rs.)
Project B
(Rs.)
30,000
30,000
Pessimistic
1,200
3,700
Most likely
4,000
4,000
Optimistic
7,000
4,500
Net Investment
Cash flow estimates :
Capital Budgeting
343
(a)
Determine the NPV associated with each estimate given for both the projects. The projects
have 20 years life each and the companys cost of capital is 10%.
(b)
Which project do you consider should be selected by the company and why?
P.V. Factor is 8.514

Solution :
Calculation of NPV
Pessimistic
Most
Optimistic
1,200
4,000
7,000
Present value of Annual cash flows

(At PV factor for 20 years)
10,217
34,056
59,598
Outflow
30,000
30,000
30,000
(-)19,783
4,056
29,598
3,700
4,000
4,500
Present value of Annual cash inflows

(At PV factor for 20 years)
31,502
34,056
38,313
Outflow
30,000
30,000
30,000
1,502
4,056
8,313
Project A :
Annual cash inflows
NPV
Project B :
Annual cash inflows
NPV
CONCLUSION :
It can be seen from the above calculations that in case of most likely cash inflows, both the
projects are equally profitable.
However, Project A involves more risk as the variation of NPV in pessimistic conditions and
optimistic conditions is more in case of Project A.
As such, if risk involved with the projects is considered as the criteria, Project B will be
selected.
(2)
Risk adjusted discounting rate :
According to this method, the discounting rate is used not only to consider the futurity of the
returns from the project but also to consider the risk involved with the project. As such, in this
method, the discounting rate is increased in case of projects involving greater risk whereas it
is reduced in case of projects involving lesser risk. This can be explained with the help of
following illustration.
344
Suppose that following two projects involving outflow of cash of Rs. 1200 generate the cash
inflows as below.
Year
Project A (Rs.)
Project B (Rs.)
800
500
700
500
300
500
150
500
Obviously, Project A is more risky than Project B. As such, the discounting rate of 14% is
applied in case of Project A whereas the discounting rate of 10% is applied in case of Project
B, the difference of 4% being to take care of risk involved in case of Project A. Thus, the
computations of net present value are made as below :
Project A :
Year
Cash inflows Rs.
PV factor 14%
Total PV Rs.
800
0.877
701.60
700
0.769
538.30
300
0.675
202.50
4.
150
0.592
88.80
1531.20
Less: Outflow
NPV
1200.00
331.20
Project B :
Years
Cash Inflow
PV factor 10%
1 to 4
500 per year
3.169
Less : Outflow
NPV
Total PV Rs.
1,584.50
1,200.00
384.50
As project B involves greater NPV, it will be accepted.

This method is advantageous in this sense that it is simple to understand and incorporates
the risks attached with the future returns in case of capital expenditure proposals. However,
this method certainly suffers from some limitations.
Capital Budgeting
345
(1)
Additional discounting rate is considered to compensate for the risk attached to a project
as compared to any other riskless project. How much additional discounting rate will be
sufficient to take care of this risk cannot be decided accurately, say with the help of any
statistical or mathematical formula. Charging additional discounting rate is a subjective
concept to be decided by the evaluator of the proposals.
(2)
This method takes into consideration the risk factor by considering additional discounting
rate, however the cash inflows forecasted for the future period are considered without
taking into consideration the risk factor. E.g. if the cash inflows of Rs. 50,000 are estimated
to be received in a riskless situation, this method assumes that the amount of cash
inflows will be the same even in a risky situation. As such, only the discounting rate is
increased to take care of risk factor.
(3)
This method presupposes that the investors are not willing to take the risk and may
demand the compensation for assuming the risk. However, it ignores the possibility of
existence of risk-seekers who may be willing to pay premium for taking the risk.
(3)
Certainty-Equivalent Approach :
According to this method, rather than adjusting the discounting rate to take care of the risk
factor, the future cash inflows themselves are adjusted by using the certainty equivalent coefficient
which can be calculated as
Certainty Cash Inflows
Risky Cash Inflows
E.g. cash inflows from a project are expected to be Rs. 25,000, however generation of cash
inflow of Rs. 20,000 is most certain. As such, the certainty equivalent coefficient can be
computed as
Rs. 20,000
= 0.80
Rs. 25,000
Accordingly, depending upon the degree of risk, the certainty equivalent coefficient is decided.
Higher the risk, lower the certainty equivalent coefficient and vice versa.
346
To explain this approach, following illustration may be considered.

Year
Cash
Inflows
Rs.
Certainty
Equivalent
Coefficient
Adjusted Cash
Inflows
Rs.
PV factor
@10%
Total PV
Rs.
6,000
0.90
5,400
0.909
4,908.60
4,000
0.80
3,200
0.826
2,643.20
2,000
0.70
1,400
0.751
1,051.40
4,000
0.60
2,400
0.683
1,639.20
10,242.40
Less : Outflow
NPV
10,000.00
242.40
(1)
One of the two machines A and B is to be purchased. From the following information,
find out which of the two will be more profitable? The average rate of tax may be taken at
50%.
Machine A
(Rs.)
Machine B
(Rs.)
50,000
80,000
4 years
6 years
Rs.
Rs.
10,000
8,000
15,000
14,000
20,000
25, 000
15,000
30,000
18,000
13,000
Cost of machine
Working life
Earnings Before Tax:
Year
Solution :
As the discounting rate is not available, the evaluation of the projects can be made with the
help of following methods.
(1)
Pay Back Period
(2)
Accounting Rate of Return
Capital Budgeting
347
(1)
Pay Back period

Machine A
Machine B
Rs. Cumulative Rs.

Cash Outflow
Rs.
Cumulative Rs.
50,000
80,000
Year 1
10,000
10,000
8,000
8,000
13,750
23,750
13,667
21,667
16,250
40,000
19,167
40,834
13,750
53,750
21,667
62,501
15, 667
78,168
13,000
91,168
Cash Inflows
As such, Pay Back Period for :

Machine A 3 years 9 months (Appr.)
Machine B 5 years 2 months (Appr.)
Hence, machine A will be profitable.
Working Notes :
The cash flows are computed as below.
Inflows : before tax
Less : Depreciation
Less Tax @ 50%
Add : Depreciation
Depreciation is computed as,
Cost of machine
Working life in years
348
credit bills/invoices raised by the company. The bank holds the bills as a security till the
payment is made by the customer. The entire amount of bill is not paid to the company.
The company gets only the present worth of the amount of the bill, the difference between
the face value of the bill and the amount of assistance being in the form of discount
charges. However, on maturity, bank collects the full amount of bill from the customer.
While granting this facility to the company, the bank inevitably satisfies itself about the
credit worthiness of the customer and the genuineness of the bill. A fixed limit is stipulated
in case of the company, beyond which the bills are not purchased or discounted by the
bank.
(5)
Working Capital Term Loans : To meet the working capital needs of the company,
banks may grant the working capital term loans for a period of 3 to 7 years, payable in
yearly or half yearly instalments.
(6)
Packing Credit : This type of assistance may be considered by the bank to take care
of specific needs of the company when it receives some export order. Packing credit is
a facility given by the bank to enable the company to buy/manufacture the goods to be
exported. If the company holds a confirmed export order placed by the overseas buyer or
an irrevocable letter of credit in its favour, it can approach the bank for packing credit
facility. Basically, packing credit facility may take two forms :
i)
Pre-shipment Packing Credit : To take care of needs of the company before the
goods are shipped to the overseas buyer.
ii)
Post-shipment Packing Credit : To take care of needs of the company from the
shipment of goods to the overseas buyer till the date of collection of dues from him.
Necessarily, both these facilities are short-term facilities. The company may be required to
repay the same within a predecided span or out of the export proceeds of the goods exported.
(c)
Security for Assistance :
The bank may provide the assistance in any of the modes as stated above. But normally no
assistance will be available unless the company offers some security in any of the following
forms.
1)
Hypothecation :
Under this mode of security, bank extends the assistance to the company against the security
of movable property, usually inventories. Under this mode of security neither the property not
the possession of the goods hypothecated is transferred to the bank. But the bank has the
right to sell the goods hypothecated to realise the outstanding amount of assistance granted
by it to the company.
385
2)
Pledge :
Under this mode of security, bank extends the assistance to the company against the security
of movable property, usually inventories. But unlike in case of hypothication, possession of
the goods is with the Bank and the goods pledged are in the custody of the bank. As such, it
is the duty of the bank to take care of the goods in its custody. In case of default on the part
of company to repay the amount of assistance, the bank has the right to sell the goods to
realise the outstanding amount of assistance.
3)
Lien :
Under this mode of security, the bank has a right to retain the goods belonging to the company
until the debt due to the bank is paid. Lien can be of two types.
i)
Particular Lien : It is valid till the claims pertaining to specific goods are fully paid.
ii)
General Lien : It is valid till all the dues payable to the bank are paid.
Normally, banks enjoy general Lien.

4)
Mortgage :
This mode of security pertains to immovable properties like land and, buildings. It indicates
transfer of legal interest in a specific immovable property as security for the payment of debt.
Under this mode, the possession of the property remains with the borrower while the bank
gets full legal title there, subject to borrowers right, to repay the debt. The party who transfers
the interest (i.e. the company) is called mortgager and the party in whose favour the interest
is so transferred (i.e. the bank) is called mortgagee.
CONTROL OVER WORKING CAPITAL :
It can be seen from the preceding discussions that the commercial banks play a very significant
role in financing working capital needs. These working capital needs used to be met mainly in
the form of cash credit facilities and these advances used to be totally security oriented rather
than end-use oriented. As such, the units which were able to provide securities to the banks
were able to get main chunk of the finances provided by the banks whereas others experienced
shortage of inputs, lower capacity utilisation, high cost of production and ultimately threat of
closure. Reserve Bank of India has attempted to identify major weaknes in the system of
financing of working capital needs by Banks in order to control the same properly. These
attempts were mainly in the form of appointment of following committees.
386
(a)
Dahejia committee
(b)
Tandon committee
(c)
Chhore Committee
(d)
Marathe Committee
(e)
Nayak Committee and Vaz Committee

(a)
Dahejia Committee :
This committee was appointed in October 1968 to examine the extent to which credit needs
of industry and trade are likely to be inflated and how such trends could be checked.
Findings : The committee found out that there was a tendency of industry to avail of short
term credit from Banks in excess of growth rate in production for inventories in value terms.
Secondly, it found out that there was a diversion of short-term bank credit for the acquisition of
long term assets. The reason for this is that generally banks granted working capital finance
in the form of cash credit, as it was easy to operate. Banks took into consideration security
offered by the client rather than assessing financial position of the borrowers. As such, cash
credit facilities granted by the banks was not utilised necessarily for short-term purposes.
Recommendations : The committee, firstly, recommended that the banks should not only
be security oriented, but they should take into consideration total financial position of the
client. Secondly, it recommended that all cash credit accounts with banks should be bifurcated
in two categories.
(i)
Hard core which would represent the minimum level of raw materials, finished goods and
stores which any industrial concern is required to hold for maintaining certain level of
production and
(ii)
Short-term component which would represent of funds for temporary purposes i.e. Shortterm increase in inventories, tax, dividend and bonus payments etc.
It also suggested that hard core part in case of financially sound companies should be put on
a term loan basis subject to repayment schedule. In other cases, borrowers should be asked
to arrange for long term funds to replace bank borrowings.
In practice, recommendations of the committee had only a marginal effect on the pattern and
form of banking.
(b)
Tandon Committee :
In August 1975, Reserve Bank of India appointed a study group under the Chairmanship of Mr.
P. L. Tandon, to make the study and recommendations on the following issues :
(i)
Can the norms be evolved for current assets and for debt equity ratio to ensure minimum
dependence on bank finance?
(ii)
How the quantum of bank advances may be determined?
(iii) Can the present manner and style of lending be improved?

(iv)
Can an adequate planning, assessment and information system be evolved to ensure a

disciplined flow of credit to meet genuine production needs and its proper supervision?
387
The observations and recommendations made by the committee can be considered as below :
(1)
Norms : The committee suggested the norms for inventory and accounts receivables for
as many as 15 industries excluding heavy engineering industry. These norms suggested,
represent maximum level of inventory and accounts receivables in each industry. However
if the actual levels are less than the suggested norms, it should be continued.
The norms were suggested in the following forms :
For Raw Materials : Consumption in months.
For Work in Progress : Cost of production in months.
For Finished Goods : Cost of Sales in months.
For Receivables : Sales in months.
It was clarified that the norms suggested cannot be absolute or rigid and the deviations
from the norms may be allowed under certain circumstances.
Further, it suggested that the norms should be reviewed constantly.
It was suggested that the industrial borrowers having an aggregate limits of more than
Rs. 10/- Lakhs from the Banks should be subjected to these norms initially and later it
can be extended even to the small borrowers.
(2)
Methods of Borrowings : The committee recommended that the amount of bank credit
should not be decided by the capacity of the borrower to offer security to the banks but
it should be decided in such a way to supplement the borrowers resources in carrying a
reasonable level of current assets in relation to his production requirement. For this
purpose, it introduced the concept of working capital gap i.e. the excess of current
assets over current liabilities other than bank borrowings. It further suggested three
progressive methods to decide the maximum limits according to which banks should
provide the finance.
Method I : Under this method, the committee suggested that the Banks should finance
maximum to the extent of 75% of working capital gap, remaining 25% should come from
long term funds i.e. own funds and term borrowings.
Method II : Under this method, the committee suggested, that the borrower should
finance 25% of current assets out of long term funds and the banks provide the remaining
finance.
Method III : Under this method, the committee introduced the concept of core current
assets to indicate permanent portion of current assets and suggested that the borrower
should finance the entire amount of core current assets and 25% of the balance current
assets out of long term funds and the banks may provide the remaining finance.
388
To explain these methods in further details, let us consider the following data :
Current Assets
Rs. 400
Core Current Assets
Rs. 100
Current Liabilities
Rs. 80
(Except bank borrowings)

The maximum amount of bank finance can be decided as below :
Method I
Current Assets
400
Less : Current Liabilities (except bank borrowings)

Working Capital Gap
80
320
25% of above from Own Sources
80
Maximum Permissible Bank Finance (MPBF)

Current Ratio
240
1.25
Method II
Current Assets
400
100
300
Less : Current Liabilities (except bank borrowings)
80
Working Capital Gap
220
220
Current Ratio
1.33
Method III
Current Assets
400
Less : Core Current Assets from Own Sources
100
300
75
225
Less : current Liabilities (except bank borrowings)

Current Ratio
80
145
1.77
389
It can be observed from above that the gradual implementation of these methods will
reduce the dependence of borrowers on bank finance and improve their current ratio. The
committee suggested that the borrowers should be gradually subjected to these methods
of borrowings from first to third.
However, if the borrower is already in second or third method of lending, he should not be
allowed to slip back to first or second method of lending respectively.
It was further suggested that if the actual bank borrowings are more than the maximum
permissible bank borrowings, the excess should be converted into a term loan to be
amortized over a suitable period depending upon the cash generating capacity.
390
(2)
Style of Lending : The committee suggested changes in the manner of financing the
borrower. It suggested that the cash credit limit should be bifurcated into two components
i.e. Minimum level of borrowing required throughout the year should be financed by way
of a term loan and the demand cash credit to take care for fluctuating requirements. It
was suggested that both these limits should be reviewed annually and that the term loan
component should bear slightly a lower rate of interest so that the borrower will be
motivated to use least amount of demand cash credit. The committee also suggested
that within overall eligibilities, a part of the limits may be in the form of bill limits (to
finance the receivables) rather than in the form of cash credit.
(3)
Credit Information Systems : In order to ensure the receipt of operational data from the
borrowers to exercise control over their operations properly, the committee recommended
the submission of quarterly reporting system, based on actual as well as estimations,
so that the requirements of working capital may be estimated on the basis of production
needs. As such, borrowers enjoying total credit limits aggregating Rs. 1 Crore and above
were required to submit certain statements in addition to monthly stock statements and
projected balance sheet and profit and loss account at the end of the financial year. The
working capital limits sanctioned were to be reviewed on annual basis. Within the overall
permissible level of borrowing, the day to day operations were to be regulated on the
basis of drawing power.
(4)
Follow up, Supervision and Control : In order to assure that the assumptions made
while estimating the working capital needs still hold good and that the funds are being
utilised for the intended purpose only it was suggested, that there should be proper
system of supervision and control. Variations between the projected figures and actuals
may be permitted to the extent of 10%, but variations beyond that level will require prior
approval. After the end of the year, credit analysis should be done in respect of new
advances when the banks should re-examine terms and conditions and should make
necessary changes. For the purpose of proper control, it suggested the system of borrower
classification in each bank within credit rating scale.
(5)
Norms for Capital Structure : As regards the capital structure or debt equity ratio, the
committee did not suggest any specific norms. It opined that debt equity relationship is
a relative concept and depends on several factors. Instead of suggesting any rigid norms
for debt equity ratio, the committee opined that if the trend of debt equity ratio is worse
than the medians, the banker should persuade the borrowers to strengthen the equity
base as early as possible.
Action Taken by RBI

According to the notification of RBI dated 21st August, 1975, RBI accepted some of the main
recommendations of the committee.
(1)
Norms for Inventories and Receivables : Norms suggested by the committee were
accepted and banks were instructed to apply them in case of existing and new borrowers.
If the levels of inventories and receivables are found to be excessive than the suggested
norms, the matters should be discussed with the borrower. If excessive levels continue
without justification, after giving reasonable notice to the borrowers, banks may charge
excess interest on that portion which is considered as excessive.
(2)
Coverage : Initially, all the industrial borrowers (including small scale industries) having
aggregate banking limits of more than Rs. 10/- Lakhs should be covered, but it should be
extended to all borrowers progressively.
(3)
Methods of Borrowing : RBI instructed the banks that all the covered borrowers should
be placed in method I as recommended by the committee. However, all those borrowers
who are already complying with requirements of Method II should not slip back to Method
I. As far as Method III is concerned, RBI has not taken any view. However, in case of the
borrowers already in Method II, matter of application of Method III may be decided on
case to case basis.
(4)
Style of Credit : As suggested by the committee, instead of granting entire facility by

way of cash credit, banks may bifurcate the limit as (i) Term loan to take care of permanent
requirement and (ii) fluctuating cash credit. Within the overall limits, bill limits may also
be considered.
(5)
Information system : Suggestions made by the committee regarding the information

system were accepted by RBI and were made applicable to all the borrowers having the
overall banking limits of more than Rs. 1 crore.
(c)
Chhore Committee :
In April 1979, Reserve Bank of India appointed a study group under the chairmanship of Mr.
K.B. Chhore to review mainly the system of cash credit management policy by banks.
391
The observations and recommendations made by the committee can be discussed as below :
(1)
The committee has recommended increasing role of short-term loans and bill finance
and curbing the role of cash credit limits.
(2)
The committee has suggested that the borrowers should be required to enhance their
own contribution in working capital. As such, they should be placed in Second Method
of lending as suggested by Tandon Committee. If the actual borrowings are in excess of
maximum permissible borrowings as permitted by Method II, the excess portion should
be transferred to Working Capital Term Loan (WCTL) to be repaid by the borrower by half
yearly instalments maximum within a period of 5 years. Interest on WCTL should normally
be more than interest on cash credit facility.
(3)
The committee has suggested that there should be the attempts to inculcate more
discipline and planning consciousness among the borrowers, their needs should be met
on the basis of quarterly projections submitted by them. Excess or under utilisation
beyond tolerance limit 10% should be treated as irregularity and corrective action should
be taken.
(4)
The committee has suggested that the banks should appraise and fix separate limits for
normal non-peak levels and also peak levels. It should be done in respect of all borrowers
enjoying the banking credit limits of more than Rs. 10 Lakhs.
(5)
The committee suggested that the borrowers should be discouraged from approaching
the banks frequently for ad hoc and temporary limits in excess of limits to meet unforeseen
contingencies. Requests for such limits should be considered very carefully and should
be sanctioned in the form of demand loans or non-operating cash credit limits. Additional
interest of 1% p.a. should be charged for such limits.
(d)
Marathe Committee
In 1982, Reserve Bank of India appointed a study group known as Marathe Committee to
review the Credit Authorization Scheme (CAS) which was in existence since 1965. Under
CAS, the banks were required to take the prior approval of RBI for sanctioning the working
capital limits to the borrowers. As per Marathe Committee recommendations, in the year
1988, CAS was replaced by Credit Monitoring Arrangement (CMA) according to which the
banks were supposed to report to RBI, sanctions or renewals of the credit limits beyond the
prescribed amounts for the post-sanction scrutiny.
(e)
Nayak Committee and Vaz Committee :
Recently, RBI has accepted the recommendations made by Nayak Committee. This was with
the intention to recognize the contribution made by the SSI Sector to the economy.
392
According to Nayak Committee recommendations, for evaluating working capital requirements

of village industries, tiny industries and other SSI units having the total fund based working
capital limits up to Rs. 50 Lakhs, the norms for inventory and receivables as suggested by
Tandon Committee will not apply. The working capital requirement of these units will be
considered to be 25% of their projected turnover (for both new as well as existing units), out of
which 20% is supposed to be introduced by the units as their margin money requirements and
remaining 80% can be financed by the bank. In other words, there are 4 working capital cycles
assumed in every year.
Vaz Committee has extended the recommendations of Nayak Committee to all the business
organisations. This has also been accepted by RBI.
As a result of Nayak Committee and Vaz Committee recommendations, projected turnover of
the borrowers is the basis for evaluating the working capital requirement. Out of the projected
turnover, 5% is supposed to be introduced by the borrower in the form of own contribution and
remaining 20% can be financed by the bank. The requirement of working capital has nothing
to do with the level of current assets and current liabilities, which was the basis of Tandon
Committee and Chhore Committee recommendations.
EVALUATION OF WORKING CAPITAL REQUIREMENTS BY THE BANKS RELAXED
With the intention to give greater autonomy to the banks while evaluating working capital
requirement, RBI has officially withdrawn the concept of MBPF with effect from 15th April,
1997. As a result of this, now the banks are free to have their own methods for evaluating the
working capital requirement of the borrowers.
( 1 ) A proforma cost sheet of a company provides the following particulars
Elements of cost
Amount per unit
Raw material
80
Direct Labour
30
Overheads
60
Total Cost
170
Profit
Selling Price
30
200
The following further particulars are available.

Raw materials are in stock for one month.
Credit allowed by suppliers is one month.
393
Credit allowed to customers is two months.

Lag in payment of wages 1.5 weeks.
Lag in payment of overheads one month.
Materials are in process for an average of half month.
Finished Goods are in stock for an average of one month.
1/4th of output is sold against cash.
Cash in hand and at bank is expected to be Rs. 25,000. You are requested to prepare a
statement showing the working capital needed to finance a level of activity of 1,04,000 units of
product.
You may assume that production is carried on evenly throughout the year. Wages and overheads
accrue similarly and a period of 4 weeks is equivalent to a month.
Solution :
Estimates of Working Capital
Rs.
(A) Current Assets

1)
Raw Material
2000 units X Rs. 80 X 4 weeks
6,40,000
2)
Work in Process
6,80,000
3)
Finished Goods
13,60,000
4)
Debtors
(Cost Equivalent)
20,40,000
5)
Cash Balance
25,000
47,45,000
(B) Current Liabilities

1)
Creditors
2)
Outstanding wages
2000 units X Rs. 30 X 1.5 weeks
3)
Outstanding Overheads
6,40,000
90,000
4,80,000
12,10,000
(C) Net Working Capital Required (A-B)
35,35,000
Working Notes :
(1)
394
It is assumed that the total units during the year are distributed over total number 52 weeks.
As total units sold during the year are 1,04,000, weekly sales work out to 2,000 units.
(2)
Calculation of Debtors : 1/4th of total units are sold in cash. As such, out of weekly
sales of 2,000 units, only 1500 units are sold on credit, each unit having the cost of Rs.
170 and the balance is outstanding for 2 months i.e. 8 weeks. As such, amount blocked
in debtors works out to
1500 Units X Rs. 170 X 8 weeks i.e. Rs. 20,40,000.
(2)
Calculate the working capital from the following particulars :
(1)
Annual Expenses
Wages
Stores and Materials
Office Salaries
(2)
(3)
(5)
Rs. 12,480
Rs. 2,000
Other Expenses
Rs. 9,600
Average amount of stocks to be maintained

Finished goods stock
Rs. 1,000
Material/stores stock
Rs. 1,600
Expenses paid in Advance

Rs. 1,600
p.a.
Annual Sales
Home Market
Rs. 62,400
Foreign Market
Rs. 15,600
Lag in Payment of
Wages
1.5
weeks
Stores and material
1.5
months
Office Salaries
0.5
months
months
1.5
months
Rent
Other Expenses
(6)
Rs. 9,600
Rent
(Quarterly advance)
(4)
Rs. 52,000
Credit Allowed to Customers

Home Market
Foreign Market
weeks
1.5
weeks
395
Solution :
Estimates of Working Capital
(A) Current Assets
Rs.
(1)
Finished goods stock
1,000
(2)
Material/Stores stock
1,600
(3)
Debtors :
Home Market
Foreign Market
(4)
62400
X 6
52
15600
X 1.5
52
Prepaid Expenses
7,200
450
400
10,650

Wages
1.5 weeks
1,500
Stores and Material
1.5 months
1,200
Office Salaries
0.5 months
520
Rent
Other Expenses
6 months
1,000
1.5 months
1,200
5,420
(C) Net working capital Required (A-B)
5,230
Notes :
It is assumed that 52 weeks constitute the year.
(3)
Raju Brothers Private Limited sells goods on a gross profit of 25%. Depreciation is
considered in cost of production. The following are the annual figures given to you.
Rs.
Sales (Two months credit)
Materials consumed (one months credit)
4,50,000
Wages paid (one month lag in payment)
3,60,000
Administration expenses (one month lag in payment)
1,20,000
Sales Promotion expenses (paid quarterly in advance)

396
18,00,000
60,000
Rs.
Income tax payable in 4 equal instalments of which
one falls in the next year.
1,50,000
Cash manufacturing exp. (one month lag in payment)
4,80,000
The company keeps one months 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.
Solution :
Estimated Working Capital Requirements of Raju Brothers Pvt. Ltd.
Rs.
(A) Current Assets
Sundry Debtors (1/6th of cash cost)
2,45,000
Sales Promotion Expenses (Paid in Advance)
15,000
Stock of Raw Material (Rs. 450,000/12)
37,500
Stock of Finished Goods (Rs. 12,90,000/12)
1,07,500
Cash in hand
1,00,000
5,05,000

Sundry Creditors (Rs. 4,50,000/12)
37,500
- Wages
30,000
- Manufacturing Expenses
40,000
- Administrative Expenses
10,000
Income Tax Payable
37,500
1,55,000
(C) Working Capital (A-B)

Add : 15% Safety Margin
Working Capital Requirement
3,50,000
52,500
4,02,500
397
Working Notes
(1)
Manufacturing Expenses
Rs.
Sales
18,00,000
Less Gross Profit @ 25%

.
. . Manufacturing Cost
4,50,000
13,50,000
Known Components of Manufacturing cost are

Material
4,50,000
Wages
3,60,000
Cash Manufacturing Expenses

.
. . Cash Manufacturing Cost
4,80,000
12,90,000
...B
Hence,
(2)
Manufacturing Cost (A)
13,50,000
Less : Cash Manufacturing Cost (B)

.
. . Depreciation
12,90,000
60,000
Total Cash Cost :

Cash Manufacturing Cost
(As per B above)
12,90,000
Administrative Expenses
1,20,000
Sales Promotion Expenses

.
. . Total cash cost
60,000
14,70,000
(3)
Income Tax liability of the company will not be considered as a part of the cost.
(4)
From the following information, make an assessment of working capital required by a

firm X & Co. The firm has approached bank A who have agreed to sanction the working
capital limits based on the data furnished by the firm. Retaining margins are as under.
Raw Materials
25%
Stocks in Process
33.33%
Finished goods
25%
Debtors
20%
You are also required to work out the working capital limits proposed to be sanctioned by the
bank.
398
Estimates for 1987
Rs.
Monthly Sales
1,00,000
Monthly cost of production
72,000
(including raw material consumption)

Monthly raw material consumption
50,000
Envisaged stocking pattern :

Raw material
1 month
Stock in process
15 days
Finished goods
15 days
While the firm may extend a credit of 1 month to its customers, it is hopeful of getting 15 days
credit from its suppliers.
Solution :
Statement Showing Requirement of Working Capital
(A)
Current Assets
Rs.
Raw Material
50,000
Work in Process
36,000
Finished Goods
36,000
Sundry Debtors
1,00,000
2,22,000
(B)
Current Liabilities
Sundry Creditors
(C)
25,000
Working Capital (A - B)
1,97,000
Working Capital Limits Proposed from Bank

Security Margin
Margin
%
Margin
Rs.
Bank Finance
Rs.
25%
12,500
37,500
33.33%
12,000
24,000
Finished Goods
25%
9,000
27,000
Sundry Debtors
20%
10,000
40,000
Raw Material
Stocks in Process
399
(5)
The management of Royal Industries has called for a statement showing the working
capital needs to finance a level of activity of 1,80,000 units of output for the year. The
cost structure for the companys product for the above mentioned activity level is detailed
below.
Cost per Unit (Rs.)
Raw Materials
20
Direct Labour
Overheads (including depreciation of Rs. 5 per unit)
15
40
Profit
10
Selling Price
50
(a)
Minimum desired cash balance is Rs. 20,000.
(b)
Raw materials are held in stock on an average for two months.
(c)
Work in progress (assume 50% completion stage) will approximate to half a months
production.
(d)
Finished goods remain in warehouse on an average for a month.
(e)
Suppliers of materials extend a months credit and debtors are provided two months
credit. Cash sales are 25% of total sales.
(f)
There is a time-lag in payment of wages of a month and half and a month in case of
overheads.
From the above facts, you are required to
400
(i)
Prepare a statement showing working capital needs.
(ii)
Determine the maximum working capital finance available under first two methods
suggested by Tandon Committee :
Solution :
Estimated Requirement of Working Capital
Rs.
(A)
Current Assets
Raw Materials
15000 units x Rs. 20 x 2 Mths.
6,00,000
Work-in-Progress
15000 units x Rs. 35 x 1/2 mth.x 1/2
1,31,250
Finished Goods
15000 units x Rs. 35 x 1 Mth.
5,25,000
Sundry Debtors
15000 units x Rs. 35 x 2 Mths. x 75%
7,87,500
Cash Balance
20,000
20,63,750
(B)
Sundry Creditors
3,00,000
Outstanding Wages
75,000
Outstanding Overheads
15000 units x Rs. 10 x 1/2 Mth.
75,000
4,50,000
(C)
Working Capital (A - B)
16,13,750
Calculation of Maximum Permissible Bank Borrowing

(A) Method I :
Current Assets
Less : Current Liabilities
Working Capital Gap
Own contribution (i.e. 25% of Working Capital Gap)
Maximum Permissible Bank Finance
20,63,750.00
4,50,000.00
16,13,750.00
4,03,437.50
12,10,312.50
(B) Method II :
Current Assets
Less : Own Contribution
(i.e. 25% of Current Assets)
20,63,750.00
5,15,937.50
15,47,812.50
Less : Current Liabilities

Maximum Permissible Bank Finance
4,50,000.00
10,97,812.50
401
Means of Finance
Current Liabilities
Bank Finance
Own Contribution
Method I
Method II
4,50,000.00
4,50,000.00
12,10,312.50
10,97,812.50
4,03,437.50
5,15,937.50
20,63,750.00
20,63,750.00
Working Notes :
(1)
It is assumed that the year consists of 360 days and that sales are evenly distributed
throughout the year. As such, monthly sales will be 15000 units.
(6)
Hi-Tech Ltd. plans to sell 30,000 units next year. The expected cost of goods is as
follows.
Rs. per unit
Raw Material
100
Manufacturing Expenses
30
Selling, Administration and Financial Expenses
20
Selling Price
200
The duration of various stages of the operating cycle is expected to be as follows :

Raw Materials Stage
Work in Process Stage
Finished Goods Stage
Debtors Stage
2 months
1 month
1/2 month
1 month
Assuming the monthly sales level of 2500 units :
402
(a)
Calculate the investment in various current assets.
(b)
Estimate the gross working capital requirement if the desired cash balance is 5% of the
gross working capital requirement.
Solutions :
Calculation of various current assets
Rs.
(a)
(b)
(c)
(d)
Raw Material
2500 units x Rs. 100 x 2 Mths.
5,00,000
Work in Progress
(Valued on manufacturing cost only, assuming 50% completion)
1,62,500
Finished Goods
(Valued on total cost)
2500 units Rs. 150 x 1/2 Mth.
1,87,500
Sundry Debtors :
(Valued on total cost)
3,75,000
12,25,000
Calculation of Gross Working Capital

Rs.
Raw Material
5,00,000
Work in Progress
1,62,500
Finished Goods
1,87,500
Sundry Debtors
3,75,000
Sub-total
Cash Balance
12,25,000
64,474
12,89,474
403
QUESTIONS
404
1.
What do you mean by working capital? Why the need for working capital arises for a
manufacturing company? State the various factors affecting the requirement of working
capital.
2.
How do you calculate the amount of working capital needed by a company? Explain the
various sources for financing these working capital needs.
3.
Explain the main recommendations of various committees appointed by Reserve Bank

of India to regulate the banks financing working capital needs of a company.
PROBLEMS
1.
Estimate working capital required from the data of Delhi Ltd.

Cost price per unit Raw Material
Rs. 40
Labour
Rs. 10
Overheads
Rs. 30
Projected sales
75000 units at
Debtors pay after
Rs. 100 per unit
10 weeks
Creditors are paid after
4 weeks
Raw Material in stock
6 weeks
Finished stock
8 weeks
Production and processing time
4 weeks
Wages are paid once in
4 weeks
Contingency 10% of working capital

Assume Cash and Bank Balance
2.
Rs. 1,87,500
You are required to calculate average amount of working capital from the following information.
Estimates for year Rs.
(a)
(b)
Average amount locked up for

Stock of finished goods
Rs. 5,000
Stock of stores/materials
Rs. 8,000
Average Credit given

Inland sales 6 weeks credit
Export sales 1.5 weeks credit
3,12,000
78,000
Estimates for year Rs.

(c)
Lag in payment of
Wages - 1.5 weeks
Stores/materials etc. 1.5 months
48,000
Rent, Royalties etc. 6 months
10,000
Staff Salary 1/2 month
62,400
Managers Salary 1/2 month

Miscellaneous Expenses 1.5 months
(d)
2,60,000
4,800
48,000
Payment in advance
Sundry Expenses (Paid Quarterly in advance)
8,000
405
3.
Following is the Balance Sheet of M/s Fairdeal & Co. as on 31.3.1970

Liabilities
Rs.
Capital
Trade Creditors
Profit & Loss A/c
10,00,000
1,40,000
60,000
Assets
Fixed Assets
Stock
Debtors
Cash and bank
12,00,000
Rs.
4,00,000
3,00,000
1,50,000
3,50,000
12,00,000
Estimates upto 31.3.1971 are (i)
Purchases
Rs. 15,20,000
(ii)
Sales
Rs. 21,20,000
(iii) Additions to Fixed Assets

(Subjected to depreciation @ 10%)
Rs. 1,00,000
Time lag for payment to trade creditors for purchase and receipts from sales is one
month. The business earns a gross profit of 30% on turnover. The expenses against
gross profits amount to 10% of turnover. The amount of depreciation is not included in
these expenses.
Draft a Balance Sheet as on 31.3.1971 assuming that creditors are all trade creditors for
purchases and debtors for sales and there is no other item of current assets and liabilities
other than stock and Cash/Bank balances.
4.
Following details are available in case of a company.

Projected Profitability Statement
Sales
Cost of Sales
Material Consumed
Wages & Expenses
Depreciation
Less : Stock of Finished Goods
Gross Profit
Administration Expenses
Selling Expenses
Rs. 21,00,000
Rs. 8,40,000
Rs. 6,25,000
Rs. 2,35,000
Rs. 17,00,000
Rs. 1,70,000
Rs. 15,30,000
Rs. 5,70,000
Rs. 1,40,000
Rs. 1,30,000
Rs. 2,70,000
Profit before tax

Provision for tax
406
Rs. 3,00,000
Rs. 1,00,000
The above figures relate only to finished goods and not to work in progress which is equal
to 15% of the years production in terms of physical units. Work in progress constitutes
100% of material cost and 40% of other expenses. Raw material in stock is for 2 months
consumption. All expenses are paid one month in arrears. Suppliers of material give 1.5
months credit. 20% sales are in cash, rest are at 2 months credit. 70% of the income
tax to be paid in advance in quarterly instalments.
You are required to compute working capital requirements after adding 10% for
contingencies.
5.
From the following details, prepare an estimate of the requirement of working capital.
Production
Selling Price per unit
Raw Materials
Direct Wages
Overheads
Materials in hand
Production time
Finished goods in stores
Credit for material
Credit allowed to customers
Average cash balance
- 60,000
units
- Rs. 5
- 60% of selling price
- 2 months requirements
- 1 month
- 3 months
- 2 months
- 3 months
- Rs. 20,000
Wages and overheads are paid at the beginning of the following month. In production, all
the required materials are charged in the initial stage and wages and overheads accrue
evenly.
6.
From the following details, you are required to make an assessment of the average
amount of working capital requirement of Fine Drinks Limited.
Average Period
of credit
Purchase of material
Wages
Overheads
Rent, Rates etc.
Salaries
Other overheads
Sales
Credit sales
Average amount of stock and
work in progress
Average amount of undrawn profits
Estimate for first

year Rs.
6 weeks
1/2 week
26,00,000
19,50,000
6 months
1 month
2 months
Cash
2 months
1,00,000
8,00,000
7,50,000
2,00,000
60,00,000
4,00,000
3,00,000
407
It is to be assumed that all expenses and income were made at an even rate for the year.
7.
PQR & Co. have approached their bankers for their working capital requirement who
have agreed to sanction the same by retaining the margins as under :
Raw Materials
- 20%
Stock-in-process
- 30%
Finished goods
- 25%
Debtors
- 10%
From the following projections for 89-90, you are required to work out
(a)
The working capital required by the company.
(b)
The working capital limits likely to be approved by bankers.
Estimates for 89-90
Rs.
Annual Sales
14,40,000
Cost of Production
12,00,000
Raw Material Purchases

Monthly Expenditure
7,05,000
25,000
Anticipated Opening Stock of Raw Materials
1,40,000
Anticipated Closing Stock of Raw Materials
1,25,000
Inventory Norms
Raw Material
2 months
Work in Progress
15 days
Finished Goods
1 month
The firm enjoys a credit of 15 days on its purchases and allows one months credit on its
supplies. On sales orders, the company has received an advance of Rs. 15,000.
State your assumptions if any.
408
8.
Following Annual figures relate to XYZ & Co.

Rs.
Sales (at two months credit)
36,00,000
Materials consumed (suppliers extend two months credit)
9,00,000
Wages paid (Monthly in areas)
7,20,000
manufacturing expenses outstanding at the end of the

year (Cash expenses are paid one month in arrear)
80,000
Total administrative expenses paid as above
2,40,000
Sales promotion expenses, paid quarterly in advance
1,20,000
The company sells its products on gross profit of 25% counting depreciation as part of
cost of production and keeps one months stock each of raw material and finished goods
and a cash balance of Rs. 1,00,000
Assuming 20% safety margin, work out the working capital requirements of the company
on cash basis. Ignore work in process.
9.
You are supplied with the following information in respect of XYZ Ltd. for the ensuing
year.
Production of the year
69,000 units
Finished goods in store
3 months
Raw material in store
2 months consumption
Production process
1 month
Credit allowed by creditors
2 months
Credit given to debtors
3 months
Selling price per unit
Rs. 50
Raw material
50% of selling price
Direct wages
Overheads
There is a regular production and sales cycle and wages and overheads accrue evenly.
Wages are paid in the next month of accrual. Material is introduced in the beginning of
production cycle.
409
You are required to find out :
10
(a)
Its working capital requirement.
(b)
Its permissible bank borrowing as per 1st and 2nd method of lending.
XYZ Cements Ltd. sells its products on a gross profit of 20% on sales. The following
information is extracted from its annual accounts for the year ended 31st December,
1989.
Rs. in lacs
Sales at 3 months credit
40.00
Raw Material
12.00
Wages paid
- 15 days in arrears
9.60
Manufacturing Expenses paid

- One month in arrears
12.00
Administrative Expenses paid

- One month in arrears
4.80
Sales Promotion Expenses

- Payable half yearly in advance
2.00
The company enjoys one month credit from the suppliers of raw materials and maintains
2 months stock of raw materials and one and half months finished goods. Cash balance
is maintained at Rs. 1,00,000 as a precautionary balance. Assuming a 10% margin, find
out the working capital requirements of XYZ Cements Ltd.
11.
The management of Gayatri Ltd. has called for a statement showing the working capital
needed to finance a level of activity of 3,00,000 units of output for the year. The cost
structure for the companys product for the above mentioned activity level is detailed
below.
Raw materials
Direct Labour
Overheads
410
Cost per unit Rs.

20
5
15
Total
Profit
40
10
Selling Price
50
(a)
Past experience indicates that raw materials are held in stock, on and average, for
two months.
(b)
Work in progress (100% complete in regard to materials and 50% for labour and
overheads) will approximately be half a months production.
(c)
Finished goods remain in warehouse on and average for a month.
(d)
Suppliers of materials extend a months credit.
(e)
Two months credit is allowed to debtors. Calculation of debtors may be made on

selling price.
(f)
A minimum cash balance of Rs. 25,000 is expected to be maintained.
(g)
The production pattern is assumed to be even during the year.

Prepare the statement of working capital requirement.
12. Mr. Fairdas wishes to commence a new trading business and has given the following
information.
(a)
(b)
(c)
(d)
(e)
(f)
Annual Expenses (Rs.)

Wages
Stores & Materials
Office salaries
Rent
Other Expenses
Average amount of stock to be maintained (Rs.)
Stock of finished goods
Stock of materials and stores
Expenses paid in advance (Rs.)
Quarterly advance
Annual sales (Rs.)
In the region
Out of the region
Lag in payment of expenses
Wages
Stores and materials
Office salaries
Rent
Other expenses
Credit allowed to customers
In the region
Out of the region
78,000
14,400
18,720
3,000
14,400
1500
2400
2400 p.a.
93,600
23,400
1.5 weeks
1.5 months
0.5 months
6 months
1.5 months
6 weeks
1.5 weeks
Calculate his working capital requirement

411
13. From the following information, prepare a statement in columnal form showing the working
capital requirement.
Budgeted sales (Rs. 10 per unit) Rs. 2,60,000.
Analysis of one rupee of sales
Raw Materials
Direct Labour
Overheads
Rs.
0.30
0.40
0.20
Total cost
Profit
0.90
0.10
Sales
1.00
It is estimated that
(a)
Raw materials are carried in stock for three weeks and finished goods for two
weeks.
(b)
Factory processing will take two weeks.
(c)
Suppliers will give full five weeks credit.
(d)
Customers will require eight weeks credit.
It may be assumed that production and overheads accrue evenly throughout the year.
412
NOTES
413
NOTES
414
Chapter 12
MANAGEMENT
OF
CASH
Management of cash is one of the most important areas of overall working capital management.
This is due to the fact that cash is the most liquid type of current assets. As such, it is the
responsibility of the finance function to see that the various functional areas of the business
have sufficient cash whenever they require the same. At the same time, it has also to be
ensured that the funds are not blocked in the form of idle cash, as the cash remaining idle also
involves cost in the form of interest cost and opportunity cost. As such, the management of
cash has to find a mean between these two extremes of shortage of cash as well as idle cash.
MOTIVES OF HOLDING CASH :
A company may hold the cash with the various motives as stated below :
(1)
Transaction Motive : The company may be required to make various regular payments
like purchases, wages/salaries, various expenses, interest, taxes, dividends etc. for
which the company may hold the cash. Similarly, the company may receive the cash
basically from its sales operations. However, receipts of the cash and the payments by
cash may not always match with each other. In such situations, the company will like to
hold the cash to honour the commitments whenever they become due. This requirement
of cash balances to meet routine needs is known as transaction motive.
(2)
Precautionary Motive : In addition to the requirement of cash for routine transactions,

the company may also require the cash for such purposes which cannot be estimated or
foreseen. Eg. There may be a sudden decline in the collection from the customers, there
may be a sharp increase in the prices of the raw materials etc. The company may like to
hold the cash balance to take care of such contingencies and unforeseen circumstances.
This need of cash is known as precautionary motive.
(3)
Speculative Motive : The company may like to hold some reserve kind of cash balance
to take the benefit of favourable market conditions of some specific nature. Eg. Purchases
of raw material available at low prices on the immediate payment of cash, purchase of
securities if interest rates are expected to increase etc. This need to hold the cash for
such purposes is known as speculative motive.
Management of Cash
415
ESTIMATING THE CASH REQUIREMENTS

As has been discussed in the preceding paragraphs, the company should hold adequate
cash balance but should necessarily avoid the excessive balances. For this purpose, basically
the company is required to assess its need for cash properly. For this purposes, one of the
best tools available with the company is to prepare the cash budget. A cash budget is the
statement showing the various estimated sources of cash receipts on one hand and the
various applications of cash on another hand. Thus, by preparing the cash budget, the company
may predict whether at any point of time there is likely to be excess or shortage of cash. If the
shortage of cash is estimated, the company has to arrange the cash from some other source.
If the excess of cash is estimated, the company may explore the possibility of investing the
cash balance profitably.
Before preparing the cash budget, following principles must be kept in mind.
(1)
The period for which the cash budget is to be prepared should be selected very carefully.
There is no fixed rule as to the period to be covered by the cash budget. It depends on
company and individual circumstances. As a general rule, the period to be covered by
cash budget should neither be too long nor too short. If it is too long, it is possible that
the estimates will be inaccurate. If it is short, the areas which are beyond the control of
the company will not be given due consideration.
(2)
The items which should appear in the cash budget should be carefully decided. Naturally,
all those items which do not have bearing on the cash flows will not be considered while
preparing the cash budget. Eg. As the cost in the form of depreciation does not involve
any cash outflow, it does not affect the cash budget, though the amount of depreciation
affects the determination of the tax liability which involves cash outflow.
While preparing the cash budget, the various items appearing in the same may be
classified under the following two categories.
416
(i)
Operating cash flows : These are the items of cash flow which arise as the result
of regular operations of the business.
(ii)
Non-Operating cash flows : These are the items of cash flow which arise as the
result of other operations of the business.
The standard items which may appear on a standard cash budget may be stated as below.
Cash Inflow
Cash Outflow
Operating
Operating
Cash Sales
Payment to creditors
Collection from debtors
Purchases of raw material
Interest/Dividend Received
Wages/Salaries
Various kinds of overheads
Non-Operating
Non-Operating
Issue of shares/debentures
Redemption of shares/debentures
Receipt of loans/borrowings
Loan Instalments
Sale of Fixed Assets
Purchase of Fixed Assets

Interest
Taxes
Dividends
PRINCIPLES OF CASH MANAGEMENT :

The basic objective of cash management is to reduce the operating cash requirement to the
minimum possible extent without affecting the routine transactions. In particular, the objectives
of cash management can be stated as below :
(a)
Accelerate the cash collections.
(b)
Delay the cash payments.
(c)
Maintenance of optimum cash balance.
(d)
Investment of excess cash available.
CONCEPT OF FLOAT
In absolutely non-technical language Float indicates the difference between the bank balance
as per the bank book and as per the bank pass book/bank statement. This float arises mainly
due to the fact that there is always a time gap between the time a cheque is written by the
company and the time when it is presented to the bank for payment or there is a time gap
between the time when a cheque is deposited by the company in the bank and the time when
the credit is actually given by the bank to the company. This time gap may arise due to various
reasons.
(a)
Time required for receiving the cheque from the customer through the post office. This is
called postal float.
Management of Cash
417
(b)
Time required by the company to process the received cheque and deposit the same in
the bank. This is called deposit float.
(c)
Time required by the banker of the company to collect the payment from the customers
bank. This is called bank float.
This concept of float can be illustrated with the help of the following example.
Suppose that company A of Calcutta has to make a payment to company B of Pune for
Rs. 10,000 towards certain purchases made by company of A from company B. Accordingly,
company A draws a cheque in favour of company B on 1st June, 1993. This cheque is sent by
company A by Registered A.D. and it is physically received by company B on 8th June, 1993.
After company B receives the cheque, it completes the various administrative formalities and
deposits the cheque in its bank account on 12th June, 1993. Company Bs bank sends the
cheque to company As bank for collection and after getting the advice from company As
bank, finally credits company Bs account with Rs. 10,000 on 20th June, 1993. Now, the
various concepts of float can be stated as below.
1st June, 93 to 8th June, 93
Postal Float
8th June, 93 to 12th June, 93
Deposit float
12th June, 93 to 20th June, 93
Bank Float
From the paying companys point of view, attempts should be made to increase these various
types of floats as much as possible. From the receiving companys point of view, attempts
should be made to decrease these various types of floats as much as possible. Now, in the
light of discussions regarding the concept of float, we will discuss the principles of cash
management.
(a)
Accelerate Cash Collections :

This can be done with the help of following techniques.
418
(1)
As far as possible insist upon the payment from the customer in the safe modes
like demand drafts, letters of credit, preaccepted hundies/bills of exchange etc.
This may reduce the bank float.
(2)
In order to ensure the prompt payment from customers, self-addressed envelope

can be sent along with the bill/invoice itself. Allowing the cash discounts is the best
possible way to induce the customer to make prompt payments.
(3)
In case of the outstation customers, faster means of communications can be used

so as to reduce the postal float to the minimum possible extent. Eg. Courier Services,
Speed Post etc.
(4)
Decentralised Collection : In case of the company which has the branches at

different places, the company can establish the decentralised collection centres.
The customers in a certain area are required to make the payment at the local
collection centre and the cheques collected by the local collection centre are
deposited in the local bank account. The balance in the local bank account beyond
a predetermined level may be transferred to the central or head office bank account
at periodic intervals. The decentralised collections may be useful for reducing the
postal float as well as bank float.
(5)
Lock Box System : Under this arrangement, the company hires a post office box
at important collection centres. The customers are instructed to make the payment
directly to the lock box. The local bankers of the company are authorised to pick up
the cheques from the lock box. After crediting the cheques to the companys account,
the bank informs the company about the details of cheques credited. The lock box
systems reduces the postal float as well as bank float. The clerical work of handling
the cheques before deposits is performed by the banker and the process of collection
of cheques can be started immediately on the receipt of cheque from the customer.
It should be noted in this connection that both the above systems of decentralised
collections as well as lock box system, help to reduce deposit float but at the same it
involves cost. Before taking any decision in this connection, it is necessary to carry out
a cost-benefit analysis to ensure that the funds released due to speedy collections
justify the additional costs.
(b)
Delay cash payments :

This can be done with the help of following techniques.
(1)
Payments can be made from a bank which is distant from the bank of the company
to which payment is to be made. This may increase the postal float and bank float.
(2)
Attempts should be made by the company to get the maximum credit for the goods
or service supplied to it. Eg. In case of wages payable to the workers, the company
gets the services in advance which are to be paid for later. Thus, they provide the
credit to the company for the period after which they are paid, say a week or a
month. As such, if the company can make monthly payment of wages rather than
weekly payment of wages, it can enjoy extended credit, slow down the payments
and reduce the requirement of operating cash balance.
(3)
Avoid Early Payments : If according to the terms of credit available to the company,
it is required to make the payment within the stipulated period, it should not make
the payment before the specified date unless the company is entitled to cash
discounts. The delay in making the payment beyond the stipulated time may affect
the credit standing of company.
Management of Cash
419
(c)
(4)
Centralised Disbursements : Under this methods, the payments are made by the
Head Office of company from its central bank account. This involves the benefits
mainly in three respects as compared to decentralised payments. Firstly, it increases
the transit time. Eg. If the creditor at Madras is to be paid out of the Central bank
account of the company in Delhi, it increases the postal float as well as the bank
float, which is ultimately beneficial for the company. Secondly if the company decides
to make decentralised payments by maintaining various bank accounts at various
branches, it will be necessary for it to maintain minimum cash balance at all these
bank accounts, whereas in case of centralised disbursement system, the problem
of maintaining minimum cash balance will be only in case of central bank account.
Thirdly, to maintain the bank accounts at different branches may prove to be
administratively difficult.
(5)
In case of a company operating on decentralised basis, the arrangements can be

made in such a way that the local branches are authorised to deposit the cheques
in the local bank accounts but are not authorised to withdraw the amounts from
there. This facilitates speedy collections as well as ensures proper control over the
disbursements from the bank accounts.
(6)
It may not be necessary for the company to arrange for the funds immediately after
it issues the cheque. If it is possible to analyse the time lag in the issue of cheque
and their presentation for payment, which is possible on the basis of past experience,
the company may make arrangements for funds only on the expected date of
presentation of cheque for payment.
Maintenance of optimum cash balance :

As stated earlier, maintenance of cash balance which is more than requirement as well
as less than requirement involves the consequences. As such, one of the basic objectives
of cash management is to maintain the optimum cash balance. One of the tools available
to the company to ensure the maintenance of optimum cash balance is to prepare the
cash budget. By preparing the cash budget in a proper way, the company can have an
idea in advance of the timing and quantum of excess availability of cash or shortage of
cash. Accordingly, the company can take the decision of investment of excess cash on
short term basis (in case of excess cash available) or to meet the shortfall (in case of
shortage of cash).
(d)
Investment of excess cash balance :

As stated earlier, one of the basic objectives of cash management is to optimise the
investment in cash. The company cannot afford to keep the excess cash balance idle as
it involves the opportunity cost. As such, one of the basic objectives of cash management
requires the company to think about the possibility of investing the excess cash balance
on short term basis.
420
The avenues available to the company to invest the excess cash balance on short term
basis may be in various forms. Eg. Inter-corporate loans/deposits, inter-corporate bills
discounting, stock market operations, commercial paper, bank deposits etc. However, the
final selection of the avenue for investing the cash balance may depend upon various factors.
(1)
Return The basic factor affecting any investment decision is essentially in the
form of return on investment. Higher the return, better the investment.
(2)
Risk Risk and return always go hand in hand. High return investments may
involve high risk. While selecting the investment yielding high return, the company
should take into consideration the risk involved with the proposition.
(3)
Liquidity In some cases, due to unexpected cash needs, it may be necessary

to sell the investment before maturity. Under these circumstances, liquidity
associated with the investment becomes an important criteria to formulate the
investment policy.
(4)
Legal requirements Some organisations may be subjected to certain legal

requirements before they can select their investment portfolio. Eg. Public charitable
trusts, co-operative societies etc. These organisations are required to invest their
funds in certain specified forms.
(1)
A Private Limited Company is formed to take over a running business. It has decided to
raise Rs. 55 lakhs by issue of Equity Shares and the balance of the capital required in
the first six months is to be financed by a financial institution against an issue for Rs. 5
lakhs, 8% Debentures (Interest payable annually) in its favour.
Initial outlay consists of :
Freehold premises
Rs. 25 Lakhs
Plant & Machinery
Rs. 10 Lakhs
Stock
Rs. 6 Lakhs
Vehicle & Other items
Rs. 5 Lakhs
Payments on the above items are to be made in the month of incorporation. Sales during
the first 6 months ending on 30th June are estimated as under :
January
Rs. 14 Lakhs
April
Rs. 25 Lakhs
February
Rs. 15 Lakhs
May
Rs. 26.50 Lakhs
March
Rs. 18.50 Lakhs
June
Rs. 28 Lakhs
Lag in payment
Debtors 2 Months
Creditors 1 Month
Management of Cash
421
OTHER INFORMATION :
(1)
Preliminary expenses Rs. 50,000 (Payable in February)
(2)
General Expenses Rs. 50,000 p.m. (Payable at the end of each month).
(3)
Monthly wages (Payable on 1st day of next month) Rs.80,000 p.m. for first 3 months
and Rs. 95,000 p.m. thereafter.
(4)
Gross profit rate is expected to be 20% on sales.
(5)
The shares and debentures are to be issued on 1st January.
(6)
The stock levels throughout is to be the same as the outlay.
Prepare cash budget for the 6 months ended 30th June.

Solution :
Cash Budget (For 6 months ending 30th June) Rs. In Lakhs
Jan.
Feb.
Mar.
Apr.
May
June
55.00
5.00
14.00
15.50
18.50
25.00
60.00
14.00
15.00
18.50
25.00
Fixed Assets
40.00
Stock (Initial)
6.00
0.50
Sundry Creditors
10.40
11.20
14.00
19.05
20.25
0.50
0.50
0.50
0.50
0.50
0.50
0.80
0.80
0.80
0.95
0.95
46.50
12.20
12.50
15.30
20.50
21.70
13.50
(12.20)
1.50
(0.30)
(2.00)
3.30
13.50
1.30
2.80
2.50
0.50
+ Surplus for the month
13.50
(12.20)
1.50
(0.30)
(2.00)
3.30
Closing Balance
13.50
1.30
2.80
2.50
0.50
3.80
(A) Cash Inflow

Issue of shares
Issue of Debentures
Collection from Debtors
(B) Cash Outflow
General Expenses
Wages
(C) Net Cash Inflows

i.e. (A B)
Opening Balance
422
Working Notes :
(1)
It is assumed that the company is incorporated in January.
(2)
Assuming that the company is carrying on manufacturing operations, the purchases

say for the month of January are computed as below:
Sales of January
14.00
Less Gross Profit @ 20%
2.80
Cost of goods sold
11.20
Less wages for January
0.80
Purchases
(3)
10.40
A newly started company Green Co. Ltd. wishes to prepare cash budget from January.
Prepare a cash budget for the first 6 months from the following estimated revenue and
expenditure.
Overheads
Production
Month
Selling
Distribution
Rs.
Total Sales
Rs.
Material
Rs.
Wages
Rs.
Rs.
Jan.
20,000
20,000
4,000
3,200
800
Feb.
22,000
14,000
4,400
3,300
900
Mar.
24,000
14,000
4,600
3,300
800
Apr.
26,000
12,000
4,600
3,400
900
May
28,000
12,000
4,800
3,500
900
June
30,000
16,000
4,800
3,600
1,000
Cash balance on 1st January was Rs. 10,000

A new machine is to be installed at Rs. 30,000 on credit, to be repaid by two equal instalments
in March and April.
Sales Commission @ 5% on total sales is to be paid within the month following actual sales.
Rs. 10,000 being the amount of second call may be received in March. Share premium
amounting to Rs. 2,000 is also obtainable with 2nd call.
Period of credit allowed by suppliers
2 months
Period of credit allowed to customers
1 month
Delay in payment of overheads
1 month
Delay in payment of wages
month
Assume cash sales to be 50% of total sales.

Management of Cash
423
Solution :
Cash Budget of Green Co. Ltd.
Jan.
Feb.
Mar.
Apr.
May
June
10,000
11,000
12,000
13,000
14,000
15,000
10,000
11,000
12,000
13,000
14,000
Share Capital (2nd Call)
10,000
Share Premium
2,000
10,000
21,000
35,000
25,000
27,000
29,000
20,000
14,000 14,000
12,000
2,000
2,200
2,300
2,300
2,400
2,400
For last month
2,000
2,200
2,300
2,300
2,400
Production overheads
3,200
3,300
3,300
3,400
3,500
800
900
800
900
900
Purchased
15,000
15,000
Sales Commission
1,000
1,100
1,200
1,300
1,400
2,000
9,200
44,800
38,900 24,300
22,600
8,000
11,800
10,000
18,000
29,800
8,000
11,800
18,000
29,800
(A) Cash Inflow

Cash sales
(B) Cash Outflows

Sundry Creditors
Wage
For current month
Selling & Distribution

overheads
Instalment for Machine
(C) Net Cash Inflows

or Outflows (A-B)
Opening Cash balance
+ Surplus for month
Closing cash balance
(3)
2,700
6,400
20,000
6,100
8,800
(-)9,800
(-)13,900
2,700
6,400
20,000
6,100
8,800
15,200
Prepare a cash budget for the quarter ended 30th September, 1987 based on the following
information.
Cash at bank on 1st July, 1987
Rs. 25,000
Salaries and Wages estimated monthly
Rs. 10,000
Interest Payable August 1987
424
(-)9,800 (-) 13,900
Rs. 5,000
June
Rs.
July
Rs.
August
Rs.
September
Rs.
1,40,000
1,52,000
1,21,000
Credit Sales
1,00,000
80,000
1,40,000
1,20,000
Purchases
1,60,000
1,70,000
2,40,000
1,80,000
20,000
22,000
21,000
Estimated cash sales
Other expenses
(Payable in same month)
Credit sales are collected 50% in the month of sales made and 50% in the month following.
Collection from credit sales are subject to 5% discount if payment is received in the month of
sales and 2.5% if payment is received in the following month.
Creditors are paid either on a prompt or 30 days basis. It is estimated that 10% of the creditors
are in the prompt category.
Solution :
Cash Budget
(For Quarter ending September 1987)
July
Rs.
August
Rs.
September
Rs.
1,40,000
1,52,000
1,21,000
Last Month
48,750
39,000
68,250
Current Month
38,000
66,500
57,000
2,26,750
2,57,500
2,46,250
17,000
24,000
18,000
1,44,000
1,53,000
2,16,000
Salaries & Wages
10,000
10,000
10,000
Other Expenses
20,000
22,000
21,000
5,000
1,91,000
2,14,000
2,65,000
35,750
43,500
(18,750)
Opening Balance
25,000
60,750
1,04,250
+ Surplus for the month
35,750
43,500
(18,750)
Closing Balance
60,750
1,04,250
85,500
(A) Cash Inflows

Cash Sales
(B) Cash Outflows

Sundry Creditors
Prompt Basis
Others
Interest
(C) Net Cash Inflows (A-B)
Management of Cash
425
WORKING NOTES :
It is assumed that salaries and wages are paid in the same month.
(4)
From the following information you are required to prepare a cash budget for six months
from January 1987 to June 1987, month by month, showing also the cash credit facility
available from the Bank. Opening overdrawn balance is Rs. 1,50,000.
Wages
Sales
Rs.
Materials
Purchases
Rs.
January
1,44,000
50,000
20,000
12,000
8,000
3,000
February
1,94,000
62,000
24,200
12,600
10,000
3,400
March
1,72,000
51,000
21,200
12,000
11,000
4,000
April
1,77,200
61,200
50,000
13,000
13,400
4,400
May
2,05,000
74,000
44,000
16,000
17,000
5,000
June
2,17,400
77,600
46,000
16,400
18,000
5,000
Month
Rs.
Production
Selling
Expenses Expenses
Rs.
Rs.
Office
Expenses
Rs.
Following further information is available.
426
(1)
Out of total sales 50% are cash sales and balance 50% is received in the month following
month of sale.
(2)
Payment for purchase of assets is to be made of Rs. 16,000 in February, Rs. 25,000 in
March and Rs. 50,000 in April.
(3)
Proceeds from sale of scrap are to be received in May, amounting to Rs. 6,000.
(4)
Dividend of Rs. 90,000 is to be paid in June.
(5)
Sales commission is to be paid at 3% of total sales in same month in which sales are
made.
(6)
Suppliers for materials are paid in the month following the month of purchases of materials.
(7)
Cash credit facility granted is Rs. 2,00,000.
(8)
Wages are paid in the same month.
(9)
Creditors of Production, Selling and Office Expenses are given one months credit period.
Solution :
Cash Budget for six months ending June 1987
Jan. 87
Feb. 87
Mar. 87
Apr. 87
May 87
June 87
72,000
97,000
86,000
88,600
1,02,500
1,08,700
Collection from
debtors
72,000
97,000
86,000
88,600
1,02,500
Sale of Scrap
6,000
72,000
1,69,000
1,83,000 1,74,600
1,97,100
2,11,200
50,000
62,000
51,000
61,200
74,000
20,000
24,200
21,200
50,000
44,000
46,000
Production Expenses
12,000
12,600
12,000
13,000
16,000
Selling & Dist.

Expenses
8,000
10,000
11,000
13,400
17,000
Admn. Expenses
3,000
3,400
4,000
4,400
5,000
Purchases of Assets
16,000
25,000
50,000
Dividend
90,000
4,320
5,820
5,160
5,316
6,150
6,522
24,320
1,19,020
1,39,360 1,83,316
1,42,150
2,54,522
47,680
49,980
43,640
(-)8,716
54,950
(-)43,322
1,50,000
1,02,320
52,340
8,700
17,416
(-)37,534
+ Surplus/Deficit for
the month
47,680
49,980
43,640
(-)8,716
54,950
(-)43,322
Closing
overdrawing
52,340
8,700
17,416 (-)37,534
5,788
(A) Cash Inflow

Cash Sales
(B) Cash Outflow

Creditors Materials
Wages
Sales Commission
(C) Net Cash Inflows/

Outflows (A-B)
Opening
overdrawing
Management of Cash
1,02,320
427
Note :
Even though, the cash credit facility is granted to the extent of Rs. 2,00,000 the company is
not likely to utilise it fully. At the end of June 1987, the overdrawn balance is likely to be only
Rs. 5,788.
(5)
ABC Co. Ltd. wishes to arrange overdraft facilities with its bankers during the period April
to June 1987 when it will be manufacturing mostly for stock. Prepare a cash budget for
the above period from the following data, indicating the extent of the bank facility the
company will require at the end of each month.
Month
Sales
Rs.
Purchases
Rs.
Wages
Rs.
February
1,80,000
1,24,800
12,000
March
1,92,000
1,44,000
14,000
April
1,08,000
2,43,000
11,000
May
1,74,000
2,46,000
10,000
June
1,26,000
2,68,000
15,000
(1)
All sales are credit sales, 50% of credit sales are realised in the month following
the sales and the remaining 50% in the second month following.
(2)
Creditors are paid in the month following the month of purchases.
(3)
Cash at Bank on 1.4.87 (Estimated) Rs. 25,000.
Solution :
Cash Budget of ABC Co. Ltd.
April 87
May 87
June 87
First 50%
96,000
54,000
87,000
Second 50%
90,000
96,000
54,000
1,86,000
1,50,000
1,41,000
(A) Cash Inflows

Sundry Debtors
428
April 87
May 87
June 87
1,44,000
2,43,000
2,46,000
11,000
10,000
15,000
1,55,000
2,53,000
2,61,000
31,000
(-) 1,03,000
(-) 1,20,000
Opening cash balance
25,000
56,000
(-) 47,000
+ Surplus/Deficit for the month
31,000
(-) 1,03,000
(-) 1,20,000
Closing cash balance
56,000
(-) 47,000
(-) 1,67,000
(B) Cash Outflows

Sundry Creditors
Wages
(C) Net Cash Inflows or Outflows (A-B)

(D) Estimated Cash surplus or shortage
Note :
It can be seen that the company will be required to arrange for the bank finance of Rs. 47,000
at the end of May 1987 and an additional amount of Rs. 1,20,000 at the end of June 1987.
Management of Cash
429
QUESTIONS
430
1.
Explain the various motives for holding the cash.
2.
Explain the various principles to be followed for managing the cash in a very big size
organisation having the branches all over the country.
PROBLEMS
(1)
From the following budgeted data of ABC Ltd. prepare cash budget for the quarter ending
31st December, 1984.
Month
Sales
Purchases
Wages
Misc. Exp.
August
1,20,000
84,000
10,000
7,000
September
1,30,000
1,00,000
12,000
8,000
80,000
1,04,000
8,000
6,000
November
1,16,000
1,06,000
10,000
12,000
December
88,000
80,000
8,000
6,000
October
Cash on hand on 1.10.84 : Rs. 5,000
Sales : 20% realised in the month of sale, discount allowed 2%, balance realised in 2
subsequent months.
Purchases : These are paid in the following month of supply.
Wages : 25% in arrears paid in the following month
Misc. expenses : paid a month in arrears
Rent : Rs. 1000 per month paid quarterly in advance due to October.
Income Tax : Instalments of Rs. 25,000 due on or before 15.12.84
Income from investment : Rs. 5,000 received quarterly April, July, Oct. etc.
Insurance claim : Rs. 72,936 receivable in December.
(2)
A firm expects to have Rs. 30,000 in Bank on 1.10.86 and requires you to prepare an
estimate of cash position during the three months October 86 to December 86. The
following information is supplied to you.
Wages
Month
Sales Purchases
Rs.
Factory
Office
Selling
Exp.
Exp.
Exp.
Rs.
Rs.
Rs.
Rs.
Rs.
August
40,000
24,000
6,000
3,000
4,000
3,000
September
46,000
28,000
6,500
3,500
4,000
3,500
October
50,000
32,000
6,500
4,000
4,000
3,500
November
72,000
36,000
7,000
4,000
4,000
4,000
December
84,000
40,000
7,250
4,250
4,000
4,000
Management of Cash
431
Other information :
(3)
(1)
25% of the sales are for cash, remaining amount in the month following that of sale.
(2)
Suppliers supply goods at 2 months credit.
(3)
Delay in the payment of wages and all other expenses is one month.
(4)
Income Tax of Rs. 10,000 is due to be paid in December.
(5)
Preference shares dividend of 10% on Rs. 1,00,000 is to be paid in October.
Following details are available in case of Pam Industries Ltd.

Actual Sales (Rs.)
Estimated Sales (Rs.)
January
75,000
May
1,05,000
February
80,000
June
1,20,000
March
90,000
July
1,50,000
August
1,60,000
April
1,00,000
Consider the following additional information :

(1)
Cash sales are 50 per cent of the total sales. The remaining 50 per cent will be
collected equally during the following two months.
(2)
Cost of goods manufactured is 70 per cent of sales. 90 per cent of this cost is paid
during the first month after incurrence and the balance is paid in the following
month.
(3)
Sales and administrative expenses are Rs. 15,000 per month plus 10 per cent of
sales. All these expenses are paid during the month of incurrence.
(4)
Half-yearly interest of 6 per cent on Rs. 4,50,000 debenture is paid during July.
(5)
Rs. 60,000 are expected to be invested in fixed assets during June.
(6)
A dividend of Rs. 15,000 will be paid in July.
(7)
An Income tax of Rs. 15,000 will be paid in July.
It is the policy of the company to have a minimum cash balance of Rs. 30,000/-.
Accordingly as on 30th April the actual cash balance was Rs. 30,000/-.
The Management wishes to know whether it will be required to borrow during the quarter
ending on 31st July and if so when and how much?
432
(4)
A company has its cost of goods of 70% of its sales, 70% of this cost is paid in the
month of the sale and the balance in the next month. Salary and administrative expenses
amount to Rs. 40,000 per month plus 5% of sales. These expenses must be paid during
the month following the month when expenses are actually incurred. The company has
also 10% Debentures of Rs. 1,50,000 and interest has to be paid in 4 quarters from
January onwards. The company gives its actual and forecast sales as below.
Actual Sales
Rs.
Forecast Sales
Rs.
January
2,00,000
May
2,00,000
February
2,00,000
June
2,50,000
March
3,00,000
July
2,50,000
April
3,00,000
August
3,00,000
You are required to prepare a cash budget for six months from March onwards.
(5)
Prepare a cash budget for the three months ending 30th June, 1986 from the information
given below.
(a)
(b)
Month
Sales
Materials
Wages
Overheads
February
14,000
9,600
3,000
1,700
March
15,000
9,000
3,000
1,900
April
16,000
9,200
3,200
2,000
May
17,000
10,000
3,600
2,200
June
18,000
10,400
4,000
2,300
Credit terms are :

Sales/Debtors 10% of sales are on cash, 50% of the credit sales are collected
next month and balance in the month following.
Creditors
Materials
2 months
Wages
1/4 month
Overheads
month
(c)
Cash and Bank balance on 1st April, 1986 is expected to be Rs. 6,000.
(d)
Other relevant information :

(i)
Plant and Machinery will be installed in February 1986 at a cost of Rs. 96,000.
The monthly instalments of Rs. 2,000 is payable from April onwards.
Management of Cash
433
(ii)
Dividend @5% on preference share capital of Rs. 2,00,000 will be paid on 1st
June.
(iii) Advance to be received for sale of vehicle Rs. 9,000 in June.
(6)
(iv)
Dividends from investment amounting to Rs. 1,000 expected to be received in

June.
(v)
Income Tax advance is to be paid in June Rs. 2,000.
Anand & Co. has furnished the following information. Based on this, prepare a cash
budget for three months June 87, July 87 and August 87.
Month
Sales
Materials
Wages
Production
Exp.
Office &
Selling Exp.
June 87
72,000
25,000
10,000
6,000
5,500
July 87
97,000
31,000
12,100
6,300
6,700
August 87
86,000
25,500
10,600
6,000
7,500
Assumptions :
(a)
(b)
(c)
(d)
(e)
(f)
(7)
Lal and Company has given the forecast sales of January 1989 to July 1989 and actual
sales for November and December 1988 as under. With the other particulars given,
prepare a cash budget for the five months i.e. from January 1989 to May 1989.
(1)
434
Cash balance in hand on 1.6.87 Rs. 72,500.

50% of sales are cash sales.
A fixed asset has to be purchased for Rs. 8,000 in July 87.
Debtors are allowed one months credit.
Creditors for materials grant one months credit.
Sales commission @3% on sales is paid to the salesman each month.
Sales
Rs. in lakhs
1988
November
December
1.60
1.40
1989
January
February
March
April
May
June
July
1.60
2.00
1.60
2.00
1.80
2.40
2.00
(2)
Sales 20% cash, 80% credit, payable in the third month (January sales in March etc.)
(3)
Variable expenses 5% on turnover, time lag half month.
(4)
Commission 5% of credit sales, payable in the third month.
(5)
Purchases, 60% of the sales of the third month, payment will be made on 3rd
month of purchases.
(6)
Rent and other expenses Rs. 6,000 paid every month.
(7)
Other payments :
Fixed assets purchases
Taxes
(8)
March
April
Rs. 1,00,000
Rs. 40,000
Opening cash balance Rs. 50,000.
Management of Cash
435
NOTES
436
Chapter 13
MANAGEMENT OF RECEIVABLES
Receivables or Debtors as Current Assets get created on account of the credit sales made by
the company i.e. the company makes the sales to the customers but the customers do not
make the payment immediately. Even if the customers do not pay the cash immediately, the
company has to make credit sales to the customers in order to face the competition and also
to attract the new and potential customers to buy the goods or services from the company.
OBJECTS OF MANAGEMENT OF RECEIVABLES
As in case of general objective of working capital management, the receivables management
is also to achieve a trade off between the risk and profitability. The aim of receivables
management is to ensure optimum investment in receivables i.e. the investment in receivables
should be neither less nor more. If the objective of the company is to reduce the investment in
receivables to the minimum extent, the company will not make any credit sales at all, as
receivables is the result of credit sales made by the company. This will reduce the investment
in receivables, but the company will suffer in terms of profitability as the customers will not
buy from the company, particularly if the competitors offer the credit to the customers. On the
other hand, if the company makes credit sales to the customers in order to increase the sales
and profitability, the company may be accepting the risk of bad debts, more collection efforts
etc. As such, the objective of receivables management is to increase the credit sales to such
an extent that the risk of non-recoverable dues is reasonable and within control. As in case of
any other financial decisions, decisions regarding the receivables management also involve
the cost benefit analysis. Costs associated with the receivables management may be in the
form of credit administration costs, cost of bad debts and opportunity cost of funds blocked in
receivables. Benefits associated with the receivable management are naturally in the form of
profits from the sales made on credit basis. An effective receivables management policy tries
to increase the credit sales to such an extent that the profits arising therefrom are more than
the costs attached to it.
437
FLOAT IN RECEIVABLES MANAGEMENT

The concept of float can be extended to the receivables management as well. The time gaps
in the receivables management can be in the following forms
a)
Frequency of period of service at which invoices or bills are raised in favour of the customers.
b)
Administrative delay for raising the invoices or bills in favour of the customers.
c)
Period of credit offered to the customers.
An effective receivables management will target at reducing these time gaps to the maximum
possible extent. From this angle, following propositions should be remembered
a.
If the bills or invoices are raised in favour of the customers at the periodic intervals,
attempts should be made to reduce this time interval. E.g. If the bills are raised in favour
of the customers on monthly basis, raising the bills on customers on fortnightly basis
may be an effective way of managing the receivables. This will reduce the first time gap.
b.
Bills or invoices should be raised in favour of the customers immediately after the dispatch
of material or rendering the services. Documentation for this purpose should be completed
as early as possible. This will reduce the second category of time gap.
c.
Period of credit offered to the customers gets affected due to many other factors which
are discussed later on.
AREAS COVERED BY RECEIVABLES MANAGEMENT

Receivables Management may be concerned with the following aspects
a.
Credit Analysis.
b.
Credit Terms
c.
Financing of Receivables
d.
Credit Collection
e.
Monitoring of Receivables.
(a)
Credit Analysis :
Even though the intention of the company will be to increase the profits by increasing the
sales, the company will not like to sell its products to any customer who comes its way. For
this purpose the company has to decide the customers to whom it should sell its products on
credit. The credit should be extended only to those customers whose creditworthiness is
established. For deciding the credit worthiness of the customers, the company may consider
various factors viz. analysis of the financial status of the customer, reputation of the customer,
record of previous dealing of the customer with the company, quality and character of the
438
management running the business of the customer etc. For deciding the credit worthiness of
the customer, the company may need information which may be available from the following
sources.
(1)
Trade References :
The company can ask the prospective customer to give trade references. The company
may insist that the references should be given of those names who are currently dealing
with the company. The company in turn can obtain the information from these references,
either by personal interview or by sending short questionnaires. While doing this, honesty,
seriousness and integrity of the references should be examined.
(2)
Bank Reference
The company can ask the prospective customer to instruct its banker to give the relevant
information to the company. In this case, there may be two problems. Firstly, the banker
of the prospective customer may not give clear answers to the enquiries made by the
company. Secondly, even though the Bank of prospective customer certifies the proper
conduct of the account, it may not mean that he will settle his dues of the company in
time. As such, along with Bank reference, other ways of obtaining the information should
also be used.
(3)
Credit Bureau Reports :

The sources of trade references and bank references may be biased in some cases. In
such cases, the credit bureau reports may be considered. In some cases, the associations
for some specific industries maintain credit bureau that may give useful and authentic
information about their members.
(4)
Financial Statements :
This is one of the easiest ways to obtain the information about the creditworthiness of
the prospective customer. If the prospective customer is a public limited company, there
may not be any difficulty in getting the financial statements in the form of Profit and Loss
Account and Balance Sheet. However, getting the financial statements, may be difficult
in case of private limited companies or partnership firms.
(5)
Past Experience :
This can be considered to be the most reliable source of getting the information about
the creditworthiness of the customer who is dealing with the company presently. If there
is the question of extending further credit to the existing customer, the company should
inevitably consider the past experience while dealing with that customer.
439
(6)
Salesmans Interviews and Reports :

Many a times, companies may depend upon the reports given by the sales personnel for
evaluating the creditworthiness of the customers.
After the creditworthiness of the customer is ascertained, the next question is to decide the
limit on the credit to be allowed to them, both in terms of amount and duration. The decision
depends upon the amount of anticipated sales, increased cost of monitoring and servicing the
receivables and the financial strength of the customer. If the customer is a frequent buyer of
the goods of the company, a line of credit for selling may be established which means the
maximum amount of credit which the company may extend. In such case, the company need
not investigate every order of the customer so long as it is within the limit of line of credit. The
line of credit granted for the customer should be reviewed periodically in the light of the collection
of the previous dues, specific requirements of the customer for the future and so on.
(b)
Credit Terms :
Credit terms indicate the terms on which the company should extend the credit to the customer.
This involves the consideration of following aspects,
Credit Period
Credit Limit
Discount Policy.
Credit Period :
Credit period is the time allowed by the company to the customers to pay their dues. The
duration of this credit period may depend upon various factors. One, in case of the products
having inelastic demand, the credit period may be small, however if the demand is elastic,
small credit period may affect quantum of sales. Two, credit period may depend upon the
nature of industry. In the buyers market, the company may be required to offer more credit
period. In the sellers market, the company may afford to offer smaller credit period. Further, it
also depends upon the policies followed by the competitors. Three, decisions regarding the
credit period may be affected by the management attitudes. If the management attitude is
aggressive, it may offer more credit period to increase sales and profits. However, if management
attitude is conservative, it will like to restrict the credit period. Lastly, the credit period may
depend upon the amount of funds available and also upon possible bad debts losses. Naturally,
the company will like to have credit period as short as possible, whereas the customers will
like to have longer credit period. As such, by liberalising its credit period, the company can
attract new customers. However, the proposition of liberalising the credit period may involve
the consequences in the form of more investment in receivables, possibility of bad debts
losses, increased cost of monitoring and servicing the receivables etc. As such, policy to
liberalise the credit period should be viewed from this angle.
440
Illustration:
A company is currently selling 12000 units at Rs. 50 per unit. Variable cost per unit is Rs. 40.
At present, the company gives credit of one month which is proposed to be extended to two
months, whereby it will be able to increase sales by 25%. If the required rate of return is 18%
and average cost per unit is Rs. 45, should the new credit policy be implemented?
Solution :
Calculation of incremental profits
Present Costs
Structure
Rs.
Proposed Costs
Structure
Rs.
Differences
Sales
6,00,000
7,50,000
1,50,000
Variable cost
4,80,000
6,00,000
1,20,000
Contribution
1,20,000
1,50,000
30,000
Fixed Costs
60,000
60,000
__
Profit
60,000
90,000
30,000
Rs.
Thus, the new credit policy will result into increased profits of Rs. 30,000.
The costs involved with the new credit policy will be as below.
Variable cost
Fixed Cost
Total Cost
Average Debtors
Investment in Debtors
Present Policy
Rs.
New Policy
Rs.
4,80,000
60,000
5,40,000
(1 month)
45,000
6,00,000
60,000
6,60,000
(2 months)
1,10,000
As such, incremental investment in debtors is Rs. 65,000 i.e. 1,10,000 Rs. 45,000. As the
required rate of return is 18% p.a., costs attached with incremental debtors will be Rs. 11,700
i.e. 18% of Rs. 65,000.
As the increased profits of Rs. 30,000 are more than increased costs of Rs. 11,700 the new
credit policy will be desirable.
However, before liberalising the credit period, following factors should also be considered.
(i)
Liberalising the credit period is likely to increase the demand. It should be verified whether
the company has the capacity to meet this additional demand. If the company is operating
441
at its full capacity and it is necessary to increase the capacity to meet the additional
demand, the effect of this possibility on the cost structure of the company is required to
be considered.
(ii)
Liberalising the credit period may increase the demand which in turn may call for the
additional investment in working capital say inventory. While evaluating the proposal to
liberalise the credit period, cost associated with the additional investment in working
capital is also required to be considered.
Discount Policy :
Discounts are usually allowed to speed up the collection process, and to induce the customers
to pay the dues early. The decisions regarding the rate of discount and period of discount
depends upon the usual cost benefit considerations i.e. The cost of carrying the debts on one
hand and on another hand, the benefits received from getting the amount released from the
debtors immediately, which may be available for some different and beneficial use.
Proposal to liberalise the discount policy should be evaluated in terms of loss of revenue on
one hand and the benefits arising out of released investment in receivables on another hand.
Illustration :
A Ltd. Is considering to introduce cash discount policy of 3/10 net 30 i.e. if the customer
pays his dues within 10 days, he will be entitled to a cash discount of 3%, otherwise he has
to pay the dues within 30 days. The company expects that 60% of the sales will opt for this
facility which will improve the Average Collection Period from 30 days to 18 days. If sales of
the company amount to Rs. 50 lakhs and if required rate of return is 15%, should the proposal
be accepted?
Solution :
(a)
Loss of Revenue
60% of Rs. 50,00,000 X 3%
(b)
Receivables before discount

50,00,000
360
(c)
X 30
Rs. 4,16,666
Receivables after discount

50,00,000
360
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Rs. 90,000
X 18
Rs. 2,50,000
(d)
Investment in receivables released

i.e. b c
(e)
Rs. 1,66,666
Return on investment released

15% on Rs. 1,66,666
Rs. 25,000
As the return on investment released is likely to be less than loss of revenue, the proposal of
cash discount should not be accepted.
(c)
Financing the Receivables :
Whichever sources are available to the company for financing the working capital requirement,
are equally the sources available for financing the receivables. This is due to the fact that
receivables is a part of working capital. However, following sources may be identified as the
sources available for financing the receivables particularly.
a)
Bills Discounting
b)
Cash Credit against hypothecation of book debts as the security.
c)
In the recent past, factoring has become one of the sources available for financing the
receivables. The mechanism of factoring is discussed in the following paragraphs.
(d)
Credit Collection :
This indicates the steps taken by the company to collect the dues from the customer. For this
purpose, the company may follow the standard practices of reminding the customer just
before the due date. This can be done by sending the reminder letters, or making telephone
calls or by paying the personal visits.
The customers who are slow paying ones should be handled property. If they are permanent
customers, they may object to harsh collection procedure and the company may loose them
ultimately. If the slow paying customer is facing some temporary funds problem, the company
should understand the same. If there are some defaulting customers, the company should
decide as how many reminders should be sent and how each of them should be drafted. If
these measures fail, the next step taken may be the personal call to these customers or the
personal visit by the companys representative. If all these above courses of action fail, the
company may decide to take the legal action against the defaulting customer as a last resort.
It is a very regular practice to offer cash discounts to the customers in order to speed up the
credit collection process.
While designing the credit collection policy, following propositions should be remembered.
443
(a)
Before deciding collection policies and procedures, it is essential to make a cost benefit
analysis. The costs are the administrative expenses associated with the collection policies
and the benefits are the reduced bad debts losses and interest on released investment
in debtors. As a financial management proposition, it is necessary that the cost should
be justified by the benefits.
(b)
Before deciding collection policies and procedures, provisions of the Indian Limitation
Act should be kept in mind. In spite of the repeated reminders, if the customer fails to
pay the amount due from him, the legal action should be initiated against the customer
before the limitation period is over.
(e)
Monitoring the Receivables :
It may be necessary to ensure that the outstanding receivables are within the framework of the
credit policy decided by the company. For this, the company may be required to apply regular
checks and have a regular system to monitor the receivables property. For this, the company
may use the following techniques.
Techniques available on Macro Basis :
One of the most common methods to monitor the receivables on macro basis is to calculate
the Average Collection Period (ACP) which effectively indicates the period taken by the
customers to make payment to the company or the average period of credit allowed by the
company to the customers.
Average Collection Period may be calculated in two stages described below :
a.
Calculation of daily or monthly sales

Credit Sales during the year
No. of days / No. of months
b.
Calculation of Average Collection Period

Sundry Debtors in Balance Sheet
Daily/Monthly Sales
For the purpose of proper interpretation of ACP, it needs to be compared with the NCP, i.e. the
Normal Credit Period offered by the company to customers for making the payment. If ACP
works out to be more than the NCP, it indicates inefficiency on the part of marketing department
or sales department or collection department of the company in collecting the dues from the
customers. If ACP works out to be less than the NCP, it indicates efficiency on the part of
marketing department or sales department or collection department of the company in collecting
the dues from the customers. However, calculation of ACP as a tool to monitor the receivables
involves some limitations
444
a.
Calculation of ACP assumes that the credit sales are evenly spread throughout the year.
In practical circumstances, credit sales are not evenly spread throughout the year. In
such situations, ACP may give wrong indications.
b.
Calculation and interpretation of ACP as a tool to judge the efficiency or inefficiency of

the company in collecting the dues from the customers is not possible based upon the
published financial statements of the company due to non-availability of sufficient data
for the same. Eg. The amount of credit sales made by company or the normal credit
period offered by the company are not available in the published financial statements.
Techniques available on Micro Basis :

Considering the limitations associated with the calculation of ACP, it may not be a tool available
to monitor the receivables on micro basis. For this, the calculation of age-wise analysis of
receivables may be made. Age-wise analysis of the receivables involves the classification of
outstanding receivables at any given point of time (say at the end of every month) into the
different age groups (age of the receivables indicating the number of days since the date
receivables become outstanding). Percentage of receivables falling under each age group
may also be calculated. For example,
Age Group
(No. of days)
Amount
Rs.
Less than 30 days

31-60 days
60-90 days
More than 90 days
Now, if the normal credit period offered by the company to the customers is 30 days, any
amount which is outstanding for more than 30 days is definitely indicating the inefficiency on
the part of collection department of the company in collecting the receivables. Thus age-wise
analysis of the receivables may provide superior information about the quality of receivables
and the company can concentrate its collection efforts on those receivables which are
outstanding for a longer period of time.
FACTORING
In the recent past, factoring has emerged as one of the major financial service in the Receivables
Management area.
What is Factoring?
Factoring indicates the relationship between a financial institution (called as the factor) and
a business organisation (called as the client) who in turn sells the goods/services to its
445
customers (called as the customer), whereby the factor purchases book debts of the client,
either with recourse or without recourse, and in relation thereto controls the credit extended to
the customers and administers the sales ledger of the client. In non-technical language, the
financial service in the form of factoring tries to provide the services which the marketing
department of an organisation will be undertaking. Eg. The factor may provide the following
services to the client :
a.
Factor may undertake the credit analysis of the customers of the client. Factor may also
help the client in deciding the credit limit upon each customer and the other credit terms
like period of credit, discount to be allowed etc. It should be noted that the factor need
not factor all the debts of the client. He may have his own assessment of the customers
of the client and accordingly, he will factor the debts of the client.
b.
Factor will undertake the various bookkeeping and accounting activities in relation to the
receivables management. This will consist of maintenance of debtors ledger and generation
of the various periodical reports on behalf of the client (like outstanding from the customers,
age wise analysis of the outstandings etc.)
c.
The factor undertakes the responsibility of following up with the customers for the purpose
of making the collection from the customers. For this it will be necessary that the client
informs its customers about the fact that the debts have been factored by the factor and
that the customers should make the payments to the factor directly.
d.
Factor can purchase the debts of the client making the immediate payment of these
debts to the client after maintaining about 20% to 30% margin. This reduces the strain
on the working capital requirements of the client and the client can concentrate on the
manufacturing and other activities. After the customer makes the payment to the factor
on the due date, the factor passes on the funds to the client after adjusting the funds
advanced by him to the client. If the factor purchases the debt of the client, it will be
involving the cost and the cost is slightly higher than the interest which the client would
have paid had he borrowed the funds from the bank. If some of the debts are not purchased
by the factor, the client can borrow from the bank against these debts.
e.
Factor can assume the risk of non-payment by the customers if the factoring is without
recourse factoring and in such cases, the factor is not able to recover the money from
the client. If the factoring is with recourse factoring, the risk of non-payment by the
customers is assumed by the client and not by the factor. As such, the factor is entitled
to recover the funds advanced by him to the client.
Factoring Vs. Bills Discounting :

Factoring is different from the bills discounting in two ways. One, Bills Discounting is essentially
a financial function whereby the client gets the finance against the book debts, whereas the
446
factoring is a financial as well as administrative function. The factor is engaged not only in
financing the book debts of the client, but he is engaged in the various administrative activities
as well like the maintenance of sales ledger, generation of the various reports, follow up with
the customers, collection of dues from the customers etc. Secondly, in case of Bills Discounting,
the risk of non-payment of dues by the customers is essentially assumed by the client,
whereas in the case of factoring the risk of non-payment by the customers may be assumed
by the factor if the factoring is without recourse factoring.
Procedure of Factoring :
a.
After the careful evaluation of customers and setting the credit limits upon the customers,
the factoring firm enters into the agreement with the selling company.
b.
Sales invoices raised by the selling company in favour of its customers consists of an
indication to the customer that the amount is being factored with the factor and on the
due date, the customer should make the payment to the factor directly.
c.
The factor makes the prepayment of the invoice to the selling company after keeping the
margin as stipulated.
On the due date, when the customer makes the payment, the factoring firm recovers its
fees/charged as agreed upon and also the amount already advanced to the selling
company and passes on the balance amount to the selling company.
The various steps involved in the factoring operations may be explained with the help of following
figure.
MECHANICS OF FACTORING
1
CLIENT
(SELLER)
8
5
4
2
CUSTOMER
(BUYER)
FACTOR
447
Description of Numbers in above figure

1.
Places the order
2.
Fixes the limit
3.
Delivers the goods and instructs the customer to make payment to the factor
4.
Sends the invoice copy
5.
Makes the prepayment of invoice
6.
Follows up
7.
Makes the payment
8.
Pays the balance amount
Types of Factoring :
On the basis of above features of factoring, factoring can be classified in the following ways :
a.
Without Recourses Factoring : In case of this type of factoring, the risk on account of
non-payment by the customer is assumed by the factor. The factor is not entitled to
recover the amount from the selling company. Thus, without Recourse Factoring results
into the outright buying of selling companys receivables by the factor. This type of
factoring is also referred to as full factoring.
b.
With Recourse Factoring : In case of this type of factoring, the risk on account of nonpayment by the customer is assumed by the selling company and the factor is entitled
to recover the funds advanced by him the selling company.
Advantages of Factoring :
448
a.
Factoring is the way in which the company can finance its requirement of working capital
in respect of receivables. Immediate availability of cash reduces the strain on working
capital of the company. As the financing in the form of factoring moves with the level of
receivables directly, the company need not worry about financing the additional requirement
of working capital due to the increased amount of sales.
b.
Factoring orgainsation is a professional specializing in the various fields. The company

can take the advantage of the expertise of the factor in the areas of credit evaluation,
credit analysis, deciding the credit limits upon the customers etc.
c.
With the help of factoring as a financial service, the company can be relieved of the
administrative responsibilities of maintaining the debtors ledger, periodical report
generations and following up with the customers for collecting the dues etc. This not
only results in the cost saving for the company, but the company is able to concentrate
its efforts on business development.
Disadvantages of Factoring :
a.
As the amount charged by the factoring organisation, consists of the components towards
the administrative services rendered by the factor as well as the cost of finance provided
by the factor, the effective financial burden on the company increases.
b.
the Indian circumstances, Factoring is mainly with-recourse factoring. This means that
the risk of non-payment on the part of customer is not borne by the factor. It is borne by
the selling firm. This has restricted the popularity of factoring services in the Indian
circumstances.
c.
While making the credit evaluation, if the factor adopts a very conservative approach with
the intention to minimize the risk of delay and default, it may restrict the sales growth of
the selling company.
d.
Factoring may be considered to be a symptom of financial weakness on the part of the

selling company. It may indicate that the selling company is not able to manage its
receivables effectively on its own and is required to take the help of an outside agency in
the form of factor.
Factoring in Indian situations :

Factoring services in Indian circumstances started on the basis of the recommendations of
Kalyanasundaram Committee which was appointed in the year 1989 with the intention of
studying the scope of starting factoring services in India. The committee recommended the
factoring in India. Reserve Bank of India demarcated the zones for the banks who wished to
get involved in the factoring business. The distribution of zones bank wise was as below :
Western Zone
State Bank of India
Southern Zone
Canara Bank
Northern Zone
Punjab National Bank
Eastern Zone
Allahabad Bank
Recently, Export Credit Guarantee Commission (ECGC) has been authorised to start the
Export Factoring business.
Out of the above banks, State Bank of India started its factoring services in 1991 by forming a
separtate subsidiary viz. SBI Factors Limited.
449
Generally the factoring in India is with recourse factoring i.e. the risk of non-payment by the
customer is not accepted by the factor but by the client. That may be the reason that the
experience of factoring in India is not very encouraging.
(1)
A firm is proposing strict collection policies. At present the firm sells 36,000 units with
the average collection period of 60 days. Collection charges amount to Rs. 10,000 and
bad debts are 3% of sales. If collection procedures are tightened, it will reduce the
collection period to 40 days and bad debts losses to 1% of sales. However it involves
additional collection charges of Rs. 20,000 and the sales decline by 500 units. If selling
price is Rs. 32, average cost is Rs. 28 and variable cost is Rs. 25, whether the firm
should implement the policy? Assume 20% rate of return.
Solution :
Costs attached to proposal
(1)
(2)
Loss of contribution
(500 units X Rs. 7)
Rs. 3,500
Additional Collection Expenses
Rs. 20,000
Rs. 23,500
Benefits attached to proposal

(1)
Saving in bad debts losses

3% of old sales Rs. 11,52,000
Rs. 34,560
1% of revised sales Rs. 11,36,000
Rs. 11,360
Rs. 23,200
(2)
Reduced investment in Receivables
Rs. 57,444
Assuming 20% rate of return, the firm

will save due to this reduced investment.
Rs. 11,489
Rs. 34,689
As the benefits attached to the proposal to tighten the collection procedures exceeds the
costs attached to the same, the firm should implement the proposal.
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WORKING NOTES :
Cost Structure
Sales (Rs. 32/- per unit)

Variable cost (Rs. 25/- per unit)
Fixed cost
Total cost
Average collection period
Average outstanding (on the basis of cost of sales)
Reduced average outstanding
(2)
36000 Units
35500 Units
Rs. 11,52,000
Rs. 11,36,000
Rs. 9,00,000
Rs. 8,87,500
Rs 1,08,000
Rs. 1,08,000
Rs. 10,08,000
Rs. 9,95,000
60 days
40 days
Rs. 1,68,000
Rs. 1,10,556
Rs. 57,444
XYZ Corporation is considering relaxing its present credit policy and is in the process of
evaluating two proposed policies. Currently, the firm has annual credit sales of Rs. 50
lakhs and accounts receivable turnover ratio of 4 times a year. The current level of loss
due to bad debts is Rs. 1,50,000. The firm is required to give a return of 25% on the
investment in new accounts receivables. The companys variable costs are 70% of the
selling price. Given the following information, which is the better option?
Annual Credit Sales (Rs.)
Present
Policy
Policy
Option
I
Policy
Option
II
50,00,000
60,00,000
67,50,000
4 times
3 times
2.4 times
1,50,000
3,00,000
4,50,000
Accounts Receivable
Turnover Ratio
Bad Debts Losses (Rs.)
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Solution :
Evaluation of credit policy options
Option I
Option II
Benefits
(a)
Sales (Rs.)
60,00,000
67,50,000
(b)
Incremental Sales (Rs.)
10,00,000
17,50,000
(c)
Additional contribution (30% of sales)
3,00,000
5,25,000
60,00,000
67,50,000
2.4
20,00,000
28,12,500
Costs
(a)
Sales (Rs.)
(b)
Accounts Receivables Turnover Ratio

(No. of times)
(c)
Accounts Receivables (Rs.)
(d)
Incremental Receivables (Rs.)
7,50,000
15,62,500
(e)
Investment in incremental Receivables

(70%) (Rs.)
5,25,000
10,93,750
Return on investment in Receivables

(25%)
1,31,250
2,73,438
(g)
Incremental Bad Debt losses
1,50,000
3,00,000
(h)
Total Costs (i.e. f + g)
2,81,250
5,73,438
18,750
(48,438)
(f)
Net Benefits
Conclusion :
As credit policy option no. II generates the incremental loss of Rs. 48,438, the company
should reject the same.
Credit policy option no. I generates the incremental profit of Rs. 18,750, which can be accepted
by the company.
(3)
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STS Ltd. which sells on credit basis has ranked its customers in categories 1 to 5 in
order of credit risk.
Category
% bad debts
ACP
0.0
30 days
1.0
45 days
2.0
60 days
5.0
90 days
10.0
120 days
The companys current policy is to allow unlimited credit to firms in categories 1 to 3, limited
credit to firms in category 4 and no additional credit to firms in category 5.
As a result, orders amounting to Rs. 25,00,000 from category 4 and Rs. 75,00,000 from
category 5 customers are rejected every year. If the STS Ltd. makes a 10% gross profit on
sales and has an opportunity cost on investment in receivables of 12% what would be the
effect on profits of allowing full credit to all categories of customers? Should credit be extended
to all categories of customers?
Solution :
Evaluation of Credit Policies
Category 4
Category 5
25,00,000
75,00,000
2,50,000
7,50,000
25,00,000
75,00,000
90
120
(c ) Receivables (Rs.)
6,25,000
25,00,000
(d)
Investment in receivables i.e. 90%(Rs.)
5,62,500
22,50,000
(e)
Return on investment in receivables

67,500
2,70,000
Benefits
(a)
Loss of sales (Rs.)
(b)
Loss of profit (10% of sales (Rs.)
Costs
(a)
Loss of sales (Rs.)
(b)
Average collection Period days
@ 12% (Rs.)
(f)
Bad debt losses
1,25,000
7,50,000
(g)
Total Costs (i.e. e + f)
1,92,500
10,20,000
57,500
(2,70,000)
Net Benefits
453
Conclusion :
As extending credit to the customers in category 5 results into the loss, the company should
not extend credit to them.
However, it can extent the credit to category 4 customers, as it results into a plus.
(4)
A trader whose current sales are in the region of Rs. 6 lakhs per annum and an average
collection period of 30 days wants to pursue a more liberal policy to improve sales. A
study made by a management consultant reveals the following information :
Credit Policy
Increase in
collection period
(Days)
Increase in
sales
%default
anticipated
10
30,000
1.5%
20
48,000
2%
30
75,000
3%
45
90,000
4%
Selling price per unit is Rs. 3, average cost per unit is Rs. 2.25 and variable cost per unit is
Rs. 2
Current bad debt loss is 1%. Required return on additional investment is 20%. Assume 360
days a year.
Which of the above policies would you recommend for adoption.
Solution :
Evaluation of credit policies
Benefits
(a)
Credit Policy
(b)
Credit Period (days)
(c)
(d)
(e)
454
40
50
60
75
Additional Sales (Rs.)
30,000
48,000
75,000
90,000
Contribution generated
by additional sales (Rs.)
10,000
16,000
25,000
30,000
6,30,000
6,48,000
6,75,000
Total Sales (Rs.)
6,90,000
(f)
Bad Debts (Rs.)
9,450
12,960
20,250
27,600
(g)
Additional Bad Debts (Rs)
3,450
6,960
14,250
21,600
(h)
Net Additional
6,550
9,040
40
50
60
75
6,30,000
6,48,000
6,75,000
6,90,000
Contribution (Rs.)
i.e. d minus g
10,750
8,400
Costs :
(a)
Credit Policy
(b)
(c)
Total Sales (Rs.)
(d)
Average Debtors (Rs.)
70,000
90,000
1,12,500
1,43,750
(e)
Investment in Receivables (Rs.) 46,667
60,000
75,000
95,833
(f)
Additional investment
in receivables (Rs.)
13,334
26,667
41,667
62,500
Investment
2,667
5,333
8,333
12,500
Net Benefit :
3,883
3,707
2,417
(-) 4,100
(g)
Return on additional
Conclusion :
As the benefit is maximum in case of credit policy A, the company should adopt that policy.
Note :
(a)
Additional bad debts will be considered as excess of anticipated bad debts as compared
to the existing bad debts.
(b)
Additional investment in receivables in calculated as below

Existing sales Rs. 6,00,000
Average Collection Period 30 days
Average Debtors Rs. 50,000
As variable cost is 2/3rd of selling price, investment in debtors is 50,000 X 2/3 = 33,333
The investment in debtors under all the proposed credit policies should be considered on the
basis of the existing investment in debtors as stated above i.e. Rs. 33,333.
455
QUESTIONS
456
1.
How would you manage the credit policy in a company where the amount locked up in
receivables (debtors) is equal to six months sales?
2.
What is meant by a firms credit terms? What are the expected effects of (a) A decrease
in the firms cash discounts and (b) A decrease in credit period.
3.
The credit policy of a company is criticised because bad debt losses have increased
considerably and collection period has also increased. Discuss under what conditions
the criticism may not be justified.
4.
What are the important dimensions of a firms credit policy? Discuss the consequences
of a liberal credit policy.
5.
Write a detailed essay on factoring.
PROBLEMS
(1)
XYZ Corporation is considering relaxing its present Credit policy and is in the process of
evaluating two proposed policies. Currently, the firm has annual credit sales of Rs. 50
Lakhs and accounts receivable turnover ratio of 4 times a year. The current level of loss
due to bad debts is Rs. 1,50,000. The firm is required to give a return of 25% on the
investment in new accounts receivables. The companys variable costs are 70% of the
selling price. Given the following information, which is the better option?
Present Policy
Policy Option
I
Policy Option
II
Annual credit sales
Rs. 50 Lakhs
Rs. 60 Lakhs
Rs. 67.5 Lakhs
Accounts receivable
turnover ratio
4 times
3 times
2.4 times
Rs. 1.5 Lakhs
Rs. 3 Lakhs
Rs. 4.5 Lakhs
Bad debt losses
(2)
The credit manager of ABC Company had to decide on a proposal for liberal extention of
credit which will result in a slowing process of average collection period from one month
to two months. The companys product was sold for Rs. 20 per unit of which Rs. 15
represented variable cost (including credit department cost). The current actual sales
amounted to Rs. 24 Lakhs, represented entirely by credit sales. The average total costs
was Rs. 18. The extention in credit policy was expected to result in a 25% increase in
sales i.e. Rs. 30 Lakhs annually. The corporate management aimed at a return of 25%
on additional investment. You are required to make relevant calculations to help the
credit manager in examining the financial implications of liberalising the credit policy.
(3)
Pune Sandals Ltd. is planning a strategy to increase its sales in the domestic market
and one of its strategy is to extend its credit terms to various classes of customers. The
company has ranked its customers in categories 1 to 5 in the Ascending order of risk.
Category
% Bad Debts
Average Collection Period
Nil
30 days
2.00
45 days
4.00
60 days
7.00
90 days
10.00
180 days
457
The Companys current policy is to allow unlimited credit to customers in category 1 to

3, limited credit to customers in category 4 and no additional credit to customers in
category 5.
As a result of the existing policy, the company lost orders of Rs. 50 lakhs from customers
in category 4 and Rs. 100 lakhs from customers in category 5.
As the Finance Manager, would you recommend that credit should be extended to all
categories of customers. Your analysis should contain the effect on profits.
(4)
MNQ Ltd. wants to relax its credit on sales from the current level of 1 month to 2 months.
Due to this , the sales would increase to Rs. 72 lakhs from the present level of Rs. 60
lakhs per annum but the percentage of bad debts losses is likely to go up by 2 % of
sales which, is now at 3% of sales. The companys variable cost is 75% of sales and
fixed expenses are Rs. 12 lakhs per annum. Advice the company on the implications of
revising the credit policy. Interest on the additional funds required to extend credit need
not be considered.
(5)
A firm sells 40,000 units of its product per annum @ Rs. 35 unit. The average cost per
unit is Rs. 31 and the variable cost per unit is Rs. 28. The average collection period is 60
days. Bad debts losses are 3% sales and the collection charges amount to Rs. 15,000.
The firm is considering proposal to follow a stricter collection policy which would reduce
bad debts losses to 1% of sales and the average collection period to 45 days. It would,
however reduce sales volumes by 1000 units and increase collection expenses
Rs. 25,000.
The firms required rate of return is 20%. Would you recommend the adoption of the new
collection policy? Assume 360 days in a year for the purpose of your calculation.
(6)
Agro Products Ltd. is considering the following credit policy alternatives :

Existing
Policy
Option
I
Option
II
30
14
60
Sales (Rs. in lakhs)
10
9.60
12
3.33
.6
20,000
12,000
25,000
45
51
72
Bad debts (% of sales)

Cost of credit administration (Rs.)
Average effective collection period (Days)
458
The average effective collection period differs from the credit period as all debtors dont
strictly adhere to the condition stipulated . The company achieves a contribution of 40%
on sales and the firm requires a 20% p.a. return on investment. You are required to
suggest which credit period is more suitable to the company. Do you have any further
suggestions to the management in the context of your finding.
(7)
Premier Steels Limited has a present annual sales turnover of Rs. 40,00,000. The unit
sales price is Rs. 20. The variable costs are Rs. 12 per unit and fixed costs amount to
Rs. 5,00,000 per annum. The present credit period of one month is proposed to be
increased to either 2 or 3 months whichever will be more profitable. The following additional
information is available.
On the basis of credit period of
1 Mth.
2 Mths.
3 Mths.
Increase in sales (Rs)
10%
30%
% of bad debts to sales
Fixed cost will increased by Rs. 75,000 when sales will increase by 30%. The company
requires a pretax return on investment of 20%.
Evaluate the profitability of the proposals and recommend best credit period for the
company.
459
NOTES
460
NOTES
461
NOTES
462
To conclude, it can be said that the objective of inventory management is to minimise the
investment in inventory without affecting the production or sales operations.
TECHNIQUES OF INVENTORY MANAGEMENT :
(1)
Economic Order Quantity :
It indicates that quantity which is fixed in such a way that the total variable cost of managing
the inventory can be minimised. Such cost basically consists of two parts. First, Ordering
Cost (which in turn consists of the costs associated with the administrative efforts connected
with preparation of purchase requisitions, purchase enquiries, comparative statements and
handling of more number of bills and receipts). Second, Carrying Cost i.e. the cost of carrying
or holding the inventory. (which in turn consists of the cost like godown rent, handling and
upkeep expenses, insurance, opportunity cost of capital blocked i.e. interest etc.) There is a
reverse relationship between these two types of costs i.e. if the purchase quantity increases,
ordering cost may get reduced but the carrying cost increases and vice versa. A balance is to
be struck between these two factors and it is possible at Economic Quantity where the total
variable cost of managing the inventory is minimum.
It is possible to fix the Economic Order Quantity with the help of mathematical formula. The
following assumptions may be made for this purpose.
Let Q
be Economic Order Quantity.
be Annual Requirement of material in units.
be cost of placing an order (which is assumed to remain constant irrespective of

size of order).
be cost of carrying one unit per year.
Now, if A is the annual requirement and Q is the size of one order, the total number of orders
will be A/Q and the total ordering cost will be : A/Q x O.
Similarly, if the size of one order is Q and if it is assumed that the inventory is reduced at a
constant rate from order quantity to zero when it is repurchased, the average inventory will be
Q/2 and the cost of carrying one unit per year being C, the total carrying cost will be Q/2 x C.
Thus,
Total cost = Ordering Cost + Carrying Cost,
=
A x
Q
O +
Q x
2
465
The intention is that the value of Q should be such that the total cost should be minimum.
Hence, taking the first derivative of the equation with respect to Q and setting the result to
zero.
do
1
C
= AO ( 2 ) +
dq
Q
2
=0
or
Q=
Where
2 x A x O
C
Q = Order Quantity
A = Annual Requirement in Units
O = Cost of Placing an Order
C = Cost of Carrying One Unit Per Year
Illustration :
A manufacturer uses 200 units of a component every month and he buys them entirely from
outside supplier. The order placing cost is Rs. 100 per order and annual carrying cost per unit
is Rs. 12. From this set of data, calculate Economic Order Quantity.
Solution :
EOQ
2 x A x O
C
2 x 2400 x 100
12
200 units
In some cases, the carrying cost may be expressed as an annual percentage of the unit cost
of purchases. In which case, the calculation of Economic Order Quantity takes the following
form.
EOQ
where
2 x A x O
C x i
= Annual requirement in units
O = Cost of placing an order
466
= Unit purchase price
= Carrying cost expressed as a percentage of unit purchase price.

Illustration :
From the following data, work out the EOQ of a particular component,
Annual Demand
5000 Units
Ordering Cost
Rs. 60 per Order
Price Per Unit
Rs. 100
Inventory Carrying Cost
15% on average inventory.
Solution :
EOQ
2 x 5000 x 60
15% of 100
= 200 units.
The total cost of managing inventory will be
Ordering Cost
500
200
Carrying Cost
200
2
x 60 i.e. 25 x 60
= Rs. 1,500
x 15% of 100
= Rs. 1,500
Rs. 3,000
(Based on average inventory)

Now, the next question is whether the purchases in Economic Order Quantity really reduce
the total cost of managing inventory to the minimum. We can verify this, by trial and error
method, by considering the above results.
Order
Quantity
No. of
Orders A/Q
Ordering Cost
A/Q x O
Rs.
Carrying Cost
Q/2 x Ci
Rs.
Total
Cost
Rs.
50
100
6,000
375
6,375
100
50
3,000
750
3,750
200
25
1,500
1,500
3,000
250
20
1,200
1,875
3,075
1,000
300
7,500
7,800
1,250
240
9,375
9,615
2,500
120
18,750
18,870
467
It can be observed from the above, that the order size of 200 units proves to be the most
economic one in terms of minimum total cost. If the purchases are made in any other way, the
same may not necessarily result into minimum total cost.
Illustration :
Kapil Motors purchase 9,000 motor spare parts for its annual requirements, ordering one
month usage at a time. Each spare part costs Rs. 20. The ordering cost per order is Rs. 15
and the carrying charges are 15% of the average inventory per year. You have been asked to
suggest a more economical puchasing policy for the company. What advice would you offer
and how much would it save the company per year?
Solution :
Present Policy :
Number of Orders
Annual Requirement
Order size
= 9000
= 12
750
Ordering Cost
= 12 x 15
= 180
Order Size
=
x Cost Price
2
= 750
x 15% of Rs. 20
2
Carrying Cost
(1)
x Carrying cost in %
= 375 x 3
= 1,125
Total cost i.e. 1 + 2
(2)
= 180 x 1125
= 1,305
(3)
Proposed Policy :
To purchase in Economic Order Quantity
EOQ
468
2xAxO
Cxi
2 x 9000 x 15
15% of 20
300 units
Now, the revised total cost will be

Number of Orders
9000
300
= 30
Ordering Cost
= 30 x 15
= 450
Carrying Cost
(4)
300
x 15% of 20
2
= 150 x 3
= 450
Total Cost i.e. 4 + 5
(5)
= 450 + 450
= 900
(6)
Thus, purchases in Economic Order Quantity will result into the yearly saving of Rs. 405
(i.e. Rs. 1305 - Rs. 900)
(2)
Fixation of Inventory Levels :
Fixation of various inventory levels facilitates initiating of proper action in respect of the movement
of various materials in time so that the various materials may be controlled in a proper way.
However, the following propositions should be remembered.
(i)
Only the fixation of inventory levels does not facilitate the inventory control. There has to
be a constant watch on the actual stock level of various kinds of materials so that proper
action can be taken in time.
(ii)
The various levels fixed are not fixed on a permanent basis and are subject to revision
regularly.
The various levels which can be fixed are as below :

(1)
Maximum Level :
It indicates the level above which the actual stock should not exceed. If it exceeds, it may
involve unnecessary blocking of funds in inventory. While fixing this level, following factors are
considered.
469
(i)
Maximum usage.
(ii)
Lead time
(iii) Storage facilities available, cost of storage and insurance etc.

(iv)
Prices for material
(v)
Availability of funds
(vi)
Nature of material e.g. If a certain type of material is subject to Government regulations

in respect of import of goods etc. maximum level may be fixed at a higher level.
(vii) Economic Order Quantity.

(2)
Minimum Level :
It indicates the level below which the actual stock should not reduce. If it reduces, it may
involve the risk of non-availability of material whenever it is required. While fixing this level,
following factors are considered.
(3)
(i)
Lead time
(ii)
Rate of consumption
Re-order Level :
It indicates that level of material stock at which it is necessary to take the steps for procurement
of further lots of material. This is the level falling in between the two existences of maximum
level and minimum level and is fixed in such a way that the requirements of production are met
properly till the new lot of material is received.
(4)
Danger Level :
This is the level fixed below minimum level. If the stock reaches this level, it indicates the need
to take urgent action in respect of getting the supply. At this stage, the company may not be
able to make the purchases in a systematic manner but may have to make rush purchases
which may involve higher purchases cost.
CALCULATION OF VARIOUS LEVELS :
The various levels can be decided by using the following mathematical expressions.
(1)
Re-order level :
Maximum Lead Time x Maximum Usage.
(2)
Maximum Level
Re-order Level + Re-order Quantity - (Minimum Usage x Manimum Lead Time)
470
(3)
Minimum Level :
Reorder Level - (Normal Usage + Normal Lead Time)
(4)
Average Level :
Minimum Level + Minimum Level
2
(5)
Danger Level :
Normal Usage x Lead time for emergency purchases
Note : It should be noted that the expression of the Re-order Quantity in the calculation of
Maximum Level indicates Economic Order quantity.
Illustration :
Two components X and Y as used as follows:
Normal usage
50 units per week each
Minimum usage
Maximum usage
Re-order quantity
X - 400 units
Y - 600 units
Re-order period
X - 4 to 6 weeks
Y - 2 to 4 weeks
Calculate for each component :

(a)
Reorder level
(b)
Minimum level
(c)
Maximum level
(d)
Average stock level
Solution :
(1)
Re-order Level :
Maximum Lead Time x Maximum Usage
X
= 6 weeks x 75 units
= 450 units.
471
= 4 weeks x 75 units
= 300 units
(2)
Minimum Level :
Re-order Level - (Normal Usage x Normal Lead Time)
X
= 450 units - (50 units x 5 weeks)

= 200 units.
= 300 units - (50 units x 3 weeks)

= 150 units.
(3)
Maximum Level :
Re-order Level + Re-order Quantity - (Minimum Usage x Minimum Lead time)
X
= 450 units + 400 units - (25 units x 4 weeks)

= 750 units
= 300 units + 600 units - (25 units x 2 weeks)

= 850 units
(4)
Average Stock Level :

Maximum Level + Minimum Level
2
X
200 units + 750 units

2
= 475 units
Y

2
= 500 units
As stated above, the expression of the Re-order Quantity in the calculation of Maximum level
indicates Economic Order Quantity. Hence, in some cases, it may be necessary to decide
the Economic Order Quantity before fixing the inventory levels.
472
Illustration :
Shriram Enterprises manufactures a special product ZED.
The following particulars are collected for the year 1986.
(a)
Monthly demand of ZED 1000 units.
(b)
Cost of placing an order Rs. 100.
(c)
Annual carrying cost per unit Rs. 15.
(d)
Normal Usage 50 units per week.
(e)
Minimum Usage 25 units per week.
(f)
Maximum Usage 75 units per week.
(g)
Re-order period 4 to 6 weeks.
Compute from the above :

(1)
Re-order Quantity.
(2)
Re-order Level.
(3)
Minimum Level.
(4)
Maximum Level.
(5)
Average stock Level.
Solution :
(1)
Re-order Quantity :
2xAxO
C
Where,
= Annual Requirement
= Ordering cost per order
= Carrying cost per unit per year
EOQ =
2 x 12000 x 100
15
= 400 units
473
(2)
Reorder Level :
Maximum Lead Time x Maximum Usage
.
. . 6 weeks x 75 units = 450 units
(3)
Minimum Level :
Re-order Level - (Normal Usage x Normal Lead Time)
.
. . 450 units - (50 units x 5 weeks)
=
(4)
200 units
Maximum Level :
Re-order Level + Re-order Quantity/- (Minimum usage x Minimum Lead time)
.
. . 450 units + 400 units - (25 units x 4 weeks)
=
(5)
750 units

Minimum Level + Minimum Level
2
2
= 475 units
There may be one more way in which the various inventory levels may be fixed and for this,
determination of the safety stock (also called as minimum stock or buffer stock) is essential.
Safety stock is that level of stock below which the actual should not be allowed to fall. The
safety stock may be calculated as :
(Maximum Usage x Maximum Lead time) less
(Normal Usage x Normal Lead time)
According to this method, the various inventory levels as discussed above may be fixed as
below :
(1)
Minimum Level :
It is equal to safety stock.
(2)
Maximum Level :
It can be calculated as - Safety Stock + EOQ
474
(3)
Re-order Level :
It can be calculated as :
Safety Stock + (Normal Usage x Normal Lead time)
(4)

It can be calculated as :
Minimum Level + Maximum Level
2
=
Safety Stock + Safety Stock + EOQ

2
Safety Stock +
EOQ
2
Illustration :
You have been asked to calculate the following levels for part No. 007 from the information
given thereunder :
(a)
Re-ordering level.
(b)
Maximum level.
(c)
Minimum level.
(d)
Danger level.
(e)
Average level.
There ordering quantity is to be calculated from the following data :

(i)
Total cost relating to one order : Rs. 20.
(ii)
Number of units to be purchased during the year : 5,000.
(iii) Purchase price per unit : Rs. 50.

(iv)
Annual cost of storage of one unit : Rs. 5.
Lead Times :
Average
10 days
Maximum
15 days
Minimum
6 days
Maximum for emergency purchases

Rate of consumption :
4 days
Average
15 units per day
Maximum
20 units per day

475
Solution :
Working Notes :
(a)
Calculation of Safety Stock :
(Maximum Usage x Maximum Lead Time ) (Normal Usage x Normal Lead time)
(b)
(20 units x 15 days) - (15 days x 10 days)
300 units - 150 units
150 units
Calculation of EOQ :
2 x A x O
C
Where
Annual requirement
Ordering cost per order
Carrying cost per unit per year
2 x 500 x 20
Hence,
EOQ
5
=
(1)
200 units.
Re-ordering Level :
It can be calculated as Safety Stock + (Normal Usage x Normal Lead time)
(2)
150 units + (15 units x 10 days)
300 units.
Maximum Level :
It can be calculated as Safety Stock + EOQ
476
350 units
(3)
Minimum Level :
It is equal to Safety Stock
=
(4)
150 units.
Danger Level :
Normal Usage x Lead time for emergency purchases
(5)
15 units x 4 days
60 units

It can be calculated as Safety Stock +
(3)
150 units +
250 units
EOQ
2
200 units
2
Inventory Turnover :
Inventory turnover indicates the ratio of materials consumed to the average inventory held. It is
calculated as below :
Value of material consumed
Average inventory held
where value of material consumed can be calculated as :
Opening Stock + Purchases Closing Stock.
Average inventory held can be calculated as :
Opening Stock + Closing Stock
2
Inventory turnover can be indicated in terms of number of days in which average inventory is
consumed. It can be done by dividing 365 days (a year) by inventory turnover ratio.
477
Illustration :
From the following data for the year ended 31st December 1986, calculate the inventory
turnover ratio of the two items and put forward your comments on them.
Material A
Rs.
Material B
Rs.
Opening Stock 1.1.86
10,000
9,000
Purchases during the year
52,000
27,000
6,000
11,000
Material A
56,000
Material B
25,000
8,000
10,000
2.5
Inventory Turnover Period =
365
365
2.5
52 days
146 days
Closing Stock 31.12.86

Solution :
Inventory turnover ratio
Value of material consumed

Average Inventory held
Inventory turnover ratio
A high inventory turnover ratio or low inventory turnover period indicates that maximum material
can be consumed by holding minimum amount of inventory of the same, thus indicating fast
moving items. Thus, high inventory turnover ratio or lower inventory turnover period will always
be preferred.
Thus, knowledge of inventory turnover ratio or inventory turnover period in case of various types
of material will enable to reduce the blocked up capital in undesirable types of stocks and will
enable the organisation to exercise proper inventory control.
(4)
ABC Analysis :
This technique assumes the basic principle of Vital Few Trivial Many while considering the
inventory structure of any organisation and is popularly known as Always Better Control. It is
an analytical method of inventory control which aims at concentrating efforts in those areas
where attention is required most. It is usually observed that, in practice, only a few number of
items of inventory prove to be more important in terms of amount of investment in inventory or
value of consumption, while a very large number of items of inventory account for a very
478
meagre amount of investment in inventory or value of consumption. This technique classifies

the various inventory items according to their importance. Eg. A class consists of only a small
percentage of total number of items handled but are most important in nature. B class items
include relatively less important items. C class items concists of a very large number of items
which are less important. The importance of the various items may be decided on the basis of
following factors.
(i)
Amount of investment in inventory.
(ii)
Value of material consumption.
(iii) Critical nature of inventory items.

An example of ABC Analysis can be given as below :
Class
No. of
items
% of total
no. of items
Value/Consumption
Rs.
% of Total Value
Consumption
300
5,60,000
70
1,500
30
1,60,000
20
3,200
64
80,000
10
5,000
100
8,00,000
100
In order to exercise proper inventory control, A class items are watched very closely and
control is exercised right from initial stages of estimating the requirements, fixing minimum
level/lead times, following proper purchase/storage procedures etc. Whereas in case of C
class of items, only those inventory control measures may be implemented which are
comparatively simple, elaborate and inexpensive in nature.
Advantages of ABC Analysis :
(a)
A close and strict control is facilitated on the most important items which constitute a
major portion of overall inventory valuation or overall material consumption and due to
this, costs associated with inventories may be reduced.
(b)
The investment in inventory can be regulated in proper manner and optimum utilisation of
the available funds can be assured.
(c)
A strict control on inventory items in this manner helps in maintaining a high inventory
turnover ratio.
However it should be noted that the success of ABC analysis depends mainly upon correct
categorisation of inventory items and hence should be handled by only experienced and
trained personnel.
479
(5)
Bill of Materials :
In order to ensure proper inventory control, the basic principle to be kept in mind is that proper
material is available for production purpose whenever it is required. This aim can be achieved
by preparing what is normally called as Bill of Materials.
A bill of material is the list of all the materials required for a job, process or production order.
It gives the details of the necessary materials as well as the quantity of each item. As soon as
the order for the job is received, bill of materials is prepared by Production Department or
Production Planning Department.
The form in which the bill of material is usually prepared is as below :
BILL OF MATERIALS
No.
Date of Issue
Production/Job Order No.
Department authorised
S.No.
Description
of Material
Code
No.
Qty.
For Department Use only

Material
Date
Quantity
Requisition
Demanded
No.
Remarks
The function of bill of materials are as below :
480
(1)
Bill of materials gives an indication about the orders to be executed to all the persons
concerned.
(2)
Bill of materials gives an indication about the materials to be purchased by the Purchase
Department if the same is not available with the stores.
(3)
Bill of material may serve as a base for the Production Department for placing the material
requisition slips.
(4)
Costing/Accounts Department may be able to compute the material cost in respect of a

job or a production order. A bill of material prepared and valued in advance may serve as
base for quoting the price for the job or production order.
(6)
Perpetual Inventory System :
As discussed earlier, in order to exercise proper inventory control, perpetual inventory system
may be implemented. It aims basically at two facts.
(1)
Maintenance of Bin Cards and Stores Ledger in order to know about the stock in quantity
and value at any point of time.
(2)
Continuous verification of physical stock to ensure that the physical balance and the
book balance tallies.
The continuous stock taking may be advantageous from the following angles :
(1)
Physical balances and book balance can be compared and adjusted without waiting for
the entire stock taking to be done at the year end. Further, it is not necessary to close
down the factory for Annual stock taking.
(2)
The figures of stock can be readily available for the purpose of periodic Profit and Loss
Account.
(3)
Discrepancies can be located and adjusted in time.
(4)
Fixation of various levels and bin cards enables the action to be taken for the placing the
order for acquisition of material.
(5)
A systematic maintenance of perpetual inventory system enables to locate slow and

non-moving items and to take remedial action for the same.
(6)
Stock details are available correctly for getting the insurance of stock.
(1)
A company uses annually 50,000 units of an item each costing Rs. 1.20. Each order
costs Rs. 45 and inventory carrying costs 15% of the annual average inventory value.
(a)
Find EOQ
(b)
If the company operates 250 days a year, the procurement time is 10 days, and
safety stock is 500 units, find reorder level, maximum, minimum and average
inventory.
481
Solution :
(a)
Economic Order Quantity

2xAxO
Ci
=
2 x 50,000 x 45
15% of 1.20
= 5,000 units
(b)
(1)
Reorder Level :
Safety Stock + (Normal Usage x Normal Lead time)
(2)
500 units + (200 units x 10 days)
2,500 units
Maximum Level :
Safety stock + EOQ
(3)
500 units + 5,000 units
5,500 units
Minimum Level
It is equal to safety stock i.e. 500 units
(4)
Average Level
Safety Stock +
= 500 units +
=
(2)
482
EOQ
2
5000 units
2
3000 units.
M/s. Kailas Pumps Ltd. uses about 75,000 valves per year and the usage is fairly constant
at 6,250 per month. The value costs Rs. 1.50 per unit when purchased in quantities and
inventory carrying cost is 20% of the average inventory investment on annual basis. The
cost to place an order and to process the delivery is Rs. 18. It takes 45 days to receive
from the date of an order and minimum stock of 3,250 valves is desired. You are required
to determine :
(a)
The most economical order quantity and the number of orders in year.
(b)
The reorder level.
(c)
The most economic order quantity if value costs Rs. 4.50 each instead of Rs. 1.50
each.
Solution :
(a)
Economic Order Quantity :

EOQ
2 x A x O
Ci
2 x 75,000 x 18
20% of 1.50
3,000 units
Number of Orders :
Annual Consumption
EOQ
=
75,000 units
3,000 units
=
(b)
25
Reorder Level :
Safety stock + (Normal Usage x Normal Lead time)
(c)
3,250 unts + (6,250 units x 1.5 months)
12,625 units
Revised EOQ
(If unit cost is Rs. 4.50 instead of Rs. 1.50)
EOQ
2 x A x O
ci
2 x 75,000 x 18
20% of 4.50
=
1,732 units
483
(3)
The Purchase Department of your Organisation has received an offer of quantity discounts
on its orders of materials as under.
Price Per Tonne Rs.
Tonnes
1,200
Less than 500
1,180
500 and less than 1000
1,160
1,140
1,120
3000
and above
The annual requirement for the material is 5000 tonnes. The delivery cost per order is
Rs. 1,200 and the stock holding cost is estimated at 20% of material cost per annuam.
You are required to advice the Purchase Department the most economic purchase level.
Solution :
As the price discount varies with lot size, EOQ will have to be decided by Trial and Error
Method.
Lot Size
(Units) Q
Price per
Tonne
Rs. P
Purchase
Cost for
5,000
Tonnes Rs.
Ordering
Cost
5000
x 1200
Q
Q
x P x 20%
2
6(3+4+5)
100
1200
60,00,000
60,000
12,000
60,72,000
250
1200
60,00,000
24,000
30,000
60,54,000
500
1180
59,00,000
12,000
59,000
59,71,000
625
1180
59,00,000
9,600
73,750
59,83,350
1,000
1160
58,00,000
6,000
1,16,000
59,22,000
1,250
1160
58,00,000
4,800
1,45,000
59,49,800
2,000
1140
57,00,000
3,000
2,28,000
59,31,000
2,500
1140
57,00,000
2,400
2,85,000
59,87,400
3,000
1120
56,00,000
2,000
3,36,000
59,38,000
4,000
1120
56,00,000
1,500
4,48,000
60,49,500
Carrying
Cost
Total
Cost
Rs.
It will be observed, that if the purchases are made in the lot size of 1,000 units, it proves to be
most economical.
484
(4)
A company needs 24,000 units of raw materials which costs Rs. 20 per unit and ordering
cost is expected to be Rs. 100 per order. The company maintains safety stock of 1 months
requirements to meet emergency. The holding cost of carrying inventory is supposed to
be 10% per unit of average inventory. Find out :
1.
Economic lot size.
2.
Ordering cost.
3.
Holding cost.
4.
Total cost.
The supplier of raw material has agreed to supply the goods at a discount of 5% in price
on a lot size of 4,000 units. Find where the concession price should be availed.
Solution :
(a)
(1)
Economic Lot Size

2xAxO
Ci
=
2 x 24,000 x 100
10% of 20
= 1,550 units (Approx.)

(2)
Ordering Cost
Annual requirement
EOQ
x Ordering cost per order

= 24,000
1550
x 100
= Rs. 1,548 (Approx.)

(3)
Holding Cost :
As the company maintains safety stock of one months requirement, the average inventory
held at any point of time will not only be EOQ/2 but safety stock + EOQ/2. Assuming that the
usage of raw material is steady throughout the year i.e. 2,000 units per month, holding cost
will be :
(Safety Stock + EOQ/2) Carrying cost per unit per year)
485
(4)
1,550 units
(2,000 units +
2,775 units x Rs. 2
Rs. 5,550
) x 10% of Rs. 20
Total Cost :
Cost of material 24,000 x 20
Rs. 4,80,000
Ordering Cost
Rs.
1,548
Holding Cost
Rs.
5,550
Total Cost
Rs. 4,87,098
(b)
Revised Total Cost : (with 5% discount)
(1)
Ordering Cost :
As order size is going to be 4,000 units, total 6 orders will be placed. Hence total
ordering cost will be :
6 orders x Rs. 100 per order i.e. Rs. 600
(2)
Holding Cost :
The holding cost will be as below :
(Safety Stock +
(3)
486
Order Size
) x Carrying cost per unit per year.
2
(2,000 units +
Rs. 7,600
4,000 units
) x 10% of Rs. 19
2
Total Cost :
Cost of material 24,000 x 19
Rs. 4,56,000
Ordering Cost
Rs.
600
Holding Cost
Rs.
7,600
Total Cost
Rs. 4,64,200
Conclusion :
If purchased in Economic Lot Size, total cost (including material cost) is Rs. 4,87,098.
If purchased in Lot Size of 4,000 units with 5% discount, total cost (including material cost) is
Rs. 4,64,200.
As purchases in Lot Size of 4,000 units result in the saving of Rs. 22,898 (i.e. Rs. 4,87,098 Rs. 4,64,200) that alternative will be preferred.
PROBLEMS
(1)
XYZ Ltd. requires 20,000 units of product A per annum. The purchase price is Rs. 4 per
unit. The inventory carrying cost is 20% per annum and the cost of ordering is Rs. 100
per order. Advise the company, on how many times they should order in a year, so as to
minimise the cost of product A?
(2)
A manufacturer buys certain essential spares from outside suppliers at Rs. 40 per set.
Total annual requirements are 45000 sets. The annual cost of investment in inventory is
10% and costs like rent, stationery, insurance, taxes etc. per unit per year work to
Re. 1, cost of placing an order is Rs. 5. Calculate the Economic Order Quantity.
(3)
Following information relating to a raw material is available.

Annual Demand
2,400 units
Unit Price
Rs. 2.40
Ordering cost per order
Rs. 4.00
Storage cost
2% p.a.
Interest Rate
10% p.a.
Lead Time
Half month
Calculate Economic Order Quantity and total annual inventory cost in respect of the
particular raw material.
(4)
From the particulars given below, your are required to compute.

(a)
Economic Order Quantity.
(b)
Maximum Level.
(c)
Minimum Level.
(d)
Re-ordering Level.
(e)
Average stock level.
487
(i)
Quantity required annually 3,000 units @Rs. 5 per unit.
(ii)
Interest and cost of carrying one unit - 10%
(iii)
Cost of placing an order at Rs. 30 per order.
(iv)
Consumption per week
Normal 60 units.
Maximum 70 units.
Minimum 50 units.
(v)
Lead time (in weeks)
Normal 5
Maximum 6
Minimum 4
(5)
Following information is available in respect of two components A and B.

Particulars
Normal Usage
units
50
50
Minimum Usage
units
25
25
Maximum Usage
units
75
75
Week
46
24
Units
9,000
6,250
Ordering cost per year
Rs.
45
100
Carrying cost per unit per year
Rs.
Lead Time
Annual Consumption
Calculate for each component

(i)
Re-order level.
(ii)
Minimum level
(iii) Maximum level

(iv)
(6)
488
Average level
P. Ltd. uses three types of materials A, B and C for production of X, the final product. The
relevant monthly data for the components are as given below.
A
Normal Usage (Units)
200
150
180
Minimum Usage (Units)
100
100
90
Maximum Usage (Units)
300
250
270
Re-order Quantity (Units)
750
900
720
Re-order period (Months)
2 to 3
3 to 4
2 to 3
Calculate for each component.
(7)
(1)
Reorder Level.
(2)
Minimum Level
(3)
Maximum Level
(4)
Average Stock Level
The Following data are available from the records of M/s. Naveen Industries Ltd., using
two types of materials A and B for the manufacture of their product.
A
Normal Usage (units per month)
250
200
Minimum Usage (Units per month)
100
200
Maximum Usage (Units per month)
350
400
Reorder Quantity (Units)
900
1000
Reorder Period (Months)
Compute for each type of material, the following levels.
(8)
(1)
Reorder Level.
(2)
Minimum Level.
(3)
Maximum Level
(4)
Average Stock Level.
Following details are available in respect of a material.

(i)
Ordering cost per order Rs. 45
(ii)
Annual consumption 9,000 units.
(iii) Carrying cost per unit per year Rs. 9

(iv)
Lead Times
Average 10 days
Minimum 6 days
Maximum 15 days
Maximum for emergency purchases 4 days.
489
Calculate
(i)
Re-ordering Level
(ii)
Maximum Level.
(iii) Minimum Level.

(iv)
(9)
Average Level.
Certain purchased part of which annual requirements are 8,000 units, involves ordering
cost equal to Rs. 12.50 per order, cost per piece Re. 1 and the annual carrying cost
20%. In addition, average daily usage is 32 units (based on 250 operating days per
year), lead time is 10 days and safety stock has been calculated to be 100 units.
Calculate :
a)
b)
Re-order point.
(10) (i)
(ii)
XYZ company buys in the lots of 500 boxes which is a 3 months supply. The cost
per box is Rs. 125 and the ordering cost is Rs. 150. The inventory carrying cost is
estimated at 20% of unit value. What is the total annual cost of the existing inventory
policy?
How much money could be saved by employing the economic order quantity?
(11) To decide to buy an item, the following data are given.

Annual Demand 600 units.
Ordering Cost Rs. 400
Holding Cost Rs. 40%
Cost per unit Rs. 15.
Discount 10% if the order quantity is 500
What should be the decision? Justify your answer.
(12) A manufacturer requires 10 lakhs components for use during the next year which is
assumed to consist of 250 working days. The cost of storing one component for one
year is Rs. 4 and the cost of placing order is Rs. 32. There must always be a safety
stock equal to two working days usage and the lead time from the supplier, which has
been guaranteed, will be 5 working days throughout the year.
Assuming usage takes place steadily throughout the working days, delivery takes place
at the end of the day and orders placed at the end of working days, you are required to
calculate.
490
(i)
(ii)
Re-order Point
(13) Anil Company buys its annual requirement of 36,000 units in six instalment. Each unit
costs Re. 1 and the ordering cost is Rs. 25. The inventory carrying cost is estimated at
20% of the unit value. Find the total cost of existing inventory policy. How much money
can be saved by using Economic Order Quantity?
(14) A company for one of the A class items, placed 6 orders each of size 200 in a year.
Given ordering cost Rs. 600, holding cost 40% cost per unit Rs. 40, find out the loss to
the company in not operating scientific inventory policy. What are your recommendations
for the future?
(15) A manufacturer has to supply his customers 600 units of his product per year. Shortages
are not allowed and the inventory carrying cost amounts to Rs. 0.60 per unit per year.
The set up cost per unit run is Rs. 80. Find.
(a)
The Economic Order Quantity
(b)
The minimum average yearly cost.
(c)
The optimum number of orders per year.
(16) A purchase manager has decided to place order for minimum quantity of 500 numbers of
a particular item in order to get a discount of 10%. From the records, it was found that in
the last year, 8 orders each of size 200 numbers have been placed. Given ordering cost
Rs. 500 per order, Inventory carrying cost 40% of the inventory value and cost per unit
Rs. 400, is the purchase manager justified in his decision. What is the effect of his
decision to the company?
(17) A publishing house purchases 200 units of a particular item per year at a unit cost of
Rs. 20, the ordering cost per order is Rs. 50 and the inventory carrying cost is 25%. Find
the optimal order quantity and minimum total cost including purchase cost.
If a 3% discount is offered by the supplier for purchase in lots of 1000 or more, should the
publishing house accept the proposal?
(18) Calculate for each component A and B the following :
(a)
Re-order Level
(b)
Maximum Level.
(c)
Minimum Level
(d)
Average Stock Level
491
Normal Usage
300 units per Week each.
Maximum Usage
450 per Week each.
Minimum Usage
150 units per Week each.
Reorder Quantity
A - 2,400 units.
B - 3,600 units.
Reorder Period
A - 4 to 6 Weeks
B - 2 to 4 Weeks.
(19) Economic Enterprises require 90,000 units of certain item annually. The cost per unit is
Rs. 3, the cost per purchase order is Rs. 300 and the inventory carrying cost is Rs. 6 per
unit per year.
(i)
What is Economic Order Quantity?
(ii)
What should the firm do if the supplier offers discounts as below viz.
Order Quantity
492
Discount in %
4500 5999
6000 and above
3.
NOTES
493
NOTES
494
Chapter 15
DIVIDEND POLICY
Profits earned by a company may be handled by it basically in two ways.

(1)
To distribute the profits among the shareholders by way of dividend.
(2)
To retain the profits in the business to be used in future.
There are no strict rules and guidelines available to decide as to what portion of the profits
should be distributed by way of dividend and what portion should be retained in the business.
As such, to decide the dividend policy may be one of the most tricky and delicate decisions
which the management of the company may be required to take.
If the management decides to retain a large portion of the profits in the business, funds
required for future expansion and modernisation needs of the company may be available to it
on long term basis, without any obligations to repay the same. The expansion or modernisation
programmes may improve the earning capacity of the company in future which may carry
forward the growth of the company. The company may be able to absorb the shocks of
business fluctuations and adverse situations boldly. A strong and stable company may earn
the confidence of the investors and creditors and funds may be available to it at reasonable
rates conveniently. As a result, the share prices and the value of the company will increase.
Thus, though the shareholders are required to forego the dividends in the short run, they get
benefit in the long run.
On the other hand, if the management decides to distribute a large portion of profits by way of
dividend, the company may be able to earn the confidence of the shareholders and may be
able to attract the prospective investors to invest in the securities of the company. Shareholders
are necessarily interested in getting larger dividends immediately due to the time value of
money and also due to uncertainty regarding the future. Shareholders are thus attracted to the
companies paying high dividends, due to which prices of the shares and value of the company
increases.
Dividend Policy
495
Thus, it can be seen that both high retentions and high dividends may be desirable, but there
is necessarily a reciprocal relationship between the retentions and dividends Higher the
retentions, lower the dividends, Lower the retentions, higher the dividends. The skill of the
Finance Manager lies in striking the balance between these two extremes.
The Finance Manager has to decide the dividend policy very carefully. A wrong dividend policy
may put the company into financial troubles and the capital structure of the company may get
unbalanced. The growth of the company may get hampered if sufficient resources are not
available to implement growth programmes. This may affect earnings per share adversely. The
stock market may react to this immediately and the share prices and the value of the company
may decline. As such, the Finance Manager has to formulate the dividend policy in such a
way which coincides with the ultimate object of the finance function of maximizing the wealth
of shareholders and value of the firm.
However, there are conflicting opinions regarding the impact of dividend policy on the valuation
of the firm. According to one school of thought, dividends are irrelevant, so the dividends have
no impact on value of the firm. According to second school of thought, dividends are relevant
to the value of the firm measured in terms of market prices of the shares.
(A) Irrelevance Approach:
This approach is suggested mainly by Modigliani and Miller. According to this approach, the
value of the company remains unaffected by the dividend policy of the company. It is the
earnings potential and the investment opportunities available to the company which affects its
value and not the dividend policy.
Suppose, that a company wants to invest in a project, it has the two options open before it.
(i)
Pay the earnings and raise the funds from market.
(ii)
Retain the earnings to be used to finance the project.
If the company pays the dividend, it will have to go to the market for raising the funds. Acquisition
of the funds from the market will dilute the shareholding which results in reduced share values.
As such, whatever the shareholders receive by way of cash dividends, they loose in terms of
reduced share values. As such, they are not concerned with the fact whether the earnings are
retained or are distributed by way of dividend. The market price of the shares and as such
value of the company remains the same in both the situations.
It is worth recollecting here the Modigliam Miller approach in relation to capital structure which
suggests that the value of firm and its cost of capital are independent of its capital structure.
As such, in relation to dividend policy also, the source from which the funds required to
finance the investment programme are raised does not affect the value of the company.
496
(B) Relevance Approach :

This approach is suggested mainly by Walter and Gordon. They hold that there is a direct
relationship between the dividend policy of the company and its value in terms of market price
of its shares.
The propositions of the above approach can be stated, in most simple words as below.
The investors prefer current dividend income to future dividend income as it does not involve
any risk. As such, increasing payout ratio increases the share prices under normal
circumstances. However, if the company has the investment opportunities open before it
where expected rate of return is more than cost of capital, the share prices may increase even
with the declining payout ratio which is due to the anticipated and future dividend income.
Factors determining Dividend Policy
Before formulating the dividend policy of the company, the Finance Manager is required to
take into consideration various factors which may be classified as below
a.
External Factors
b.
Internal Factors
External Factors
1.
Phase of Trade Cycles : The companys dividend policy depends upon the phase of
trade cycles through which the company may be moving. During the phase of boom and
prosperity, the company may not like to distribute huge amount of profits by way of
dividends though the earning capacity of the company may permit it to do so. The
company will like to retain more profits which can be used during the depression which
is likely to follow. Further, the company will like to take the benefits of investment
opportunities prevailing during the period of boom. Similarly, during the period of depression,
the company will like to withhold the dividend payments to retain the profits in the business
in order to preserve its liquidity position. At all the times, though it may be necessary to
declare higher dividends to increase marketability of its shares.
2.
Legal Restrictions: The Company can formulate its dividend policy within the overall
legal framework. If the company wants to pay the dividend in cash, relevant provisions of
Companies Act, 1956 are required to be followed by the company. If the company wants
to issue the bonus shares with the intention to capitalise its reserves, relevant SEBI
guidelines are required to be followed by the company. The relevant provisions of Companies
Act, 1956 and SEBI guidelines are discussed later.
3.
Tax Policy: Tax policy as a factor affecting the dividend policy of the company needs to
Dividend Policy
497
be considered from the point of view of company as well as the shareholders. From
companys point of view, dividend can be paid out of profit after tax. As such, tax policy
of the government necessarily affects the dividend policy of the company. From the
shareholders point of view, dividend received by them is considered to be a taxable
income which increases their individual tax liability.
4.
Investment Opportunities : Formulation of dividend policy of the company depends

upon the investment opportunities available to the company. If the investment opportunities
involve a higher rate of return than the cost of capital of the company, the company will
like to retain the profits to be invested in these projects.
5.
Restrictions imposed by the lending institutions : In practical circumstances, the

lending banks or financial institutions impose certain restrictions on the company
preventing the payment of dividend entirely or limiting the amount of dividend or disallowing
the payment of dividend if certain conditions are not fulfilled. This is due to the fact that
the payment of dividend amounts to the withdrawal of profits from the business and
company paying the dividend may be against the interest of the lending banks or financial
institutions so long as the loans are still unpaid to them.
Internal Factors
498
1.
Attitude of the Management : If the attitude of the management is aggressive, it may

decide to pay more dividend as the management be interested in increasing the recurring
income of the shareholders. Whereas if the attitude of the management is conservative,
the company will like to retain more profits in the business to take care of the contingencies.
2.
Composition of Shareholding : The composition of the shareholding may play an

important role in the dividend policy formulation of the company. If the company is a
private limited company having less number of shareholders, the company will like to
retain more profits and restrict the payment of dividend in order to reduce the tax liability
of the individual shareholders, as the dividend received by the shareholders is a taxable
income in their hands. If the company is a public limited company, tax brackets of the
individual shareholders may not have a significant impact on the dividend policy of the
company.
3.
Age of the Company : A young and growing concern will like to retain maximum profits
in the business in order to finance its growth and expansion needs as it may be difficult
for it to raise the funds from the open market whenever the need arises. On the other
hand, an old or established company having reached the saturation point, may follow a
high dividend policy.
4.
Nature of Business / Earnings : The nature of business of the company inevitably

affects its dividend policy. A company having stability of earnings may be able to formulate
long term dividend policy and may even follow a high dividend policy if the earnings so
permit. On the other hand, a company having unstable income may like to retain its
profits during boom to ensure that dividend policy is not affected by cyclical variations.
5.
Growth Rate of Company : The growth rate of the company closely affects its dividend
policies. A rapidly growing company may like to retain majority of its profits in order to
take care of its expansion needs. However, care should be taken by the management to
invest only in those projects which yield more returns than its cost of capital.
6.
Liquidity Position : Profitability and Liquidity are separated from each other. In spite of
existence of high profitability or huge reserves, the company may not have sufficient
funds to pay cash dividends. As such, before formulating the dividend policy, due
considerations should be given to the liquidity positions of the company. At the same
time, future commitments affecting the liquidity should also be considered. E.g. At present,
companys cash position may be comfortable, but it may need cash within a short time
to pay instalments of term loans or to pay creditors for materials. In such case, Finance
Manager may not like to impair its liquidity for making dividend payment.
7.
Customs and Traditions : In some cases, the customs and traditions built by the
company may affect its dividend policy. E.g. If the company is following the stable dividend
policy for 20 years, it may like to maintain the trend in 21st year also, inspite of adverse
profitability or liquidity situations.
Choosing the Dividend Policy :

As discussed above, a host of factors are required to be considered by the company before
formulating its dividend policy. The selection of ultimate dividend policy varies from industry to
industry. There may be various pattern in which a company may pay dividends.
(1)
Stable Dividend Policy :
According to this policy, the company pays a fixed amount of dividend irrespective of the
fluctuations in income. During the periods of prosperity, the company withholds extra income
to be used for paying dividends in lean years. Stable dividend policy does not indicate stagnation
in dividend payout. If the company is assured about permanent increase in earnings, amount
of dividend per share may be increased.
Stable dividend policy helps the company in following respects :
(i)
The credit standing of the company in market increases. The investors are assured of a
stable income and the company can raise as much funds as required in the market.
(ii)
The share prices of the company increase. The marketability of the shares increase and
the investors are ready to pay high premium for these shares.
Dividend Policy
499
(iii) The management of the company enjoys confidence of the shareholders. This may
enable the company to raise the funds whenever required and it also improves the morale
of management.
(iv)
The company following stable dividend policy can formulate financial plan on long term
basis as future demand and supply of capital can be correctly estimated.
While formulating stable dividend policy, care should be taken not to fix the dividend payout
ratio at a very high level which can not be maintained in lean period. For this purpose, correct
estimations of earnings capacity and future earnings of the company should be made.
2.
No Immediate Dividend Policy :
According to this policy, the company does not pay any dividend despite the huge earnings.
The company retains the earnings to be used in future for its growth and expansion programmes
if it is feared that the access to capital market will be difficult or costly in future. The main
drawback with this policy is that the shareholders do not get immediate cash income by way
of dividend and hence shareholders who invest in the shares with the view to get regular
income may not be in favour of this policy. However, this policy may attract the shareholders
who are willing to devote short term dividend income for long term capital gains and share in
the increased prosperity of the company.
3.
Regular and Extra Dividend Policy :
This policy may be used as supplement to stable dividend policy. In case of a stable dividend
policy, the dividend pay out its maintained at a constant rate. However, if in a particular year,
the earnings of the company increase abnormally, the additional earnings may be distributed
by way of extra dividends rather than increasing the dividend payout rate itself.
The advantage attached with the policy is that the shareholders are aware of the fact the extra
dividends are solely due to the abnormal earnings which may be dropped if there are no
abnormal earning in a particular year. However, if a company follows a policy of regular and
extra dividends for years together, a wrong impression may be created in the minds of
shareholders who may treat the extra dividends as a part of regular dividends and the omission
to pay extra dividend in some year may result into loss of confidence of the shareholders with
the adverse effect on share prices and credit standing of the company.
4.
Regular Stock Dividend Policy :
According to this policy, the company may decide to pay dividends in the form of stock rather
than in the form of cash i.e. by issuing bonus shares. This policy may be useful to the
company as it does not involve the effect on liquidity position of the company. However,
following its policy on a regular basis may prove to be disadvantages due to two reasons.
500
Firstly, if the company is not in the position to increase future earnings on a permanent basis,
issue of Bonus shares may reduce the earnings per share which may adversely affect the
share prices and credit standing of the company. Secondly, the shareholders who are interested
in getting cash income on regular basis may not approve of this policy on a permanent basis
and may demand cash dividends.
5.
Irregular Dividend Policy :
According to this policy, the dividend payout rate is not fixed by the company. The dividend per
share varies according to the level of earnings. As such, high earnings may result into high
dividends whereas less earnings may result into less or no dividends.
As such, this policy believes that the shareholders are entitled to dividends only when the
earnings and liquidity position of the company justify the payment of dividends. This policy
may be followed by the companies having unstable income.
This policy may be advantageous for the company as it does not commit itself to any fixed
and regular payment of dividend. However, it may not be approved by the shareholders as it
does not assure any fixed or regular dividend income.
Forms of dividend payment
If a company wants to distribute the profits among the shareholders by way of dividend, it can
do so in two forms
a.
Payment of dividend in cash
b.
Issue of Bonus Shares
Cash Dividend
If the company wants to distribute the dividend by way of cash i.e. by issuing the dividend
warrants, the company is required to fulfill various procedural and legal formalities.
a.
The rate of dividend to be paid needs to be decided by the Board of Directors. However,
the capacity of the Board of Directors is only the recommendary capacity. The dividend
is declared by the shareholders in their meeting i.e. Annual General Meeting. However,
the shareholders can not increase the rate of dividend recommended by Board of Directors.
According to the provisions of Section 205-1(B) of the Companies Act, 1956, the Board
of Directors can declare the interim dividend. The term interim dividend refers to the
dividend declared in between two Annual General Meetings.
b.
The dividend is payable out of the current years profit after providing for sufficient amount
of depreciation as per the provisions of Schedule XIV of the Companies Act, 1956.
Dividend Policy
501
c.
d.
e.
Before any dividend is paid in cash, the company is required to transfer a certain minimum
amount to reserves from the profits earned in the current year. This provision is made to
ensure that the company does not withdraw the entire amount of profits from the business.
The rates at which the profits needs to be transferred to reserves, are stated below :
Rate of dividend
To be paid
% of current profits to be
transferred to reserves
More than 10% but less than 12.5%
2.5%
More than 12.5% but less than 15%
5%
More than 15% but less than 20%
7.5%
More than 20%
10%
Generally, the company will not be able to pay the dividend unless the company has the
profits in the current year. However, in some cases, the company can pay the dividend
out of the profits earned by the company in the past and retained as reserves. If the
company pays the dividends out of the retained profits, the company needs to comply
with following conditions:
(i)
The rate of dividend declared shall not exceed the average rate at which the dividend
was declared during 5 immediately preceding years or 10% of its paid up capital.
(ii)
The total amount to be drawn from the reserves shall not exceed an amount equal
to 10% of its paid up capital and free reserves.
Any amount of dividend declared including interim dividend shall be deposited in a separate
bank account within five days from the date of declaration of such dividend and the
amount so deposited shall be used for the payment of interim dividend.
If the dividend has been declared but has not been paid or the dividend warrants are not
posted within 30 days from the declaration of dividend to any shareholder entitled to the
payment of dividend, every director of the company who is knowingly a party to the
default, shall be punishable with simple imprisonment upto three years and also to a fine
of Rs. 1000 for every day during which the default continues. Further, the company shall
be liable to pay simple interest @18% p.a. during the period for which the default
continues.
f.
502
Any dividend which has been declared by the company but which remains to be paid or
claimed within 30 days from its declaration, the company shall, within 7 days from the
expiry of such 30 days, transfer this amount of unpaid or unclaimed dividend to a separate
account opened with a scheduled bank. If any amount remains pending in this account
for a period of 7 years, such amount will be transferred by the company to a fund
established by the Central Government as Investor Education and Protection Fund

which is supposed to be used for promotion of investors awareness and protection of the
interests of the investors.
Bonus Shares :
Bonus Shares indicate the payment of dividend in the form of shares of the same company in
proportion to their existing shareholding. This form of paying the dividend does not involve any
outflow of cash, but involves only transfer of retained earnings to share capital. Profits earned
by a company in the previous years effectively belong to the equity shareholders as they are
the ultimate owners of the company. However, so long as the reserves appear on the balance
sheet of the company, the legal ownership of the reserves remain with the company. By
issuing the bonus shares, the company transfers ownership of reserves to the shareholders
legally. As such, issue of bonus shares is technically referred to as the capitalisation of
reserves. When a company issues bonus shares, reserves of the company get reduced and
share capital of the company increases.
Advantages :
(1)
To the Company :
(i)
Conservation of Cash : The company can satisfy the desire of shareholders for
dividend without affecting its cash position. Thus, issuing of bonus shares may be
a best remedy for a company having deficiency of the funds inspite of the huge
earnings.
(ii)
Remedy for Undercapitalisation : As discussed earlier, the conditions of

undercapitalisation indicate huge amount of earnings per share. By issuing bonus
shares, the company increases number of shares thereby reducing the amount of
earnings per share and the amount of dividends per share. Thus bonus shares can
be a best remedy for overcoming the situation of undercapitalisation.
(iii) Transferring Ownership of Reserves : Existence of huge reserves may tempt a

company to indulge itself in the speculative activities and manipulation of market
value of shares. Issuing the bonus shares prevents the company from doing so.
(iv) Increased Marketability : Bonus shares may increase the marketability of the
shares. Increased number of shares and reduced earnings per share may keep the
market price of the shares within the reach of an ordinary investor. Thus, the market
for the shares of the company may become wide.
(v)
Increased Prestige : Issuance of bonus shares increases the credit standing of

the company in the eyes of the lending financial institutions and it can arrange for
the funds at a reasonable cost.
Dividend Policy
503
(vi) Proper Presentation of Earning Capacity : Issuance of bonus shares results

into proper presentation of earning capacity of the company. If bonus shares are
not issued, the accumulated reserves go on increasing with no change in shares
capital which may create a false idea about the profitability and earning capacity of
the company.
To Shareholders :
Due to bonus shares, shareholders are benefited from two angles. First, their equity holding in
the company increases. Though they may get dividend per share at a reduced rate, their total
income is not affected. Second, the increased prestige of the company in the eyes of probable
investors creates a ready market for their shareholding.
To Creditors :
Creditors react favourably as companys liquidity position is not affected and the margin of
safety available for the creditors increases. But if the company continues to pay dividend at
old rates on increased capital, it increases the strain on liquidity position of company.
Disadvantages :
(1)
Issue of bonus shares presupposes that the earnings of the company will increase
proportionately, otherwise the increased capital may not be justified. If the earnings per
share are not increased with respect to the increased capital, it may suggest low profitability
of the company and its poor management. This may prove to be fatal to the company.
(2)
The stock dividends are more expensive to administer as compared to cash dividends.
Guidelines for the issue of Bonus Shares :

Earlier, the companies issuing bonus shares were governed by the guidelines issued by
Controller of Capital Issues (CCI), After the abolition of office of CCI, these guidelines were
replaced by SEBI guidelines. Whereas the guidelines issued by CCI were restrictive in nature,
the guidelines issued by SEBI are more administrative in nature. Eventhough the guidelines
issued by SEBI are more particularly applicable to the companies listed on the recognised
stock exchanges, they equally apply to non-listed companies as well. The SEBI guidelines in
respect of issue of bonus shares are as below :
504
a.
Articles of Association of the company should permit the issue of bonus shares. If there
is no provision in the Articles of Association, they need to be amended first.
b.
The authorised share capital of the company should be sufficient to absorb the share
capital of the company after the issue of bonus shares. If the authorised share capital is
not sufficient, the same needs to be increased first.
c.
The bonus shares can not be issued in respect of partly paid shares.
d.
The issue of bonus shares needs to be approved by the board of directors and the
company should issue the bonus shares within a period of six months from the date of
approval given by the board of directors. Approval given by the board of directors can not
be reversed.
e.
Bonus shares can be issued out of the free reserves appearing on the balance sheet and
the share premium amount collected in cash. It is made very clear in the SEBI guidelines
that revaluation reserve can not be used for issue of bonus shares.
f.
The company can not issue the bonus shares if it has defaulted i)
in respect of payment of interest or repayment of principal amount, either in case of

debentures or in case of public deposits. This provision is to protect the interests of
debenture holders or depositors.
ii)
in respect of payment of employee dues, like provident fund, gratuity, bonus etc.
This provision is to protect the interests of employees.
g.
Pending the conversion of Fully Convertible Debentures (FCDs) or partly Convertible

Debentures (PCDs) into the shares of the company, no company can issue the bonus
shares unless the same benefit is extended to holders of these FCDs or PCDs by
reserving a part of shares for them. Such shares can be actually issued when the
conversion into shares takes place.
h.
A company which is a listed company shall forward a certificates duly signed by the
company and countersigned by its statutory auditor or a company secretary in practice,
certifying that the company has compiled with all the terms and conditions in respect of
issue of bonus shares.
When CCI guidelines were applicable, no company could issue the bonus shares in the
proportion of more than 1:1 i.e. for every one share held in the company, maximum one bonus
share could be issued by the company. This restriction was removed by SEBI guidelines.
First company to take the advantage of these revised SEBI guidelines was Cipla Ltd., which
issued the bonus shares in the proportion of 5:1, i.e. for every one shares held in the company,
the shareholders got five bonus shares.
Dividend Policy
505
QUESTIONS
506
1.
Discuss the significance of dividend policy decisions. Which factors affect dividend policy
decisions of a company? What are the different dividend policies a company can follow?
2.
Discuss various legal and procedural formalities to be complied with by a company while
paying the dividend in cash.
3.
What do you mean by Bonus shares? What are the advantages of Bonus shares. Discuss
SEBI guidelines for the issue of Bonus shares.
NOTES
Dividend Policy
507
NOTES
508
LIST OF REFERENCE BOOKS
1.
Prasanna Chandra
2.
I.M. Pandey
3.
S.C. Kucchal
4.
Khan & Jain
5.
R.M. Shrivastava
Reference Books
509
NOTES
510
NOTES
Reference Books
511
NOTES
512

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Financial Management

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FINANCIAL

PROF. SATISH INAMDAR

(FOR PRIVATE CIRCULATION ONLY)

Symbiosis Center for Distance Learning,

Symbiosis Center for Distance Learning (SCDL)

Prof. Satish Inamdar

ABOUT THE AUTHOR

Mrs. Swati Chaudhari

Forms of Business Organisation

Interpretation of Financial Statements (Ratio Analysis)

Interpretation of Financial Statements

Illustrative Problems with Solutions

Sources of Long Term and Medium Term Finance

Working Capital Management

Illustrative Problems with Solutions

It considers the financial problems only of corporate enterprises. In that sense, it

Dividend Policy Decisions

Why the need for working capital arises?

What are the factors affecting the requirement of working capital?

How to quantify the requirement of working capital?

Working capital management is concerned with the management of current assets

DIVIDEND POLICY DECISIONS

GOALS/OBJECTS OF FINANCE FUNCTION :

Accounting and Costing

(1) Receivables management

(2) Taxes and Insurance

(3) Cost management

Statistics and Finance

(5) Banking Relations

(6) Real Estates

DUTIES AND RESPONSIBILITIES OF FINANCE EXECUTIVE :

Allocation of Income : Allocation of the income of the company is the exclusive

Evaluation of Performance : The financial executive may be required to evaluate and

Corporate Taxation : As the company is a separate legal entity, it is subjected to the

International Finance : International finance is the study of flow of funds between

Private Finance : It deals with the financial matters of non-government organisations.

FINANCE FUNCTION IN RELATION WITH OTHER FUNCTIONS

Explain the meaning, nature and scope of Business Finance.

Explain the traditional and modern concept of finance function.

State the relation of finance function to other functions of a business enterprise.

Describe the organizational structure of finance department of a large business concern.

How is finance function organized in business firms?

Joint Stock Companies

Forms of Business Organisation

On the balance amount of book profit, at the rate of 40%.

In case of any other firm :

On the balance amount of book profit, at the rate of 40%.

Forms of Business Organisation

JOINT STOCK COMPANIES

Segregation of ownership and management is a typical feature of joint stock companies.

Transferability of shares is a feature of a joint stock company. A shareholder can transfer

Transferability of shares is a facility available to the shareholders. If the shareholders

Double Taxation is a typical characteristic feature of a company form of organization.

Private Limited Company

Public Limited Company

Forms of Business Organisation

PRIVATE LIMITED COMPANY

Minimum number of shareholders is 2 and the maximum number is 50.

that the shares to be transferred should be offered to the existing members on

A private limited company needs to have a minimum paid-up share capital of

PUBLIC LIMITED COMPANY

Minimum number of shareholders is 7 and there is no restriction on the maximum number

Critically evaluate the following forms of business organisations.

Joint Stock Companies