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STUDY NOTES
Financial Management
MBA/112 (MBA 2nd Sem.)
Department of Management
SHRI RAM COLLEGE OF ENGINEERING AND MANAGEMENT
SRCEM, Palwal
UNIT - I
THE FINANCE FUNCTION
INTRODUCTION:
In our present day economy, Finance is defined as the provision of
money at the time when it is required. Every enterprise, whether big,
medium or small needs finance to carry on its operations and to achieve its
targets. In fact, finance is so indispensable today that it is rightly said to be
the life blood of an enterprise.
MEANING OF FINANCE
TYPES OF FINANCE
Finance is one of the important and integral part of business concerns,
hence, it plays a major role in every part of the business activities. It is used
in all the area of the activities under the different names. Finance can be
Definition:
Finance may be defined as the provision of money at the time when it is required. Finance refers
to the management of flow of money through an organization
According to WHEELER, business finance may be defined as “that business activity which is
concerned with the acquisition and conservation of capita
Due to recent trends in business environment, financial managers are identifying new
ways through which finance function can generate great value to their organization.
1. Current Business Environment: The progress in financial analytics is
because of development of new business models, trends in role of traditional
finance department, alternations in business processes and progress in
technology.
Finance function in this vital environment emerged with enormous
opportunities and challenges.
2. New Business Model: At the time when internet was introduced, three
new e- business models have evolved. They are business-to-business (B2B),
business-to-
customer (B2C) and business-to-employees (B2E) future of financial
analytics can be improved with the help of this new model of business.
Traditionally, financial analytical is emphasizing on utilization of
tangible assets like cash, machinery etc, whereas some companies are
mainly focused on intangible assets which are not easy to evaluate
and control. Hence financial analytics solved this problem by:
i) Recognizing the complete performance of organization.
ii) Determining the source through which value of intangible assets
can be evaluated and increased.
iii) Predict the trends in market.
iv) The abilities of information system is encouraged.
v) Minimizes the operating costs and enterprise-wide investments are
effectively controlled and upgrade the business processes.
3. Changing Role of the Finance Department: The role of finance
function has been changing simultaneously with the changes in
economy. These changes are mainly due to Enterprise Resource Planning
(ERP), shared services and alternations in its reporting role.
In the field of transaction processing, the role of financial staff has
been widened up because of automated financial transactions. Now
financial executives are not just processing and balancing
transactions but they are focusing on decision- making processes.
1. Profit Maximization
Main aim of any kind of economic activity is earning profit. A business
concern is also functioning mainly for the purpose of earning profit. Profit is
the measuring techniques
to understand the business efficiency of the concern. Profit maximization is
also the traditional and narrow approach, which aims at, maximizes the
profit of the concern. Profit maximization consists of the following
important features.
1. Profit maximization is also called as cashing per share maximization. It
leads to maximize the business operation for profit maximization.
2. Ultimate aim of the business concern is earning profit, hence, it considers
all the possible ways to increase the profitability of the concern.
3. Profit is the parameter of measuring the efficiency of the business
concern. So it shows the entire position of the business concern.
4. Profit maximization objectives help to reduce the risk of the business.
The following important points are against the objectives of profit maximization:
(i) Profit maximization leads to exploiting workers and consumers.
(ii) Profit maximization creates immoral practices such as corrupt practice,
unfair trade practice, etc.
(iii) Profit maximization objectives leads to inequalities among the sake
holders such as customers, suppliers, public shareholders, etc.
(ii) It ignores risk: Profit maximization does not consider risk of the
business concern. Risks may be internal or external which will affect the
overall operation of the business concern.
2. Wealth Maximization
Most students agree that what $10, today, will buy will be more than what $10 will buy in 5
years in the future. Similarly, they also agree $10 would have got them a lot more 5 years ago
than what it will get them today. Since they agree that this is true, I tell them that they have
understood the time value of money concept! This is exactly what the time value of money
concept in finance is trying to show. As time flows the value of money declines.
The value of money declines due to the combined impact of the following:
The present value formula quantifies how fast the value of money declines. This formula shows
you how much once single cash payment (FV) received in a future time period (t) is worth in
today’s terms (PV).
Present Value (PV) stands for the value of the money in today’s terms.
Future Value (FV) stands for the amount of cash received in the future.
r is the discount rate or the speed at which the decline in value is happening (covered in detail
later).
t is the time period in which the future value or cash is received.
FVt = PV*(1+r)t
where:
PV = present value
Each period may be a year, a month, a week, etc. The terms in the formula must be consistent
with each other; for example, if it is measured in months, then r must be a monthly rate of
interest.
As an example, suppose that a sum of $1,000 is invested for four years at an annual rate of
interest of 3%. What is the future value of this sum? In this case, t = 4, r = 3% and PV = $1,000.
FVt = PV(1+r)t
FV4 = 1,000(1+.03)4
FV4 = 1,000(1.12551)
FV4 = $1,125.51
The Present Value of a Sum
Note that the present value is simply the inverse of the future value.
As an example, how much must be deposited in a bank account that pays 5% interest per year in
order to be worth $1,000 in three years? In this case, t = 3, r = 5% and FV3 = $1,000.
Present Value Or What must be deposited to get $1,000 = 1,000/(1.1576) = $863.84
Compounding refers to the frequency with which interest rates are charged or paid during a
given year. In practice, interest rates can be compounded anywhere from once per year to once
per day; the theoretical limiting case is known as continuous compounding, in which rates are
compounded at every instant in time. Compounding frequency is one of the most important
determinants of the future value and the present value of a sum.
For example, if a bank offers a 4% rate of interest with annual compounding, an investor who
holds $1,000 in the bank for one year will have a balance of: $1,000(1 + 0.04) = $1,040 at the
end of the year. In other words, the future value of this sum is $1,040.
If the interest is compounded semi-annually, then the investor will receive half of the annual rate
twice per year; i.e., 2% every six months during the year. At the end of six months, the investor
will have a balance of: $1,000(1 + 0.02) = $1,020 at the end of the year, the investor will have a
balance of: $1,020(1 + 0.02) = $1,000(1 + 0.02)(1 + 0.02) = $1,000(1 + 0.02)2 = $1,040.40
In this case, since the principal is $1,000, the total interest is $40.40. Of this:
As the compounding frequency increases, the simple interest earned during a given period
remains fixed, but the compound interest increases. For example, with quarterly compounding,
the investor in the previous example will receive 1% every three months; at the end of the year
the investor will have a balance of:
As another example, suppose that a sum of $1,000 is invested for two years at an annual rate of
interest of 8%. What is the future value of this sum based on the following compounding
frequencies?
Annual compounding
Semi-annual compounding
Monthly compounding
With annual compounding, t = 2, r = 8% and PV = $1,000.
FVt = PV*(1+r)^t
FV2 = 1,000*(1+.08)^2
FV2 = 1,000*(1.16640)
FV2 = $1,166.40
With semi-annual compounding, t = 4, r = 4% and PV = $1,000. The time frame is now 4 semi-
annual periods, and the rate of interest is 4% per semi-annual period.
FVt = PV*(1+r)^t
FV4 = 1,000*(1+.04)^4
FV4 = 1,000*(1.16986)
FV4 = $1,169.86
With monthly compounding, t = 24, r = 0.6667% and PV = $1,000.
FVt = PV*(1+r)^t
FV24 = 1,000*(1+.006667)^24
FV24 = 1,000*(1.17289)
FV24 = $1,172.89
These results show that the future value of a sum continues to increase as the compounding
frequency increases.
For the present value, a higher compounding frequency reduces the present value. This is
because more compound interest is earned, which reduces the amount that must be saved today
to be worth a specified sum in the future.
As an example, suppose that an investor has a target of $100,000 in five years, and can invest in
a bank account that pays an annual rate of interest of 6%. How much must the investor save
today in order to reach this goal based on the following compounding frequencies?
Annual compounding
Semi-annual compounding
Monthly compounding
With annual compounding, t = 5, r = 6% and FV5 = $100,000.
PV = FVt / (1+r)^t
PV = 100,000 / (1+.06)^5
PV = 100,000 / 1.33823
PV = $74,725.82
With semi-annual compounding, t = 10, r = 3% and FV10 = $100,000.
PV = FVt / (1+r)^t
PV = 100,000 / (1+.03)^10
PV = 100,000 / 1.34392
PV = $74,409.39
With monthly compounding, t = 60, r = 0.5% and FV60 = $100,000.
PV = FVt / (1+r)^t
PV = 100,000 / (1+.005)^60
PV = 100,000 / 1.34885
PV = $74,137.22 (Article Index)
Annuities:
An annuity is a periodic stream of equally-sized payments. The word annuity is derived from the
Latin word annum (yearly). In spite of this, any stream of periodic payments of equal size can be
treated as an annuity. As an example, mortgage payments are made monthly and are of equal
size, and so can be thought of as a type of annuity.
Ordinary annuity
Annuity due
Ordinary Annuities
With an ordinary annuity, the first payment takes place one period in the future. Most annuities
are ordinary; some examples are:
The formula for computing the future value of an ordinary annuity is:
where:
As an example, suppose that a sum of $1,000 is invested each year for four years, starting next
year, at an annual rate of interest of 3%. Since the cash flows start next year, this is an ordinary
annuity. What is its future value? In this case, t = 4, r = 3% and C = $1,000.
Alternatively, the future value of each individual cash flow can be computed and then combined
as follows:
The first cash flow is invested for three years (from year one to year four):
FV3 = PV(1+r)t
FV3 = 1,000(1+.03)3
FV3 = 1,000(1.09273)
FV3 = $1,092.73
The second cash flow is invested for two years (from year two to year four):
FV2 = PV(1+r)t
FV2 = 1,000(1+.03)2
FV2 = 1,000(1.06090)
FV2 = $1,060.90
The third cash flow is invested for one year (from year three to year four):
FV1 = PV(1+r)t
FV1 = 1,000(1+.03)1
FV1 = 1,000(1.03)
FV1 = $1,030.00
The fourth and final cash flow does not earn any interest since it is not deposited into the bank
until year four. The future value is therefore $1,000.
The formula for computing the present value of an ordinary annuity is:
where:
PVAt = present value of a t-period ordinary annuity
As an example, how much must be invested today in a bank account that pays 5% interest per
year in order to generate a stream of payments of $1,000 in each of the following three years? In
this case, t = 3, r = 5% and C = $1,000.
Alternatively, the present value of each individual cash flow can be computed and then
combined as follows:
The present value of the first cash flow (paid in one year) is:
PV = FVt / (1+r)t
PV = 1,000 / (1+.05)1
PV = 1,000 / 1.05
PV = $952.38
The present value of the second cash flow (paid in two years) is:
PV = FVt / (1+r)t
PV = 1,000 / (1+.05)2
PV = 1,000 / 1.10250
PV = $907.03
The present value of the third cash flow (paid in three years) is:
PV = FVt / (1+r)t
PV = 1,000 / (1+.05)3
PV = 1,000 / 1.15763
PV = $863.84
The sum of these present values is:
Annuities Due
With an annuity due, the first payment takes place immediately. This is a less common type of
annuity than the ordinary annuity. An example of this would be a lease agreement or a loan
where the first payment is due immediately.
Due to the timing of the cash flows, the present value and future value of an annuity will be
affected by whether the annuity is an ordinary annuity or an annuity due.
Referring to the previous example, the future value of an annuity due would be: 4,183.63(1+.03)
= $4,309.14
This can be confirmed by computing the future value of each cash flow individually. Each cash
flow will be invested for one additional year compared with the ordinary annuity.
The first cash flow is invested for four years (from today to year four):
FV4 = PV(1+r)t
FV4 = 1,000(1+.03)4
FV4 = 1,000(1.12551)
FV4 = $1,125.51
The second cash flow is invested for three years (from year one to year four):
FV3 = PV(1+r)t
FV3 = 1,000(1+.03)3
FV3 = 1,000(1.09273)
FV3 = $1,092.73
The third cash flow is invested for two years (from year two to year four):
FV2 = PV(1+r)t
FV2 = 1,000(1+.03)2
FV2 = 1,000(1.06090)
FV2 = $1,060.90
The fourth cash flow is invested for one year (from year three to year four):
FV3 = PV(1+r)t
FV3 = 1,000(1+.03)1
FV3 = 1,000(1.03)
FV3 = $1,030.00
The sum of these future values is:
Referring to the previous example, the present value of an annuity due would be:
2,723.25(1+.05) = $2,859.41
Alternatively, the present value of each individual cash flow can be computed and then
combined as follows:
The first cash flow is withdrawn immediately, so the present value equals $1,000.
The present value of the second cash flow (paid in one year) is:
PV = FVt / (1+r)t
PV = 1,000 / (1+.05)1
PV = 1,000 / 1.05
PV = $952.38
The present value of the third cash flow (paid in two years) is:
PV = FVt / (1+r)t
PV = 1,000 / (1+.05)2
PV = 1,000 / 1.10250
PV = $907.03
The sum of these present values is:
Perpetuities
A perpetuity is an investment in which interest payments are made forever, but principal is not
repaid. As an example, a stock that pays a regular stream of constant dividends can be thought of
as a perpetuity. This is because the same cash flows are paid each year, and the stock has an
infinite lifetime. Another example is a consol, which is a bond that makes interest payments
forever but does not repay the principal.
PV = C/r
As an example, suppose that a perpetuity pays $100 per year; assume that the appropriate rate of
interest is 5% per year. The present value of the perpetuity is $100/0.05 = $2,000.
PV = C/(r – g)
where:
As an example, suppose that a perpetuity currently pays $50 per year; assume that the
appropriate rate of interest is 7% per year, and that the cash flow paid by the perpetuity is
estimated to grow at a rate of 3% per year. The present value of the perpetuity is: $50/(0.07 –
0.03) = $1,250.
In order to compare interest rates with different compounding frequencies, they can be converted
into an effective annual rate (EAR); this reflects the true cost of borrowing (or the return to
lending) when interest is compounded more than once per year. EAR is computed from APR as
follows:
where:
As an example, suppose that a bank charges an APR of 6% per year, compounded quarterly for a
loan, what is the effective annual rate? This can be determined as follows:
This indicates that the borrower is actually paying 6.136% per year for this loan.
An effective annual rate may be converted to an annual percentage rate by inverting the previous
formula:
As an example, if a bank charges an EAR of 5.25% per year, compounded monthly for a loan,
what is the annual percentage rate? This can be determined as follows:
A business requires funds to purchase fixed assets like land and building, plant and machinery,
furniture etc. These assets may be regarded as the foundation of a business. The capital required
for these assets is called fixed capital. A part of the working capital is also of a permanent nature.
Funds required for this part of the working capital and for fixed capital is called long term
finance.
1. To Finance fixed assets : Business requires fixed assets like machines, Building, furniture
etc. Finance required to buy these assets is for a long period, because such assets can be used for
a long period and are not for resale.
2. To finance the permanent part of working capital: Business is a continuing activity. It must
have a certain amount of working capital which would be needed again and again. This part of
working capital is of a fixed or permanent nature. This requirement is also met from long term
funds.
1. Shares: These are issued to the general public. These may be of two types: (i) Equity and (ii)
Preference. The holders of shares are the owners of the business.
2. Debentures: These are also issued to the general public. The holders of debentures are the
creditors of the company.
3. Public Deposits : General public also like to deposit their savings with a popular and well
established company which can pay interest periodically and pay-back the deposit when due.
4. Retained earnings: The company may not distribute the whole of its profits among its
shareholders. It may retain a part of the profits and utilize it as capital.
5. Term loans from banks: Many industrial development banks, cooperative banks and
commercial banks grant medium term loans for a period of three to five years.
6. Loan from financial institutions: There are many specialised financial institutions
established by the Central and State governments which give long term loans at reasonable rate
of interest. Some of these institutions are: Industrial Finance Corporation of India ( IFCI),
Industrial Development Bank of India (IDBI), Industrial Credit and Investment Corporation of
India (ICICI), Unit Trust of India ( UTI ), State Finance Corporations etc.
UNIT – II
THE INVESTMENT DECISION (CAPITAL BUDGETING)
INTRODUCTION
1. Purchase of fixed assets such as land and building, plant and machinery,
good will, etc.
MEANING
The process through which different projects are evaluated is known as
capital budgeting. Capital budgeting is defined “as the firm’s formal process
for the acquisition and investment of capital. It involves firm’s decisions to
invest its current funds for addition, disposition, modification and
replacement of fixed assets”.
DEFINITION
Capital budgeting (investment decision) as, “Capital budgeting is
long term planning for making and financing proposed capital outlays.” --
--- Charles T.Horngreen
“Capital budgeting consists in planning development of available capital for
the purpose of maximizing the long term profitability of the concern” –
Lynch
4. Long-term effect: Capital budgeting not only reduces the cost but also
increases the revenue in long-term and will bring significant changes in the
profit of the company by avoiding over or more investment or under
investment. Over investments leads to be unable to utilize assets or over
utilization of fixed assets. Therefore before making the investment, it is
required carefully planning and analysis of the project thoroughly.
PROJECT GENERATION
PROJECT EVALUATION
Independent proposals are those which do not compete with one another and
the same may be either accepted or rejected on the basis of a minimum
return on investment required. The contingent proposals are those whose
acceptance depends upon the acceptance of one or more other proposals, eg.,
further investment in building or machineries may have to be undertaken as
a result of expansion programmed. Mutually exclusive proposals are those
which compete with each other and one of those may have to be selected at
the cost of the other.
PROJECT SELECTION
1. Fixing Priorities:
After evaluating various proposals, the unprofitable or uneconomic
proposals may be rejected straight ways. But it may not be possible for the
firm to invest immediately in all the acceptable proposals due to limitation
of funds. Hence, it is very essential to rank the various proposals and to
establish priorities after considering urgency, risk and profitability involved
therein.
PROJECT EXECUTION
3. Implementing Proposal:
Preparation of a capital expenditure budgeting and incorporation of a
particular proposal in the budget does not itself authorize to go ahead with
the implementation of the project. A request for authority to spend the
amount should further be made to the Capital Expenditure Committee which
may like to review the profitability of the project in the changed
circumstances.
4. Performance Review:
The last stage in the process of capital budgeting is the evaluation of
the performance of the project. The evaluation is made through post
Sales xxxx
PBDT xxxx
PBT xxxx
PAT xxxx
The ‘pay back’ sometimes called as pay out or pay off period method
represents the period in which the total investment in permanent assets pays
back itself. This method is based on the principle that every capital
expenditure pays itself back within a certain period out of the additional
MERITS
2. Pay-back method provides further improvement over the accounting rate return.
DEMERITS
Merits
Demerits
3. Different methods are used for accounting profit. So, it leads to some
difficulties in the calculation of the project.
Accept/Reject criteria
If the actual accounting rate of return is more than the predetermined
required rate of return, the project would be accepted. If not it would be
rejected.
By investing $5,000 today, you are getting in return a promise of a cash flow
in the future that is worth $5,785.12 today. You increase your wealth by
$785.12 when you make this investment.
Merits
Demerits
Accept/Reject criteria
If the present value of cash inflows is more than the present value of cash
outflows, it would be accepted. If not, it would be rejected.
Steps to be followed:
Step1. Find out factor Factor is calculated as follows:
Demerits
Accept/Reject criteria
If the present value of the sum total of the compounded reinvested cash
flows is greater than the present value of the outflows, the proposed project
is accepted. If not it would be rejected.
Key differences between the most popular methods, the NPV (Net
Present Value) Method and IRR (Internal Rate of Return) Method,
include:
• The IRR Method cannot be used to evaluate projects where there are
changing cash flows (e.g., an initial outflow followed by in-flows and a
later out-flow, such as may be required in the case of land reclamation by
a mining firm);
• While both the NPV Method and the IRR Method are both DCF models
and can even reach similar conclusions about a single project, the use of
the IRR Method can lead to the belief that a smaller project with a shorter
life and earlier cash inflows, is preferable to a larger project that will
generate more cash.
• The Profitability Index (PI) Method, which is modeled after the NPV
Method, is measured as the total present value of future net cash
inflows divided by the initial investment; this method tends to favor
smaller projects and is best used by firms with limited resources and
high costs of capital;
The decisions which involve risk-return trade off are explained below:
COST OF CAPITAL
The cost of capital of a firm is the minimum rate of return expected
by its investors. It is the weighted average cost of various sources of finance
used by a firm. The capital used by a firm may be in the form of debt,
preference capital, retained earnings and equity shares. The concept of cost
of capital is very important in the financial management. A decision to
invest in a particular project depends upon the cost of capital of the firm or
the cut off rate which is the minimum rate of return expected by the
investors.
DEFINITIONS
James C.Van Horne defines cost of capital as,”a cut-off rate for the
allocation of capital to investments of projects. It is the rate of return on a
project that will leave unchanged the market price of the stock.
According to Solomon Ezra, “Cost of capital is the minimum
required rate of earning or the cut-off rate of capital expenditures”.
� � =Σ� � /Σ�
� � � � , � � =� � � � � � � � � � � � � � � � � � � � � � � � � � �
COST OF DEBT
The cost of debt is the rate of interest payable on debt. For example,
a company issues Rs.1, 00,000 10%debentures at par; the before-tax cost of
this debt issue will also be 10%. By way of a formula, before tax cost of debt
may be calculated as:
� � � =� � � =� /�
� � � � � , � � � =� � � � � � � � � � � � � � � � � � � I=Interest P=Principal
In case the debt is raised at premium or discount, we should consider P as
the amount of net proceeds received from the issue and not the face value of
securities. The formula may be changed to
� � � =� /� � (� � � � � ,� � =� � � � � � � � � � � )
Further, when debt is used as a source of finance, the firm saves a
considerable amount in payment of tax as interest is allowed as a deductible
expense in computation of tax. Hence, the effective cost of debt is reduced.
The After-tax cost of debt may be calculated with the help of following
formula:
� � � =� /� � (� −� )
� � � � � , � � � =� � � � � � � � � � � � � � � � � � t= Rate of Tax
COST OF PREFERENCE CAPITAL
A fixed rate of dividend is payable on preference shares. Though
dividend is payable at the discretion of the Board of directors and there is no
legal binding to pay dividend, yet it does not mean that preference capital is
cost free. The cost of preference capital is a function of dividend expected
by its investors, i.e., its stated dividend. In case dividend share not paid to
preference shareholders, it will affect the fund raising capacity of the firm.
Hence, dividends are usually paid regularly of preference shares expect
when there are no profits to pay dividends. The cost of preference capital
which is perpetual can be calculated as:
� � = � /�
Where, � � = Cost of preference Capital D = Annual Preference
Dividend P = Preference Share Capital (Proceeds.) Further, if preference
shares are issued at Premium or Discount or when costs of floatation are
incurred to issue preference shares, the nominal or par value or preference
share capital has to be adjusted to find out the net proceeds from the issue of
preference shares. In such a case, the cost of preference capital can be
computed with the following formula:
� � = � /� �
The cost of equity is the „maximum rate of return that the company
must earn of equity financed portion of its investments in order to leave
unchanged the market price of its stock‟. The cost of equity capital is a
function of the expected return by its investors. The cost of equity is not the
out-of-pocket cost of using equity capital as the equity shareholders are not
paid dividend at a fixed rate every year. Moreover, payment of dividend is
not a legal binding. It may or may not be paid. But is does not mean that
equity share capital is a cost free capital. Share holders invest money in
equity shares on the expectation of getting dividend and the company must
earn this minimum rate so that the market price of the shares remains
unchanged. Whenever a company wants to raise additional funds by the
issue of new equity shares, the expectations of the shareholders have to
evaluate.
UNIT – III
Capital Structure refers to the amount of debt and/or equity employed by a firm to fund its
operations and finance its assets. The structure is typically expressed as a debt-to-equity or debt-
to-capital ratio.
Debt and equity capital are used to fund a business’ operations, capital expenditures,
acquisitions, and other investments. There are tradeoffs firms have to make when they decide
whether to raise debt or equity and managers will balance the two try and find the optimal capital
structure.
The optimal capital structure of a firm is often defined as the proportion of debt and equity that
result in the lowest weighted average cost of capital (WACC) for the firm. This technical
definition is not always used in practice, and firms often have a strategic or philosophical view of
what the structure should be.
In order to optimize the structure, a firm will decide if it needs more debt or equity and can issue
whichever it requires. The new capital that’s issued may be used to invest in new assets or may
be used to repurchase debt/equity that’s currently outstanding as a form or recapitalization.
Below is an illustration of the dynamics between debt and equity from the view of investors and
the firm.
Debt investors take less risk because they have the first claim on the assets of the business in the
event of bankruptcy. For this reason, they accept a lower rate of return, and thus the firm has a
lower cost of capital when it issues debt compared to equity.
Equity investors take more risk as they only receive the residual value after debt investors have
been repaid. In exchange for this risk equity investors expect a higher rate of return and
therefore the implied cost of equity is greater than that of debt.
As an example, let's compare a utility company with a retail apparel company. A utility company
generally has more stability in earnings. The company has les risk in its business given its stable
revenue stream. However, a retail apparel company has the potential for a bit more variability in
its earnings. Since the sales of a retail apparel company are driven primarily by trends in the
fashion industry, the business risk of a retail apparel company is much higher. Thus, a retail
apparel company would have a lower optimal debt ratio so that investors feel comfortable with
the company's ability to meet its responsibilities with the capital structure in both good times and
bad.
3. Financial Flexibility
This is essentially the firm's ability to raise capital in bad times. It should come as no surprise
that companies typically have no problem raising capital when sales are growing and earnings
are strong. However, given a company's strong cash flow in the good times, raising capital is not
as hard. Companies should make an effort to be prudent when raising capital in the good times,
not stretching its capabilities too far. The lower a company's debt level, the more financial
flexibility a company has.
The airline industry is a good example. In good times, the industry generates significant amounts
of sales and thus cash flow. However, in bad times, that situation is reversed and the industry is
in a position where it needs to borrow funds. If an airline becomes too debt ridden, it may have a
decreased ability to raise debt capital during these bad times because investors may doubt the
airline's ability to service its existing debt when it has new debt loaded on top.
4. Management Style
Management styles range from aggressive to conservative. The more conservative a
management's approach is, the less inclined it is to use debt to increase profits. An aggressive
management may try to grow the firm quickly, using significant amounts of debt to ramp up the
growth of the company's earnings per share (EPS).
5. Growth RateFirms that are in the growth stage of their cycle typically finance that growth
through debt, borrowing money to grow faster. The conflict that arises with this method is that
the revenues of growth firms are typically unstable and unproven. As such, a high debt load is
usually not appropriate.
More stable and mature firms typically need less debt to finance growth as its revenues are stable
and proven. These firms also generate cash flow, which can be used to finance projects when
they arise.
6. Market Conditions Market conditions can have a significant impact on a company's capital-
structure condition. Suppose a firm needs to borrow funds for a new plant. If the market is
struggling, meaning investors are limiting companies' access to capital because of market
concerns, the interest rate to borrow may be higher than a company would want to pay. In that
situation, it may be prudent for a company to wait until market conditions return to a more
normal state before the company tries to access funds for the plant.
CAPITAL STRUCTURE
Capital structure is the proportion of all types of capital viz. equity, debt, preference etc. It is
synonymously used as financial leverage or financing mix. Capital structure is also referred as
the degree of debts in the financing or capital of a business firm.
Financial leverage is the extent to which a business firm employs borrowed money or debts.
In financial management, it is a significant term and an important decision in a business. In the
capital structure of a company, broadly, there are mainly two types of capital i.e. Equity and
Debt. Out of the two, debt is considered a cheaper source of finance because the interest
payments are a tax-deductible expense.
Capital structure or financial leverage deals with a very important financial management
question. The question is – ‘what should be the ratio of debt and equity?’ Before scratching our
minds to find the answer to this question, we should know the objective of doing all this. In the
financial management context, the objective of any financial decision is to maximize the
shareholder’s wealth or increase the value of the firm. The other question which hits the mind in
the first place is whether a change in the financing mix would have any impact on the value of
the firm or not. The question is a valid question as there are some theories which believe that
financial mix has an impact on the value and others believe it to be not connected.
Apparently, under this view, financial leverage is a useful tool to increase value but, at the same
time, nothing comes without a cost. Financial leverage increases the risk of bankruptcy. It is
because higher the level of debt, higher would be the fixed obligation to honor the interest
payments to the debts providers.
Discussion of financial leverage has an obvious objective of finding an optimum capital structure
leading to maximization of the value of the firm. If the cost of capital is high
Important theories or approaches to financial leverage or capital structure or financing mix are as
follows:
This approach is also provided by Durand but it is totally opposite to the Net Income Approach.
It says that the weighted average cost of capital remains constant. It believes in the fact that the
market analyses firm as a whole which discounts at a particular rate which is not related to debt-
equity ratio.
TRADITIONAL APPROACH
This approach is not defined hard and fast facts but it says that cost of capital is a function of the
capital structure. The special thing about this approach is that it believes an optimal capital
structure. Optimal capital structure implies that at a particular ratio of debt and equity, the cost of
capital is minimum and value of the firm is maximum.
Proposition I: It says that the capital structure is irrelevant to the value of a firm. The
value of two identical firms would be same and it would not be affected by the mode of finance
adopted to finance the assets. The value of a firm is dependent on the expected future earnings.
Proposition II: It says that the financial leverage boosts the expected earnings but it does
not increase the value of the firm because the increase in earnings is compensated by the change
in the required rate of return.
To summarize, it is essential for finance professionals to know about the nitty-gritty of capital
structure they have suggested to the management. Accurate analysis of capital structure can help
a company save on the part of their cost of capital and hence improve profitability for
the shareholders.
Industries that are characterised by stability of earnings may formulate a more consistent policy
as to dividends than those having an uneven flow of income. For example, public utilities
concerns are in a much better position to adopt a relatively fixed dividend rate than the industrial
concerns.
Newly established enterprises require most of their earning for plant improvement and
expansion, while old companies which have attained a longer earning experience, can formulate
clear cut dividend policies and may even be liberal in the distribution of dividends.
A closely held company is likely to get consent of the shareholders for the suspension of
dividends or for following a conservative dividend policy. But a company with a large number of
shareholders widely scattered would face a great difficulty in securing such assent. Reduction in
dividends can be affected but not without the co-operation of shareholders.
The extent to which the profits are ploughed back into the business has got a considerable
influence on the dividend policy. The income may be conserved for meeting the increased
requirements of working capital or future expansion.
During the boom, prudent corporate management creates good reserves for facing the crisis
which follows the inflationary period. Higher rates of dividend are used as a tool for marketing
the securities in an otherwise depressed market.
Sometimes government limits the rate of dividend declared by companies in a particular industry
or in all spheres of business activity. The Government put temporary restrictions on payment of
dividends by companies in July 1974 by making amendment in the Indian Companies Act, 1956.
The restrictions were removed in 1975.
The past trend of the company’s profit should be thoroughly examined to find out the average
earning position of the company. The average earnings should be subjected to the trends of
general economic conditions. If depression is approaching, only a conservative dividend policy
can be regarded as prudent.
Corporate taxes affect dividends directly and indirectly— directly, in as much as they reduce the
residual profits after tax available for shareholders and indirectly, as the distribution of dividends
beyond a certain limit is itself subject to tax. At present, the amount of dividend declared is tax
free in the hands of shareholders.
Accumulation of profits becomes necessary to provide against contingencies (or hazards) of the
business, to finance future- expansion of the business and to modernise or replace equipments of
the enterprise. The conflicting claims of dividends and accumulations should be equitably settled
by the management.
If the working capital of the company is small liberal policy of cash dividend cannot be adopted.
Dividend has to take the form of bonus shares issued to the members in lieu of cash payment.
The regularity of dividend payment and the stability of its rate are the two main objectives aimed
at by the corporate management. They are accepted as desirable
High earnings may be used to pay extra dividends but such dividend distributions should be
designed as “Extra” and care should be taken to avoid the impression that the regular dividend is
being increased.
A stable dividend policy should not be taken to mean an inflexible or rigid policy. On the other
hand, it entails the payment of a fair rate of return, taking into account the normal growth of
business and the gradual impact of external events.
A stable dividend record makes future financing easier. It not only enhances the credit- standing
of the company but also stabilises market values of the securities outstanding. The confidence of
shareholders in the corporate management is also strengthened.
It is illegal to pay a dividend, if after its payment; the capital would be impaired (reduced). This
requirement might be met if only capital surplus existed. An upward revaluation of assets,
however, would create a capital surplus, but at the same time might operate as a fraud on
creditors and for that reason is illegal.
Basically the dividend laws were intended to protect creditors and therefore prohibit payment of
a dividend if a corporation is insolvent or if the dividend payment will cause insolvency.
The corporate laws must be taken into consideration by the directors before they declare a
dividend. The company can postpone the distribution of dividend in cash, which may be
conserved for strengthening the financial condition of the company by declaring stock dividend
or bonus shares.
To sum up, the decision with regard to dividend policy rests on the judgement of the
management, since it is not a contractual obligation like interest. The formulation of dividend
policy requires a balanced financial judgement by judiciously weighting the different factors
affecting the policy.
It results in a transfer of an amount from the accumulated earnings or surplus account to the
share capital account. In other words, the reserves are capitalised and their ownership is formally
transferred to the shareholders.
The equity of the shareholders in the corporation increases. Stock dividends do not alter the cash
position of the company. They serve to commit the retained earnings to the business as a part of
its fixed capitalisation.
Two principal reasons which usually actuate the directors to declare a stock dividend are:
(1) They consider it advisable to reduce the market value of the stock and thereby facilitate a
broader distribution of ownership.
(2) The corporation may have earnings but may find it inadvisable to pay cash dividends. The
declaration of a stock dividend will give the stock holders evidence of the increase in their
investment without interfering with the company’s cash position. If the stock holders prefer cash
to additional stock in the company, they can sell the stock received as dividend.
Sometimes, a stock dividend is declared to protect the interests of old stock holders when a
company is about to sell a new issue of stock (so that new shareholders should not share the
accumulated surplus).
The bonus shares entail an increase in the capitalisation of the corporation and this can only be
justified by a proportionate increase in the earning capacity of the corporation. Young companies
with uncertain earnings or companies with fluctuating income are likely to take great risk by
distribution stock dividends.
Every stock dividend carries an implied promise that future cash dividends will be maintained at
a steady level because of the permanent capitalisation of reserves. Unless the corporate
management has reasonable grounds of entertaining this hope, the wisdom of large stock
dividend is always subject to grave suspicion.
The existence of legal sanction for distributing the accumulated earnings or reserves does not
warrant the issue of stock dividends from the point of view of sound financial practice. There
should be other conditioning factors also for the issue of stock dividend.
(a) Bonus shares bring about a capitalisation of undistributed profits in the companies where the
profits originate and this lead to a linear development of corporate enterprise and greater
concentration of economic power.
(b) By issuing stock dividends-the corporations deprive the capital market of ‘secondary’ funds
which would otherwise have flowed into more widely dispersed investments.
(c) Bonus shares enable companies to appropriate to their own use undistributed profits which,
otherwise, would have led either to an increase in the share of labour or a reduction in prices for
the consumer.
Dividend model
1. Walter’s model
2. Gordon’s model
1. Walter’s model:
Professor James E. Walterargues that the choice of dividend policies almost always affects the
value of the enterprise. His model shows clearly the importance of the relationship between the
firm’s internal rate of return (r) and its cost of capital (k) in determining the dividend policy that
will maximise the wealth of shareholders.
2. The firm’s internal rate of return (r), and its cost of capital (k) are constant;
4. Beginning earnings and dividends never change. The values of the earnings pershare (E), and
the divided per share (D) may be changed in the model to determine results, but any given values
of E and D are assumed to remain constant forever in determining a given value.
Walter’s formula to determine the market price per share (P) is as follows:
P = D/K +r(E-D)/K/K
ADVERTISEMENTS:
The above equation clearly reveals that the market price per share is the sum of the present
value of two sources of income:
i) The present value of an infinite stream of constant dividends, (D/K) and
[r (E-D)/K/K]
Criticism:
Walter’s model is quite useful to show the effects of dividend policy on an all equity firm under
different assumptions about the rate of return. However, the simplified nature of the model can
lead to conclusions which are net true in general, though true for Walter’s model.
2. Walter’s model is based on the assumption that r is constant. In fact decreases as more
investment occurs. This reflects the assumption that the most profitable investments are made
first and then the poorer investments are made.
The firm should step at a point where r = k. This is clearly an erroneous policy and fall to
optimise the wealth of the owners.
3. A firm’s cost of capital or discount rate, K, does not remain constant; it changes directly with
the firm’s risk. Thus, the present value of the firm’s income moves inversely with the cost of
capital. By assuming that the discount rate, K is constant, Walter’s model abstracts from the
effect of risk on the value of the firm.
2. Gordon’s Model:
One very popular model explicitly relating the market value of the firm to dividend policy is
developed by Myron Gordon.
Assumptions:
7. The retention ratio (b), once decided upon, is constant. Thus, the growth rate (g) = br is
constant forever.
8. K > br = g if this condition is not fulfilled, we cannot get a meaningful value for the share.
According to Gordon’s dividend capitalisation model, the market value of a share (Pq) is equal to
the present value of an infinite stream of dividends to be received by the share. Thus:
The above equation explicitly shows the relationship of current earnings (E,), dividend policy,
(b), internal profitability (r) and the all-equity firm’s cost of capital (k), in the determination of
the value of the share (P0).
3. Modigliani and Miller’s hypothesis:
According to Modigliani and Miller (M-M), dividend policy of a firm is irrelevant as it does not
affect the wealth of the shareholders. They argue that the value of the firm depends on the firm’s
earnings which result from its investment policy.
Thus, when investment decision of the firm is given, dividend decision the split of earnings
between dividends and retained earnings is of no significance in determining the value of the
firm. M – M’s hypothesis of irrelevance is based on the following assumptions.
4. Risk of uncertainty does not exist. That is, investors are able to forecast future prices and
dividends with certainty and one discount rate is appropriate for all securities and all time
periods. Thus, r = K = Kt for all t.
Under M – M assumptions, r will be equal to the discount rate and identical for all shares. As a
result, the price of each share must adjust so that the rate of return, which is composed of the rate
of dividends and capital gains, on every share will be equal to the discount rate and be identical
for all shares.
Thus, the rate of return for a share held for one year may be calculated as follows:
Where P^ is the market or purchase price per share at time 0, P, is the market price per share at
time 1 and D is dividend per share at time 1. As hypothesised by M – M, r should be equal for all
shares. If it is not so, the low-return yielding shares will be sold by investors who will purchase
the high-return yielding shares.
This process will tend to reduce the price of the low-return shares and to increase the prices of
the high-return shares. This switching will continue until the differentials in rates of return are
eliminated. This discount rate will also be equal for all firms under the M-M assumption since
there are no risk differences.
From the above M-M fundamental principle we can derive their valuation model as follows:
Multiplying both sides of equation by the number of shares outstanding (n), we obtain the value
of the firm if no new financing exists.
If the firm sells m number of new shares at time 1 at a price of P^, the value of the firm at time 0
will be
The above equation of M – M valuation allows for the issuance of new shares, unlike Walter’s
and Gordon’s models. Consequently, a firm can pay dividends and raise funds to undertake the
optimum investment policy. Thus, dividend and investment policies are not confounded in M –
M model, like waiter’s and Gordon’s models.
Criticism:
Because of the unrealistic nature of the assumption, M-M’s hypothesis lacks practical relevance
in the real world situation. Thus, it is being criticised on the following grounds.
2. M-M argue that the internal and external financing are equivalent. This cannot be true if the
costs of floating new issues exist.
3. According to M-M’s hypothesis the wealth of a shareholder will be same whether the firm
pays dividends or not. But, because of the transactions costs and inconvenience associated with
the sale of shares to realise capital gains, shareholders prefer dividends to capital gains.
4. Even under the condition of certainty it is not correct to assume that the discount rate (k)
should be same whether firm uses the external or internal financing.
If investors have desire to diversify their port folios, the discount rate for external and internal
financing will be different.
5. M-M argues that, even if the assumption of perfect certainty is dropped and uncertainty is
considered, dividend policy continues to be irrelevant. But according to number of writers,
dividends are relevant under conditions of uncertainty.
UNIT – IV
Meaning of Working Capital
Capital required for a business can be classified under two main categories viz.
(i) Fixed capital
(ii) Working capital.
Every business needs funds for two purposes for its establishment and to carry out its day-to-
day operations. Long-term funds are required to create production facilities through purchase of
fixed assets such as plant and machinery, land, Building etc. Investments in these assets
represent that part of firm’s capital which is blocked on permanent basis and is called fixed
capital. Funds are also needed for short-term purposes for purchase of raw materials, payment of
wages and other day-to-day expenses etc. These funds are known as working capital which is
also known as Revolving or circulating capital or short term capital. According to Shubin,
“Working capital is amount of funds necessary to cover the cost of operating the enterprise”.
8. Quick and regular return on investments: Every investor wants a quick and regular
return on his investments. Sufficiency of working capital enables a concern to pay quick
and regular dividends to is investor as there may not be much pressure to plough back
profits which gains the confidence of investors and creates a favourable market to raise
additional funds in future.
9. Exploitation of Favourable market conditions: Only concerns with adequate working
capital can exploit favourable market conditions such as purchasing its requirements in
bulk when the prices are lower and by holding its inventories for higher prices.
10. High Morale: Adequacy of working capital creates an environment of security,
confidence, high morale and creates overall efficiency in a business.
Excess or Inadequate Working Capital
Every business concern should have adequate working capital to run its business
operations. It should have neither excess working capital nor inadequate working capital. Both
excess as well as short working capital positions are bad for any business.
Disadvantages of Excessive Working Capital
1. Excessive working capital means idle funds which earn no profits for business and hence
business cannot earn a proper rate of return.
2. When there is a redundant working capital it may lead to unnecessary purchasing and
accumulation of inventories causing more chances of theft, waste and losses.
3. It may result into overall inefficiency in organization.
4. Due to low rate of return on investments, the value of shares may also fall.
5. The redundant working capital gives rise to speculative transaction.
6. When there is excessive working capital, relations with banks and other financial
institutions may not be maintained.
Disadvantages of Inadequate working capital
1. A concern which has inadequate working capital cannot pay its short-term liabilities in
time. Thus, it will lose its reputation and shall not be able to get good credit facilities.
2. It cannot buy its requirements in bulk and cannot avail of discounts.
3. It becomes difficult for firm to exploit favourable market conditions and undertake
profitable projects due to lack of working capital.
4. The rate of return on investments also falls with shortage of working capital.
5. The firm cannot pay day-to-day expenses of its operations and it created inefficiencies,
increases costs and reduces the profits of business.
1. Principle of Risk Variation: Risk refers to inability of firm to meet its obligation as
and when they become due for payment. Larger investment in current assets with less
dependence on short-term borrowings increases liquidity, reduces risk and thereby decreases
opportunity for gain or loss. On other hand less investment in current assets with greater
dependence on short-term borrowings increases risk, reduces liquidity and increases profitability.
There is definite direct relationship between degree of risk and profitability. A conservative
management prefers to minimize risk by maintaining higher level of current assets while liberal
management assumes greater risk by reducing working capital. However, the goal of
management should be to establish suitable trade off between profitability and risk. The various
working capital policies indicating relationship between current assets and sales are depicted
below:-
2. Principle of Cost of Capital: The various sources of raising working capital finance
have different cost of capital and degree of risk involved. Generally, higher the risk lower is cost
and lower the risk higher is the cost. A sound working capital management should always try to
achieve proper balance between these two.
3. Principle of Equity Position: This principle is concerned with planning the total
investment in current assets. According to this principle, the amount of working capital invested
in each component should be adequately justified by firm’s equity position. Every rupee invested
in current assets should contribute to the net worth of firm. The level of current assets may be
measured with help of two ratios.
(i) Current assets as a percentage of total assets and
(ii) Current assets as a percentage of total sales.
4. Principle of Maturity of Payment: This principle is concerned with planning the sources
of finance for working capital. According to this principle, a firm should make every effort to
relate maturities of payment to its flow of internally generated funds. Generally, shorter the
maturity schedule of current liabilities in relation to expected cash inflows, the greater inability
to meet its obligations in time.
(1) The Hedging or Matching Approach: The term ‘hedging’ refers to two off-selling
transactions of a simultaneous but opposite nature which counterbalance effect of each other.
With reference to financing mix, the term hedging refers to ‘process of matching of maturities of
debt with maturities of financial needs’. According to this approach the maturity of sources of
funds should match the nature of assets to be financed. This approach is also known as ‘matching
approach’ which classifies the requirements of total working capital into permanent and
temporary working capital.
The hedging approach suggests that permanent working capital requirements should be
financed with funds from long-term sources while temporary working capital requirements
should be financed with short-term funds.
(2) The Conservative Approach: This approach suggests that the entire estimated investments in
current assets should be financed from long-term sources and short-term sources should be used
only for emergency requirements. The distinct features of this approach are:
(ii) Liquidity is greater
(iii) Risk is minimised
(iv) The cost of financing is relatively more as interest has to be paid even on
seasonal requirements for entire period.
Management of Cash
Cash is considered as vital asset and its proper management support company development and
financial strength. An effective cash management program designed by companies can help to
realise this growth and strength. Cash is vital element of any company needed to acquire supply
resources, equipment and other assets used in generating the products and services. Marketable
securities also come under near cash, serve as back pool of liquidity which provides quick cash
when needed.
Cash management is the stewardship or proper use of an entity's cash resources. It assists to keep
an organization functioning by making the best use of cash or liquid resources of the
organization. Cash management is associated with management of cash in such a way as to
realise the generally accepted objectives of the firm, maximum productivity with maximum
liquidity. It is the management's capability to identify cash problems before they ascend, to solve
them when they arise and having made solution available to delegate someone carry them out.
The notion of cash management is not new and it has attained a greater significance in the
modern world of business due to change that took place in business operations and ever
increasing difficulties and the cost of borrowing" (Howard, 1953 ). It is the most liquid current
assets, cash is the common denominator to which all current assets can be reduced because the
other current assets i.e. receivables and inventory get eventually converted into cash (Khan, 1983
). This emphasises the importance of cash management. The term cash management denotes to
the management of cash resource in such a way that generally accepted business objectives could
be accomplished. In this perspective, the objectives of a firm can be combined as bringing about
consistency between maximum possible effectiveness and liquidity of a firm. Cash management
may be defined as the ability of a management to identify the problems related with cash which
may come across in future course of action, finding appropriate solution to curb such problems if
they arise, and lastly delegating these solutions to the competent authority for carrying them out.
Cash management maintains sufficient quantity of cash in such a way that the quantity denotes
the lowest adequate cash figure to meet business obligations. Cash management involves
managing cash flows (into and out of the firm), within the firm and the cash balances held by a
concern at a point of time.
In financial literature, Cash management denotes to wide area of finance involving the
collection, handling, and usage of cash. It involves assessing market liquidity, cash flow, and
investments. The notion of cash management is not novel and it has gained more significance in
contemporary business world due to change that took place in the conduct of business and ever
increasing difficulties and the cost of borrowing.
1. To make Payment According to Payment Schedule: Firm needs cash to meet its routine
expenses including wages, salary, taxes etc.
2. To minimise Cash Balance: The second objective of cash management is to reduce cash
balance. Excessive amount of cash balance helps in quicker payments, but excessive cash
may remain unused & reduces profitability of business. Contrarily, when cash available
with firm is less, firm is unable to pay its liabilities in time. Therefore optimum level of
cash should be maintained (Excel Books India, 2008).
1. Cash management guarantees that the firm has sufficient cash during peak times for
purchase and for other purposes.
2. Cash management supports to meet obligatory cash out flows when they fall due.
3. Cash management helps in planning capital expenditure projects.
4. Cash management helps to organize for outside financing at favourable terms and
conditions, if necessary.
5. Cash management helps to allow the firm to take advantage of discount, special
purchases and business opportunities.
1.6. Cash management helps to invest surplus cash for short or long-term periods to keep the
idle funds fully employed.
ii. Local Box System: Under this system, a company rents out the local post offices
boxes of different cities and the customers are asked to forward their remittances to
it. These remittances are picked by the approved lock bank from these boxes to be
transferred to the company's central bank operated by the head office.
iii. Reviewing Credit Procedures: This type of technique assists to determine the
impact of slow payers and bad debtors on cash. The accounts of slow paying
customers should be revised to determine the volume of cash tied up. Besides this,
evaluation of credit policy must also be conducted for introducing essential
modifications. As a matter of fact, too strict a credit policy involves rejections of
sales. Thus, restricting the cash inflow. On the other hand, too lenient, a credit
policy would increase the number of slow payments and bad debts again reducing
the cash inflows.
iv. Minimizing Credit Period: Shortening the terms allowed to the customers would
definitely quicken the cash inflow side-by-side reviewing the discount offered
would prevent the customers from using the credit for financing their own
operations gainfully.
v. Others: There is a need to introduce various procedures for managing large to
very large remittances or foreign remittances such as, persona pick up of large sum
of cash using airmail, special delivery and similar techniques to accelerate such
collections.
5. Minimizing Cash Disbursements: The intention to minimize cash payments is the
ultimate benefit derived from maximizing cash receipts. Cash disbursement can be brought
under control by stopping deceitful practices, serving time draft to creditors of large sum,
making staggered payments to creditors and for payrolls.
6. Maximizing Cash Utilization: It is emphasized by financial experts that suitable and
optimum utilization leads to maximizing cash receipts and minimizing cash payments. At
times, a concern finds itself with funds in excess of its requirement, which lay idle without
bringing any return to it. At the same time, the concern finds it imprudent to dispose it, as
the concern shall soon need it. In such conditions, company must invest these funds in
some interest bearing securities. Gitman suggested some fundamental procedures, which
helps in managing cash if employed by the cash management. These include:
1. Pay accounts payables as late as possible without damaging the firm's credit rating, but take
advantage of the favourable cash discount, if any.
2. Turnover, the inventories as quickly as possible, avoiding stock outs that might
result in shutting down the productions line or loss of sales.
3. Collect accounts receivables as early as possible without losing future loss sales
because of high-pressure collections techniques. Cash discounts, if they are
economically justifiable, may be used to accomplish this objective (Gitman, 1979.).
It is well acknowledged in financial reports and various studies that cash management is
concerned with minimizing fruitless cash balances, investing temporarily excess cash usefully
and to make the best possible arrangements for meeting planned and unexpected demands on the
firm's cash (Hunt, 1966). Cash Management must have objective to reduce the required level of
cash but minimize the risk of being unable to discharge claims against the company as they arise.
There are five cash management functions:
1. Cash Planning: Experts emphases the wise planning of funds that can lead to huge
success. For any management decision, planning is the primary requirement. According to
theorists, "Planning is basically an intellectual process, a mental pre-disposition to do
things in an orderly way, to think before acting and to act in the light of facts rather than of
a guess." Cash planning is a practise, which comprises of planning for and controlling of
cash. It is a management process of predicting the future need of cash, its available
resources and various uses for a specified period. Cash planning deals at length with
formulation of necessary cash policies and procedures in order to perform business process
constantly. A good cash planning aims at providing cash, not only for regular but also for
irregular and abnormal requirements.
2. Managing Cash Flows: Second function of cash management is to properly manage cash
flows. It means to manage efficiently the flow of cash coming inside the business i.e. cash
inflow and cash moving out of the business i.e. cash outflow. These two can be effectively
managed when a firm succeeds in increasing the rate of cash inflow together with
minimizing the cash outflow. As observed accelerating collections, avoiding excessive
inventories, improving control over payments contribute to better management of cash.
Whereby, a business can protect cash and thereof would require lesser cash balance for its
operations.
3. Controlling the Cash Flows: It has been observed that prediction is not an exact
knowledge because it is based on certain conventions. Therefore, cash planning will
unavoidably be at variance with the results actually obtained. Due to this, control becomes
an unavoidable function of cash management. Moreover, cash controlling becomes
indispensable as it increases the availability of usable cash from within the enterprise. It is
understandable that greater the speed of cash flow cycle, greater would be the number of
times a firm can convert its goods and services into cash and so lesser will be the cash
requirement to finance the desired volume of business during that period. Additionally,
every business is in possession of some concealed cash, which if traced out significantly
decreases the cash requirement of the enterprise.
4. Optimizing the Cash Level: It is important that a financial manager must focus to
maintain sound liquidity position i.e. cash level. All his efforts relating to planning,
managing and controlling cash should be diverted towards maintaining an optimum level of
cash. The prime need of maintaining optimum level of cash is to meet all requirements and
to settle the obligations well in time. Optimization of cash level may be related to
establishing equilibrium between risk and the related profit expected to be earned by the
company.
5. Investing Idle Cash: Idle cash or surplus cash is described as the extra cash inflows over
cash outflows, which do not have any specific operations or any other purpose to solve
currently. Usually, a firm is required to hold cash for meeting working needs facing
contingencies and to maintain as well as develop friendliness of bankers.
In banking area, cash management is a marketing term for some services related to cash
flow offered mainly to huge business customers. It may be used to describe all bank
accounts (such as checking accounts) provided to businesses of a certain size, but it is more
often used to describe specific services such as cash concentration, zero balance
accounting, and automated clearing house facilities. Sometimes, private banking customers
are given cash management services.
Financial instruments involved in cash management include money market funds, treasury
bills, and certificates of deposit.
In the period of technology progression, the Cash Management System provides following
Benefits to its customers:
1. Funds availability as per need on day zero, day one, day two, day three etc. i.e. Corporate
can plan their cash flows.
2. Bank interest saved as instruments are collected faster.
3. Affordable and competitive rates.
4. Single point enquiry for all queries.
5. Pooling of funds at desired locations.
Management of Receivable
Accounts receivable typically comprise more than 25 percent of a firm's assets. The term
receivables is described as debt owed to the firm by the customers resulting from the sale of
goods or services in the ordinary course of business. There are the funds blocked due to credit
sales. Receivables management denotes to the decision a business makes regarding to the overall
credit, collection policies and the evaluation of individual credit applicants. Receivables
Management is also known as trade credit management. Robert N. Anthony, explained it as
"Accounts receivables are amounts owed to the business enterprise, usually by its customers.
Sometimes it is broken down into trade accounts receivables; the former refers to amounts owed
by customers, and the latter refers to amounts owed by employees and others".
Receivables are forms of investment in any enterprise manufacturing and selling goods on credit
basis, large sums of funds are tied up in trade debtors. When company sells its products, services
on credit, and it does not receive cash for it immediately, but would be collected in near future, it
is termed as receivables. However, no receivables are created when a firm conducts cash sales as
payments are received immediately. A firm conducts credit sales to shield its sales from the
rivals and to entice the potential clienteles to buy its products at favourable terms. Generally, the
credit sales are made on open account which means that no formal reactions of debt obligations
are received from the buyers. This enables business transactions and reduces the paperwork
essential in connection with credit sales.
Accounts Receivables Management denotes to make decisions relating to the investment in the
current assets as vital part of operating process, the objective being maximization of return on
investment in receivables. It can be established that accounts receivables management involves
maintenance of receivables of optimal level, the degree of credit sales to be made, and the
debtors' collection.
Receivables are useful for clients as it increases their resources. It is preferred particularly by
those customers, who find it expensive and burdensome to borrow from other resources. Thus,
not only the present customers but also the Potential creditors are attracted to buy the firm's
product at terms and conditions favourable to them.
Receivables has vial function in quickening distributions. As a middleman would act fast enough
in mobilizing his quota of goods from the productions place for distribution without any
disturbance of immediate cash payment. As, he can pay the full amount after affecting his sales.
Likewise, the customers would panic for purchasing their needful even if they are not in a
position to pay cash immediately. It is for these receivables are regarded as a connection for the
movement of goods from production to distributions among the ultimate consumer.
Maintenance of receivable
1. Increased Sales: Offering goods or services on credit enhances sales, by holding old
customers and attraction potential customers.
2. Increased Market Share: When the firm is able to maintain old customers and attract new
customers automatically market share will be bigger to the extent new sales.
3. Increase in profits: Increase sales, leads to increase in profits, because it need to produce
more products with a given fixed cost and sales of products with a given sales network in
both cost per unit comes down and the profit will be better.
Management of Inventory
Inventory management is basically related to task of controlling the assets that are produced to
be sold in the normal course of the firm's procedures. In supply chain management, major
variable is to effectively manage inventory. The significance of inventory management to the
company depends on the extent of its inventory investment.
The objectives of inventory management are of twofold:
1. The operational objective is to uphold enough inventory, to meet demand for product by
efficiently organizing the firm's production and sales operations.
2. Financial interpretation is to minimize unproductive inventory and reduce inventory,
carrying costs.
Effective inventory management is to make good balance between stock availability and the cost
of holding inventory.
1. Raw materials: Raw materials are those inputs that are transformed into completed goods
throughout manufacturing process. Those form a major input for manufacturing a product.
In other words, they are very much needed for uninterrupted production.
2. Work-in-process: Work-in-process is a stage of stocks between raw materials and
finished goods. Work-in-process inventories are semi-finished products. They signify
products that need to undergo some other process to become finished goods.
3. Finished products: Finished products are those products which are totally manufactured
and company can immediately sell to customers. The stock of finished goods provides a
buffer between production and market.
4. Stores and spares: It comprises of office and plant cleaning materials like soap, brooms,
oil, fuel, light, bulbs and are purchased and stored for the purpose of maintenance of
machinery.
Component of inventory
Inventory control encompasses managing the inventory that is previously in the warehouse,
stockroom or store. This is to know the type of products are "out there", how many each item and
where it is kept. It means having accurate, complete and timely inventory transactions record and
avoiding differences between accounting and real inventory levels. Two tools commonly used to
ensure inventory accuracy and control are ABC analysis and cycle counting.
The process of Inventory management consists of determining, how to order products and how
much to order as well as identifying the most effective source of supply for each item in each
stocking location. Inventory management contains all activities of planning, forecasting and
replenishment. The main purpose of inventory management is minimize differences between
customers demand and availability of items. These differences have caused by three factors that
include customers demand fluctuations, supplier's delivery time fluctuations and inventory
control accuracy.
Types of Inventory
The aim of carrying inventories is to separate the operations of the firm. It means to make each
function of the business independent of each other function so that delays or closures in one area
do not affect the production and sale of the final product. Because production cessations result in
increased costs, and because delays in delivery can lose customers, the management and control
of inventory are important duties of the financial manager. There are many types of inventory.
The common categories of inventory include raw materials inventory, work-in-process
inventory, and finished-goods inventory.
Raw-Materials Inventory: Raw materials inventory include basic materials purchased from other
firms to be used in the firm's production operations. These goods may include steel, lumber,
petroleum, or manufactured items such as wire, ball bearings, or tires that the firm does not
produce itself. Regardless of the specific form of the raw-materials inventory, all manufacturing
firms maintain a raw-materials inventory. The intention is to separate the production function
from the purchasing function that is, to make these two functions independent of each other so
delays in the delivery of raw materials do not cause production delays. If there is a delay, the
firm can satisfy its need for raw materials by liquidating its inventory.
Work-in-Process Inventory: Work-in-process inventory comprises of partly finished goods
requiring additional work before they become finished goods. The more difficult and lengthy the
production process, the larger the investment in work-in-process inventory. The main aim of
work-in-process inventory is to disengage the various operations in the production process so
that machine failures and work stoppages in one operation will not affect other operations.
Finished-Goods Inventory: Finished-goods inventory includes goods on which production has
been completed but that are not yet sold. The purpose of a finished-goods inventory is to separate
the production and sales functions so that it is not required to produce the goods before a sale can
occur and sales can be made directly out of inventory.
Motives of inventory management:
Managing inventories involve lack of funds and inventory holding costs.
Maintenance of inventories is luxurious. Still there is motive to retain inventories. There are
three general motives:
1. The transaction motive: Firm may hold the inventories in order to facilitate the smooth
and continuous production and sales operations. It may not be possible for the company to
obtain raw material whenever necessary. There may be a time lag between the demand for
the material and its supply. Therefore, it is needed to hold the raw material inventory.
Similarly, it may not be possible to produce the goods instantly after they are demanded by
the customers. Hence, it is needed to hold the finished goods inventory. The need to hold
work-in-progress may arise due to production cycle.
2. The precautionary motive: Firms also prefer to hold them to protect against the risk of
unpredictable changes in demand and supply forces. For example, the supply of raw
material may get delayed due to the factors like strike, transport disruption, short supply,
lengthy processes involved in import of the raw materials.
3. The speculative motive: Firms may like to buy and stock the inventory in the quantity
which is more than needed for production and sales purposes. It is done to get the
advantages in terms of quantity discounts connected with bulk purchasing or expected price
rise.
1. Price decline: It is a major disadvantage of inventory holding. Price decline is the result
of more supply and less demand. It can be said that it may be due to introduction of
competitive product. Generally, prices are not controllable in the short term by the
individual firm. Controlling inventory is the only way that a firm can counter act with these
risks. On the demand side, a decrease in the general market demand when supply remains
the same may also cause price to increase. This is also long-lasting management problem,
because reduction in demand may be due to change in customer buying habits, tastes and
incomes.
2. Product deterioration: It is also serious demerits of inventory holding. Holding of finished
completed goods for a long period or shortage under inappropriate conditions of light, heat,
humidity and pressures lead to product worsening.
1.3. Product obsolescence: If items are hold for long time, it may become outdated. Product
may become outmoded due to improved products, changes in customer choices,
particularly in high style merchandise, changes in requirements. Then this is a major risk
and it may affect in terms of huge revenue loss. It is costly for the firms whose resources
are limited and tied up in slow moving inventories.
BEST OF LUCK
By:
SRCEM, Palwal
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