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Functions Of Finance Manager & How They Have Changed In

Recent Years

The twin aspects procurement & effective utilization of funds are the
crucial tasks, which the finance manager faces. The financial manger is
required to look into financial implications of any decision in a firm. The
finance manager has to manage funds in such a way as to make their
optimum utilization & to ensure that their procurement is in a manner so
that the risk, cost & control considerations are properly balanced under a
given situation.

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

finance manager and that of the accountant .An accountant is not
concerned with management of funds which is a specialized task though
historically many accountants have been managing funds also. In the modern
day business, since the size of business has grown enormously the finance
function in separate & complex one. The finance manager has a task entirely
different from that of an accountant. He has to manage funds, which
involves a number of important decisions, which are as follows:

Estimating The Requiremen t Of Funds: In a business the requirement

of funds have to be carefully estimated. Certain funds are required for long
term purpose i.e. investments in fixed assets etc. A careful estimation of
such funds
& the timing of requirement must be made. Forecasting the
requirements of funds involves the use of
technique of budgetary control. Estimates of
requirements of fund can be made only if all physical activities of
the organization have been forecasted.

Decisions Regarding Capita l Structure : Once the requirements of funds

have been estimated, decisions regarding various sources from where
these funds would be raised have to be taken. Finance manager has to
carefully look into existing capital structure and see how the various
proposals of raising funds will affect it. He has to maintain a proper balance
between long-term funds and
short-term funds. Long-term funds rose from outside have to be in a
certain proportion with the funds procured from the owner. He has to
see that capitalization of company is such that company is able to
procure funds .All such decisions are “financing decisions”.

Investmen t Decisions : Funds procured from different sources have to

be invested in various kinds of assets. Investments of funds in a project have
to be made after careful assessment of the
various projects through capital budgeting. A part of long-
term funds is also to be kept for financing working capital requirement.
The production manager’s &-finance manager keeping in view the
requirement of production & future price estimates of raw material
availability of funds would determine inventory policy.

Dividen d Decision: Finance manager is concerned with the decision to pay

or declare dividend .He has to assist management is deciding as to what
amount of dividend should be retained in business. & This depends on
whether the company can make a more profitable use of funds. But in
practice trend of earning, share market prices; requirement of funds for
future growth, cash flow situation, tax position of shareholders has to be
kept in mind while deciding dividend.

Cash Management : Finance manager has to ensure that all sections & units
of organization are supplied with adequate funds. Sections, which have an
excess of funds, have to contribute to the central pool for use in other
sections, which needs funds. Even if one of the 200 retail branches
does not have sufficient funds whole business may be in danger. Hence
the need for laying down cash management & cash disbursement policies
with a view to supply adequate funds at all times is an important function
of a finance manager.

In the last few years, the complexion of the economic and financial
environment has altered in many ways. The important changes has been as
 The industrial licensing framework has been considerably relaxed.

 The Monopolies and Restrictive Trade Practices (MRTP) Act has
been virtually abolished.
 The Foreign Exchange Regulation Act (FERA) has been
substantially liberalized.
 Considerable freedom has been given to companies in pricing their
equity issues.
 The scope for designing new financing instruments has
been substantially widened.
 Interest rate ceilings have been largely removed.
 The rupee was devalued and, in two stages, has been made
fully convertible on the current account.
 Investors have become more demanding and discerning.
 The system of cash credit is being replaced by a system of
syndicated loans.
 A number of new investment opportunities have emerged in the
money market.
 The relative dependence on the capital market has increased.

These changes have made the job of the finance manager more
important, complex and demanding. Here is a sampling of views
expressed by leading finance professionals:
 Bhaskar Banerjee of the Duncan Group states, “There has been a
total attitudinal change owners towards the finance manager. He is no
longer referred at as ‘my accountant’. Instead of being a commodity,
the finance manager is now a part of the top management.”
 Anand Rathi of Indian Rayon proclaims, “The finance manager’s job
has vastly changed. Earlier it was a support function, now it’s mainline.
And finance itself has been a profit centre.”
 Bhaskar Mitter, Corporate Finance Director of ITC asserts, “Today and
in the future, finance heads will face a tremendous challenge to shape
their organisations. A challenge to upgrade accounting practices,
improve reporting systems, utilize the international market for
sourcing finance,

operate adeptly in the forex market, as well as aid companies to
 N. Gopalkrishnan, of Shriram Fibres avows, “The finance man’s job
has become more creative and cerebral than just juggling with
figures. Accounting is no longer means just maintaining log books.”
 Hemany Luthra of Ballarpur Industries Limited says, “In the paper
business, the returns may be 16 per cent while in the Agri-business
it may be 20 per cent. So how much to invest in which sector becomes
very crucial. The finance department tells the management where
it should increase its presence and where it should get out from.”
 The key challenges for the finance manager in India appear to
be in Investment planning, financial structure, Treasury operations,
Foreign exchange, Investor communication and Management control.
 According to Feroz Ahmed and Dilip Maitra in “Money from
Money”, Business Today, September 22, 1992, “Clearly, the clout of
the finance manager is growing along with the change in his role. And
as the reforms in the financial sector gather pace, this trend will
only increase. If the
1970s were the age of the Organization Man and the 1980s that of
Marketing Man, the 1990s will be the age of the Finance Man.”

Profit Maximization

It means the rupee income of firms. Firms may function in the market
economy or government economy. In market
economy prices are determined in competitive markets
and those are expected to produce goods and services desired by the

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

measure not only the success of the products but also development of the
market for it. The word profit implies a comparison of the operation of the
business between two specific dates, which are usually separated by an
interval of one year. In order to optimize those
corporate sources of wealth on which national
prosperity depends, the basic financial objectives of the companies is

maximize within socially acceptable limits, profit from the funds use of
funds employed to them.

Wealth Maximization

Wealth Maximization is also known as Value Maximization or Net

Present Worth Maximization. The company, which has profit
Maximization as its objective, may adopt the policies fielding exorbitant
profit in the short run which are unhealthy for the growth survival and
overall interest of the business. Hence it is commonly agreed that the
objective of the firm should be to maximize its value or health of the firm.

Features of Wealth Maximization:

 It measures the benefit in terms of cash flow and avoids the
ambiguity associated with the accounting profits.
 It consider both quality and quantity dimensions of benefits.
 It also incorporates the time value of money.

Gross Working Capital

Gross working capital refers to the firm’s investment in current assets.

Accounts receivables

When goods are sold on credit, finished goods get converted into
accounts receivables in the books of the seller. A firm’s investment
in accounts receivables depends upon how much a firm sells on credit and
how long it will take to collect receivable. For example, if a firm sells
Rs. 1 million worth of goods on credit a day and its average collection
period is 40 days, its accounts receivables will be Rs. 40 million. Accounts
receivables (or sundry debtors) constitute the third most important asset
category for business firms after plant equipment and inventories. Hence, it
behoove a firm to mange its credit well.

Contro l of receivables : Monitoring and controlling of accounts receivables
is often neither very thorough nor systematic. Very few firms have well-
defined systems for monitoring and controlling accounts receivables. The
measures generally adopted by firms for judging whether accounts
receivables are in control are:
 Bad Debt Losses
 Average Collection Period
 Ageing Schedule.

Room For Improvement : Management of receivables should be accorded

the importance it deserves. A senior executive should shoulder this
 Credit policies need to revise periodically in the light of internal as well
a external changes.
 Firms granting credit should examine the published statements
of prospective customers with greater rigors.
 Reference provided by the customers should be consulted and
necessary follow-up should be taken.
 A well defined programmed must be developed.

Net Worth

While there is no doubt that the preference shareholders are the owners of
the firm, the real owners are the ordinary shareholders who bear all
the risk, participate in the management and are entitled to all the profits
remaining after all possible claims of preference shareholders are met in full.

Thus it can be said that,

Average Ordinary Shareholders Equity = Net Worth Of Company

Return on Net Worth = Net Profit After Tax – Preference Dividend

Average Equity of the Ordinary Shareholders Equity or Net Worth

It is probably the single most important ratio to judge whether the firm
has earned satisfactory return for its equity shareholders or not. Its
adequacy is judge by
 Comparing with the past records of the same firm
 Inter-firm comparison
 Comparison with the overall industry average

Capital Employed

Total resources are also known as total capital employed and sometimes as
gross capital employed or total assets before depreciation. Thus total
capital consists of all assets fixed and current. In other words, the total of
the assets side of the balance sheet is considered as total assets

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

must be noted.
 Any asset which is not in use should be excluded.
 Intangible assets like goodwill, patents, trademarks etc should
be excluded. If they have some potential sales value, they
should be included.
 Investments which are not concerned with business, should be excluded
 Fictitious assets are to be excluded

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

The strategic aim of a business enterprise is to earn a return on capital. If
in any particular case, the return in the long-run is not satisfactory,
then the deficiency should be corrected or the activity be abandoned
for a more favourable one. Measuring the historical performance of an
investment centre calls for a comparison of the profit that has been earned
with capital employed. The rate of return on investment is determined by
dividing net profit or income by the capital employed or investment made to
achieve that profit.

ROI = Net Profit X 100
Capital Employed

Common Size Statement

The common size statement is often called as ‘Common Measurement’

‘Common Percentage’ or ‘ 100 Percent’ statement, since each statement
is reduced to the total of 100 and each individual component of the
statement is represented as a percentage of the total, which invariable serves
as the base.

This facilitates comparison of two or more business entities with a

common base. In the case of Balance sheet, total assets or liabilities or
capital can be taken as the common base and in the case of income
statement, net sales can be taken as the base.

Thus, the statement prepared to bring out the ratio of each assets or liability
to the tool of the balance sheet and the ratio of each item of expense or
revenue to net sales is known as common size statement.

State Merits/ Limitations of Common Size Statement, Comparative

Statement, trend analysis and ratio analysis

Ratio Anal ysis

It has been said that you must measure what you expect to manage
and accomplish. Without measurement, you have no reference to work
with and thus, you tend to operate in the dark.

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

an organization is to use ratios. Ratios are simply relationships between
two financial balances or financial calculations. These relationships
establish our references so we can understand how well we are performing
Ratios also extend our traditional way of measuring financial performance;
i.e. relying on financial statements. By applying ratios to a set of
financial statements, we can better understand financial performance.

Limitation s of Rati o Analysis

 Ratios by themselves mean nothing. They must all be compared.
 Ratios are calculated from financial statements which are affected by
the financial bases and policies adopted on such matters as
depreciation and the valuation of stocks.
 They do not represent a complete picture of business and do not refer
to other facts, which affect performance.
 A ratio is comparison between both numerator and denominator.
In comparing both it would be difficult to determine whether
differences is due to numerator or denominator.
 They are inter-connected. They cannot be treated in isolation.

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

then concentrate more on simply improving the ratio than on dealing
with the significant issues. For example the return on capital employed can
be improved by reducing the assets than increasing profits.

Remember ratios are result of good performance and not cause of

good performance.

Comparative Financial Statements

One final way of evaluating financial performance is to simply compare

financial statements from period to period and to compare financial
statements with other companies. This can be facilitated by vertical and
horizontal analysis.

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

 They can be used to compare the position of the firm every
month or quarter.
 It presents a review of the past activities and their cumulative effect.

 They lose their purpose and significance and tend to mislead if
the accounting principle is not applied consistently.
 Constant changes in price levels render accounting statements useless
 Inter-firm analysis cannot be made, unless the firm is of the same
size, age, and follow the same accounting principles

Common Size Statement

In this, the figures shown in the financial statements viz. Profit and
loss account and balance sheet are converted in to percentages so as to
establish each element to the total figure of the statement and these
statements are called common size statements. It is useful in analysis of the
performance of the company by analyzing each individual element to
the total figure of the statement. These statements will also assist in
analyzing the performance over the years and also with the figures of the
competitive firm in the industry for making analysis of relative efficiency.

Advantage s:
 It reveals the sources of capital and all other sources of funds
and distribution or use or application of the total funds in the assets.
 Comparison of common size statement over a period will clearly
indicate the changing proportions of the various components of assets,
liabilities, costs etc.
 Comparisons of two or the firms v/s industry as a whole helps in
corporate evaluation and ranking.

 It does not show variations in the various account item from period
to period.
 It is regarded by many as useless as there is no established
standard proportion of an asset to the total assets or of an item of
expense to net sales.
 If the statements are not followed consistently for years then the
common size statement would mislead.
 It presents a review of the past activities and their cumulative effect.

Give Any Three Objectives Of Financial Analysis

Financial statement analysis is an integral part of interpretation of

results disclosed by financial statements. It supplies to decision makers
crucial financial information and points out the
problem areas which can be investigated.
Financial statements may be analyzed with a view to achieve the following
Profitability Analysis

Objectives of
Financial Statement Liquidity Analysis

Solvency Analysis

Profitability Analysis : Users of financial statements may analyze

financial statements to decide past and present profitability of the business.
Prospective investors may do profitability analysis before taking a decision to
invest in the shares of the company.

Liquidity Analysis : Suppliers of goods, moneylenders and financial

institutions may do liquidity analysis to find out the ability of the
company to meet its obligations. Liquid assets are compared with the
commitments in order to test liquidity position of a company.

Solvenc y Analysis : It refers to analysis of long-term financial position
of a company. This analysis helps to test the ability of a company to repay its
debts. For this purpose, financial structure, interest coverage are analyzed.

Comparative Common Size Analysis

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

stated percentages of total assets and the items in the income statement are
expressed as percentages of total sales. Such percentage statements are
called common size statements. Common size analysis reinforces the
findings of time series analysis. These 2 kinds of analysis provide a
useful perspective & facilitate better understanding. They may be viewed
as a valuable adjustment to the traditional financial ratio analysis. They
are useful aids in sensitizing the analyst to secular changes & emerging.

Ratio Analysis Is Only A Tool And Not A Final Decision

Ratio analysis is a powerful tool of measuring a company’s performance, but

it has certain limitations, which doesn’t bring out any final decision.
There are certain limitations of which care has to be taken which are as
 Developmen t of benchmark s: Many firms, particularly the larger
ones have operations spanning a wide range of industries. Given the
diversity of product lines it is difficult to find out suitable
benchmarks for evaluating the financial performance and condition.
Hence it appears that meaningful benchmarks may be available only
for firms, which have a well-defined industry classification.
 Window dressin g: Firms may resort to window dressing to
project favorable financial picture. For example. A firm may prepare its
balance sheet when its inventory level is low. As a result it may
appear that he firm has a very comfortable liquidity position and
high turnover of inventories.
 Price leve l change s: financial accounting as it is currently practiced in
India and most other countries does not take into account price

changes. As a result, balance sheet figures are distorted and profits
are misreported. Hence financial statement analysis can be vitiated.
 Variations in accountin g policies : business firms have some latitude
in the accounting treatment like depreciation, valuation of stocks,
research and developmental expenses, foreign exchange transactions
installment sales, preliminary and pre-operative expenses, provision of
reserves, and revaluation of assets. Due to diversity of accounting
policies comparative financial statement analysis may be vitiated.
 Interpretation of ratio s: though industry averages and other
yardsticks are commonly used in financial ratios, it is somewhat
difficult to judge whether a certain ratio is good or bad. E.g. a
high current ratio may indicate a strong liquidity position. Likewise,
a high turnover of fixed assets may mean efficient utilization of
plant and machinery. Another problem is that, in interpretation
when a firm has some favorable and some unfavorable ratios. In
such a situation, it may be somewhat difficult to form an overall
judgment about its financial strength and weakness.
 Correlatio n amon g ratio s: in view of ratio correlations it is
often confusing to employ a large number of ratios in financial
statement analysis. Hence it is necessary to choose a small
group of ratios, consisting of say six to nine ratios, from the large
set of ratios. Such a selection requires a sharp understanding of the
meaning and limitations of various ratios and a good judgment about
the business of the firm.

Financial statements do not represent a complete picture of the business

but merely a collection of facts expressed in monetary terms. These may not
refer to other factors, which affect performance of the company.

Explain Various Components Of The Given Ratios With Illustrative


Current Rat io
1. Inventories of Raw Materials, Finished goods, work in progress,
stores and spares
2. Sundry Debtors
3. Short-term loans, Deposits & advances
4. Cash in hand and Cash at bank
5. Prepaid Expenses & Accrued Income
6. Bills Receivable
7. Marketable Investments and short-term securities

Liquid Ratio
Quick Assets and quick liabilities are the two elements of this ratio. All
current assets with the exception of inventories and prepaid expenses are
considered as quick assets. Deposits with customs, excise are not quick
assets. All current liabilities with an exception of bank overdraft and
incomes recd in advance are regarded as quick liabilities.

Proprietar y Ratio
Proprietary Ratio includes equity share capital, preference share capital,
capital reserves, revenue reserves, securities premium, surplus and
undistributed profits.

Stoc k to Working Capita l Ratio

This ratio includes stock (closing inventory & working capital) i.e.
current assets less current liabilities.

Capita l Gearing Ratio

This Ratio includes fixed interest or dividend bearing capital &
comprises of debentures, secured and unsecured loans & preference
share capital. Capital that does not bear fixed interest or dividend is the
equity share capital.

Debt equit y Ratio
Shareholders’ funds consist of preference share capital, equity share
capital, capital reserves, revenue reserves and reserves representing
earmark surplus. The amount of fictitious assets is deducted from the above.
Debts represent long-term debts. It includes mortgage loans and debentures.

Gross Prof it Ratio

This Ratio includes the gross profit, net sales & cost of goods sold.

Operatin g Ratio
The components of this ratio are operating cost and net sales. Net sales is
gross sales less returns, allowances and trade discounts on sales. Operating
cost is the total of cost of goods sold and other operating expenses like
office and administrative expenses and selling & distribution expenses.
They do not include finance expenses & other non-operating cost like taxes
on income, loss on sale of asset etc.

Net Operatin g Profi t Ratio

This ratio includes net operating profit and net sales.

Stoc k Turnove r Ratio

This ratio includes cost of goods sold and average stock.

Retur n On Equit y Share Capital

The components of this ratio are net profit after tax, financial charges
and preference dividend. Ordinary share capital without adding the
reserves or deducting the miscellaneous expenditure items.

Debtors Turnove r Ratio

The components of this ratio are Sundry debtors, Accounts Receivables
like bills receivables and average daily sales. For computing this ratio,
average collection period is to be ascertained.

What is Common Size Statement, Comparative Statement & Trend

Analysis? When & Why are they used?

Until about the turn of the century, preparation of financial statements was
a part of the work to be done by a bookkeeper. In due course of time,
bankers began to request balance sheets of applicants obviously with a view
to consider the desirability of granting credit. In spite of this, the
statements were hardly used, analyzed and interpreted in the real sense
of these terms. However, in due course of time, they started to
prescribe certain minimum current and liquid ratios for the purpose of
lending and which eventually led to the practice of analysis and
interpretation of financial statements. The growth and
development of management as a science and decision –making accepted as
the most important function of management, have contributed to the
extensive use of analysis of financial statements.

Analysis of financial statements means a systematic and specialized

treatment of the information found in financial statement so as to derive
useful conclusion on the profitability and solvency of the business entity

Objectiv e Of Financia l Statemen t Analysis

Financial statement analysis is an integral part of interpretation of
results disclosed by financial statements. It supplies to decision makers
crucial financial information and points out the problems areas,
which can be investigated. Financial statements may be analyzed with a
view to achieve the following purpose

Profitability Analysis

Objectives of
Financial Statement Liquidity Analysis

Solvency Analysis

Method s and device s used in analysi s of financia l statements
1. Comparative Financial Statement
2. Common Size Statement
3. Trend Analysis
4. Cash Flow
5. Fund Flow And Many More

Comparativ e Financia l Statement

Comparative financial statements are statements of the financial position of
a business so designed as to facilitate comparison of different
accounting variables for drawing useful inferences.

Financial statements of tow or more business enterprises may be

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

Common Size Statements

With a view to overcome the serious limitations of comparative

financial statements common size statements came into use.

The common size statements are prepared to bring out the ratio of each asset
or liability to the total of the balance sheet and the ratio of each item of
expense or revenue to net sales is know as the common-size statements.

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

“vertical analysis” or “static analysis” because it is a study of
relationship between accounts as existing at a particular date.

Trend Analysis

Study of one year’s financial statements in isolation hardly serves any

purpose. An analyst should study three to five years’ financial statements
and compare the trend of sales, cost of production and different ratios etc.
during the year.

The trend will reveal whether the unit is prospering or deteriorating year
after year. Such analysis of the trend is known as trend analysis. For
example by comparing the sales figures of last 5-6 years one can find
out what is the growth pattern of the sales and what is the percentages of
increase year after year. Similarly by studying trend of cost of sales, cost of
production and other parameters one can infer whether the business is
progressing or deteriorating.

Explain The Implication Of An Improvement In Current Ratio From

1 In 1999 To 2.5 In 2000

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

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

As per the banking norms, the minimum current ratio should be 1:3:1.
It means the current ratio should be 1.33 times more than current liability, to
pay for the current liability in the short-term period.

But in this question its not mentioned which type of industry is to be taken,
so we will take as general and all the banking norms applies on it.

Firstly, the current ratio was 1:1, which means that the current assets
are equal to current liabilities, which is less than the limit mentioned by the
RBI. So, it indicates that company wont be able to pay its short-term creditors
in due course and it may face problem of liquidity in near future. This bad
ratio will also pose negative impression on the creditors and they may not
give any credit facility. Even if the company applies to bank for loan
facility to fund their working capital requirement, they may not give the loan
due to bad ratio i.e. 1:1

Now the ratio of the company has improved to 2.5:1 i.e. current asset are
2.5 times more than current liability which is approximately double of 1:3:1,
as per the banking norms.

By 2.5:1, we can say that company would be easily able to pay its creditors
in due course of time. Company is solvent and liquid. Company won’t be
able to face any problem of liquidity if its creditors demand for money,
as current assets are 2.5 times more than current liability. If the company
ants to increase its operation or want to go for expansion, them to fund
its working capital requirement, bank would without any problem will shell
out money from their surplus to fund the working capital requirement.

So, at last this improvement in ration is good for the company, which
shows that company is trying to improve their short-term solvency. This
improvement in current ration also indicates that company’s operations are
increasing day- by-day.

Explain The Precautions To Be Taken In Trend Analysis

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

required to analyze the trend of data shown in a series of financial
statements of several successive years. The trend obtained by such an
analysis is expressed as percentages.

Trend percentage analysis moves in one direction either upward or

downward- progression or regression. This method involves the
calculation of percentage relationship that each statement bears to the
same item in the base year. The base year may be any one of the periods
involved in the analysis but the earliest period is mostly taken as the base

Metho d of Calculation
 Any of the statements is taken as the base.
 Every item in the base statement is stated as 100.
 Trend ratios are computed by dividing each amount in the
statement with the corresponding item in the base statement and
the result is expressed as a percentage.

Precaution s to be taken
While calculating trend percentages, following precautions should be taken:
 There should be consistency in the principles and practices followed
by the organization through out the period for which analysis is made.
 The base should be normal i.e. representative of the items shown in
the statement.
 Trend percentages should be calculated only for the items which
are having logical relationship with each other.
 Trend percentages should be studied after considering the
absolute figures on which they are based.
 Figures of the current year should be adjusted in the light of price
level changesas compared to the base year
before calculating trend percentages.

Classify & Explain Profitability/ Solvency ratios etc.

Solvenc y Ratio/Liquidit y Ratio

Liquidity refers to the ability of a firm to meet its obligations in the short
run usually one year. Liquidity ratios are generally based on the
relationship between current assets & current liabilities. The important
solvency ratios are: -

Current Ratio = Curren t Assets/Curren t Liabilities

Current assets include cash, marketable securities, debtors, inventories,
loans and advances and prepaid expenses. Current liabilities include
loans & advances, trade creditors, accrued expenses and provisions. The
current ratio measures the ability of the firm to meet its current liabilities-
current assets get converted into cash in the operating cycle of the firm
and provide the funds needed to pay current liabilities. Apparently the
higher the current ratio, the greater the short term solvency.

Quick Ratio/Aci d Tes t Ratio

Quick ratio = Quick Assets (Current Assets - Stock)/current liabilities

The acid test ratio is a fairly stringent measure of liquidity. It is based on
those current assets which are highly liquid inventories are excluded
from the numerator of this ratio because inventories are deemed to be
the least liquid component of current assets.

Cost Of Preference Shares

The computation of the cost of preference shares is conceptually

difficult as compared to the cost of debt. In the case if debt, the interest rate
is the basis of calculating cost, as payment of a specific amount interest is
legal commitment on the part of the firm. There is no such legal obligation in
regard to preference dividend. It is true that a fixed dividend rate is
stipulates on preference shares. It is also true that holders of such shares
have a preferential right as regards payments of dividend as well as return
of principal, as compared to ordinary shareholders. But unlike debt there is
no risk of legal bankruptcy if the firm doesn’t pay the dividend due to the
holders of such shares. Nevertheless, firms can be expected to pay the
stipulated dividend, if there are sufficient profits, for a number of reasons.
First, the preference shareholders, as already observed, carry a prior right
to receive dividends over the equity shareholders. Unless, therefore, the
firm pays out the dividend to its preference shareholders, it will not be
able to pay any thing to its ordinary shareholders. Moreover, the
preference shares are usually cumulative which means that preference
dividend will get accumulated till it is paid. As long as it remains in arrears
nothing can be paid to the equity holders, further the non-payment of
preference dividend may entitle their holders to participate in the
management of the firm as voting rights are conferred on them in such
cases. Above all, the firm may encounter difficulty in raising further equity
capital mainly because the non-payment of preference dividend adversely
affects the prospects of ordinary shareholders. Therefore, the stipulated
dividend on preference shares, like the interest on debt, constitutes the
basic for the calculation of the cost of preference shares. The cost of
preference capital may be defined as the dividend expected by the
preference shareholders.

By Anonymous MP FAN 21
However, unlike interest payments on debt, dividend payable on
preference shares is not tax-deductible because preference dividend is
not charge on earnings or an item of expenditure; it is an appropriation of
earnings. In other words, they are paid out of after-tax earnings of the
company. Therefore, no adjustment is required for taxes while computing
the cost of preference capital. There are two types of preference shares: i)
irredeemable and ii) redeemable.

Cost Of Debt

The cost structure of a firm normally includes the debt component also.
Debt may be in the form of debentures, bonds, term loans from financial
institutions and banks etc. The debt is carried a fixed rate of interest
payable to them, irrespective of the profitability of the company. Since upon
rate is fixed, the firm increases its earnings through debt financing. Then
after payment of fixed interest charges more surplus is available for the
equity shareholders and hence EPS will increase. An important point to be
remembered that dividends payable to equity shareholders and preference
shareholders is an appropriation of profit, where as the interest payable
on debt is a charge against profit. Therefore any payment towards
interest payable on debt is a charge against profit. Therefore, any
payment towards interest will reduce the profit and ultimately the
company’s liability would decrease. This phenomenon is called
‘Tax shield’. The tax shield is viewed as a benefit accrued to the company
which is geared. To gain the full tax shield the following conditions apply:

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

take full advantage of the tax shield.

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

By Anonymous MP FAN 22
Discuss Cash Budget As A Management Tool With Illustrative


Cash budget is a statement showing the estimated cash inflows and

cash outflows over the planning horizon in other words. The net cash
position of a firm as it moves from one budgeting sub period to another is
highlighted by the cash budget.

The various purposes of cash budget are:

 To coordinate the timing of cash need.
 It pinpoints the period when there is likely to be excess cash.
 It enables the firm which has sufficient cash to take the
advantage of cash discount on its account payable to pay the
obligations when due to formulate the dividend policy.
 It help to arrange needed funds so that the most favourable terms
and prevents the accumulation of excess funds.

The principle aim of cash budget as a tool to predict cash flows over a
given period of time is to ascertain whether at any point of time there is likely
to be an excess or shortage of cash.

The preparation of cash budgets involves various steps and is called

the element of cash budgeting system. The first element is selection of
period of time to be covered by the entire budget. It is referred to as the
planning horizon which mean the time span and the sub period within that
time span and the sub period within that time span over which the cash flows
are to be protected.

The second element of cash budget is the selection of the factors that
have a bearing on cash flows. The items included in the cash budget
are only cash items. The factors that generate cash flows are
generally divided for the purposes of preparing cash budget into two broad
categories: (a) operating

By Anonymous MP FAN 23
financial. While the former category includes cash flows generated by
the operations of the firms and are known as operating cash flows.

Distinguish Between Cash Budget And Cash Flows Statement

Cash budget is a statement showing the estimated cash inflows and
cash outflows over the planning horizon in other words. The net cash
position of a firm as it moves from one budgeting sub period to another is
highlighted by the cash budget.

Cash Flow Statement generally prepared annually, which shows the

sources and the uses of cash during that period. It measures the
changes in the financial position on each basis.

Cash Budget
 To coordinate the timing of cash need.
 It pinpoints the period when there is likely to be excess cash.
 It enables the firm which has sufficient cash to take the
advantage of cash discount on its account payable to pay the
obligations when due to formulate the dividend policy.
 It help to arrange needed funds so that the most favourable terms
and prevents the accumulation of excess funds.

Cash Flow Statement

 Cash Flow Statement is useful for the management to assess its ability
to meet the obligation to trade creditors and to pay bank loan to
pay interest to debenture holders and dividend to its shareholders.
 Cash Flow Statement can also be prepared month wise which is useful
in presenting the information of excess cash in some months and
shortage of cash in other months.

By Anonymous MP FAN 24
State The Need For Preparing A Cash Budget

Cash budget is a statement showing the estimated cash inflows and

cash outflows over the planning horizon. In other words, the net cash
position of a firm as it moves from one budgeting sub period to another is
highlighted by the cash budget.

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

flows over a period of time is to ascertain whether at any point of time there
is likely to be an express or shortage of cash. The preparation of cash
budget involved various steps. They may be described as the elements
of the cash budgeting system.

Cost of Capital

The cost of capital is the rate of return the company has to pay to
various suppliers of funds in the company. There are variations in the costs
of capital due to the fact that different kinds of investment carry
different levels risk which is compensated for by different levels of return on
the investment.

Opportunity Cost of Capital

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

in more than one project, then the company will meet the problem by
rationing the capital to projects whose returns are estimated to be more.
The firm might decide to estimate the opportunity cost of capital in other

Financial Leverage

This ratio indicates the effects on earnings by rise of fixed cost funds. It
refers to the use of debt in the capital structure. Financial leverage arises
when a firm deploys debt funds with fixed charge.

By Anonymous MP FAN 25
Operating Leverage

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

cost structure of any firm gives rise to operating leverage because of the
existence of fixed nature of costs. This leverage relates to the sales and
profit variations. Sometimes a small fluctuation in
sales would have a great impact on
profitability. This is because of the existence of fixed cost elements in the
cost structure of a product.

Combined Leverage

The operating leverage has its effects on operating risk and is measured by
the percentage change in EBIT due to percentage change in sales. The
financial leverage has its effects on financial risk and is measured by
the percentage change in EPS due to percentage change in EBIT. Since
both these leverages are closely concerned with ascertaining the ability to
cover fixed charges, if they are combined, the result is total leverage and the
risk associated with combined leverage is known as total risk.

How is Weighted Average Cost of Capital calculated? What weights

should be used in its calculation?

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

average of the cost of various sources of finance, weight being the market
value of each source of finance outstanding cost of various sources of
finance refers to the return expected by the respected investors.”

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

 Based on weight of costs by the book value of the different
forms of capital.
 Based on weight of market value of each form of capital.

By Anonymous MP FAN 26
The market value approach is more realistic for the reasons given below:
 The cost of funds invested at market prices is familiar with the investors.
 Investments are generally rated by the reference to their earnings
yield, and the company has a responsibility to maintain that yield.
 Historic book values have no relevance in calculation of real cost
of capital.
 The market value represents near to the opportunity cost of capital.

Explain The Dividend Approach To Calculate Cost Of Equity

The funds required for the project are raised from the equity
shareholders, which are of permanent nature. These funds need not be
repayable during the lifetime of the organization.
Hence it is a permanent source of funds. The
equity shareholders are the owners of the company. The main objective of
the firm is to maximize the wealth of the equity shareholders. Equity share
capital is the risk capital of the company. If the company’s business is doing
well the ultimate beneficiaries are the equity shareholders who will get the
return in the form of dividends from the company and the capital
appreciation for their investment. If the company comes for
liquidation due to losses, the ultimate and worst sufferers are the equity
shareholders. Sometimes they may not get their investment
back during the liquidation process.

Profits after taxation, less dividends paid out to the shareholders, are
funds that belong to the equity shareholders which have been
reinvested in the company and therefore, those retained funds should be
included in the category of equity, the cost of retained earnings is
discussed separately from cost of equity capital. The cost of equity may be
defined as the minimum rate of return that a company must earn on the
equity financed portion of an investment project so that market price of
the shares remain unchanged. The
following methods are used in calculation of cost of Equity.

Dividend yield method: The dividend yield per share is expected on the
current market price per share
By Anonymous MP FAN 27
KE = Dividend X 100
Market price

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

shareholders content. The main drawback with this method, as it does
not allow for any growth rate. Normally a shareholder expects the
returns from his equity investment to grow over time. This approach has no
relevance to the company.

What Are Marketable Securities?

Marketable securities are short-term investment instruments to obtain a

return on temporarily idle funds. In other words, they are securities,
which can be converted into cash in a short period of time, typically a few
days. The basic characteristics of marketable securities
affect the degree of their
marketability/liquidity and are a ready market and safety of principal.

Policies Of Collection Of Receivables

Policies of collection of receivables refer to the procedures followed to

collect accounts receivables when, after the expiry of the credit period,
they become due. These policies cover two aspects:
 Degree of effort to collect the over dues, and
 Type of collection efforts
The collection policies of a firm may be categorized into
 Strict
 Lenient
A tight collection has implications which involve benefits as well as
costs. In case of lenient collection policy the cost benefit trade off is affected.

By Anonymous MP FAN 28
Types of Risk


Systematic Risk Unsystematic Risk

Market Risk

Interest Rate Risk Business Risk Financial Risk

Inflation Risk

Internal External

Systematic Risk

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

factors that affects the price of all securities. The effect in systematic return
causes the prices of all individual shares/bonds to move in the same
direction. This movement is generally due to the response to economic,
social and political changes. The systematic risk cannot be avoided. It
relates to economic trends which affect the whole market.

When the stock market is bullish, prices of all stocks indicate rising trend
and in the bearish market, the prices of all stocks will be falling. The
systematic risk cannot be eliminated by diversification of portfolio,
because every share is influenced by general market trend. This type of
risk will arise due to the following reasons.

By Anonymous MP FAN 29
Marke t Risk
Variations in price sparked off due to real social, political and economic
events is referred to as market risk.

Interes t Rat e Risk

The uncertainty of future market values and the size of future incomes,
caused by fluctuations in the general level of interest is known as interest
Rate Risk. Generally, price of securities tend to move inversely with changes
in the rate of interest.

Inflation Risk
Uncertainties of purchasing power is referred to as risk due to inflation.
If investment is considered as consumption sacrificed, then a person
purchasing securities foregoes the opportunity to buy some goods or services
for so long as he continues to hold the securities. In case, the prices of
goods and services, increases during this period, the investor actually looses
purchasing power.

Unsystematic Risk

Unsystematic risk refers to that portion of the risk which is caused due
to factors unique or related to a firm or industry. The unsystematic risk is
change in the price of stocks factors unique or related to a firm or
industry. The unsystematic risk is the change in the price of stocks due to
the factors which are particular to the stock. For example, if excise duty
or customs duty on viscose fibre increases, the price of stocks of synthetic
yarn industry declines. The unsystematic risk can be eliminated or
reduced by diversification of portfolio. The unsystematic risk will arise due
to the following reasons:

Externa l Business Risk

External business risk arises due to change in operating conditions caused
by conditions thrust upon the firm which are beyond its control – such
as business cycles, government controls etc.

By Anonymous MP FAN 30
Interna l Business Risk
Internal business risk is associated with the efficiency with which a
firm conducts its operations within the broader environment imposed upon it.

Financia l Risk
Financial Risk is associated with the capital structure of a firm. A firm with
no debt financing has no financial risk. The extent of financial risk depends on
the leverage of the firm’s capital structure.

Collection Cost

Collection costs are administrative costs incurred in collecting the re from

the customers to whom credit sales have been made. Included in this
category of costs are
 Additional expenses on the creation and maintenance of a
credit department with staff, accounting records, stationery, postage
and other related items.
 Expenses involved in acquiring credit information either through
outside specialist agencies or by staff of the firm itself. These expenses
would not be incurred if the firm does not sell on credit.

Default Cost

The firm may not be able to recover the over dues because of the mobility of
the customers. Such debts are created as bad debts and have to be written
off, as they cannot be realized. Such costs are known as default costs
associated with credit sales and accounts receivable.

Capital Cost

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

have to be financed thereby involving a cost. There is a time lag between
the sale of goods to, and payment by, the customers. Meanwhile, the
firm has to pay

By Anonymous MP FAN 31
employees and suppliers of raw materials, thereby implying that the
firm should arrange for additional funds to meet its own obligations while
writing for payment from its customers. The cost on the additional capital to
support credit sales, which alternatively could be profitably employed
elsewhere, is, therefore, a part of the cost of extending credit or receivables.

Delinquency Cost

This cost arises out of the failure of the customers to meet their
obligations when payment on credit sales becomes due after the expiry of the
credit period. Such costs are called delinquency costs. The important
components of this cost are: (1) blocking up of funds for an extended
period, (2) cost associated with steps that have to be initiated to collect
the over dues, such as, reminders and other collection efforts, legal charges,
where necessary, and so on.

Del-Credre Commission/Agent

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

agent sold goods on behalf of a principal

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

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

Various Collection Methods from Receivables

Sometimes a customer fails to pay on the due date. The following procedure
will help in efficient collection of overdue receivables:
 A reminder
 A personal letter
 Several telephone calls
 Personal visit of sales man
 A telegram

By Anonymous MP FAN 32
 A visit from salesman responsible to customer
 A reminder to the sales person that commission is based on
cash received not on invoiced sales.
 Restriction of credit
 Use of collection agencies
 Legal action, as a last resort

Treasury Bills

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

These bills are sold on discount basis. Here, the investor does not receive
an actual interest payment so the return is nothing but the difference
between the purchase price and the face value of the bill. The treasury bills
are issued only in bearer form so we can say that ownership is easily

Bills Discounting

Under this system, a borrower can obtain credit from the bank against the
bills. The amount provided under this system is covered within the
overall cash credit or overdraft limit. Before purchasing or discounting the
bills, the bank satisfies itself as to the creditworthiness of the drawer.
Though the term “bills payable” implies that the bank becomes owner of
the bills but in practice the bank holds bills as security for the credit. A
bill discounted, the borrower is paid the discounted amount of the bill. A
bank collect full amount of maturity.

Inter Corporate Deposits

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

six months, is referred to as inter corporate deposit. Such deposits are
usually of three types;
 Call Deposits : A call deposit is withdrawable by the lender on giving
a days notice. In Practice, however the lender has to wait for at least
three days. The interest rate on such deposit may be around 16% p.a.

By Anonymous MP FAN 33
 Three Month s Deposit : These are more popular in practice.
These deposits are taken from borrowers to tide over a short
term cash inadequacy that may be caused by one or more of the
following factors: disruption in production, excessive
imports of raw materials, tax
payment, delay in collection, dividend payment and unplanned
capital expenditure. The interest rate on such deposits is around 18%
 Six Month s Deposits: Normally, lending companies do not
extend deposits beyond this time frame. Such deposits usually made
with first class borrowers. These deposits carry an interest rate of
around 20% p.a.

Objectives of Cash Management

A sound cash management scheme maintains the balance between the

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

To mee t the cash disbursemen t needs as per the paymen t schedul e –

In the normal course of business, firms have to make payment in cash
on a continuous and regular basis to the suppliers of goods, employees and
so on. At the same time there is constant flow of cash through collection of
debtors. Cash is, therefore aptly described as the ‘oil to lubricated the ever-
turning wheels of business: without the process grinds to a stop.

To minimiz e the amoun t locke d up as cash balanc e –

The second objective of cash management is to minimize the cash balances.
In minimizing the cash balances, two conflicting aspects to be reconciled. A
high level of cash balancesensures prompt payment
together with all the advantages. But it also implies that
large funds will remain idle as cash is the non-earning asset and the firm
will have to forego profits. A low level of cash balances, on the other hand,
may mean failure to meet the payment schedule. The aim of cash
management therefore should be to have an optimal amount of cash
By Anonymous MP FAN 34
What is Cash Operation Cycle?

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

overemphasized. Given the objective of financial decision making to
maximize the shareholders wealth, it is necessary to generate sufficient
profits. The extent to which profits can be earned will naturally depend,
among other things, upon the magnitude of the sales. A successful sales
programme is, in other words, necessary for earning profits by any business
enterprise. However, sales do not convert into cash instantly; there is
invariably a time lag between the sale of goods and the receipt of cash.
There is, therefore, a need for working capital in the form of current assets
to deal with the problem arising out of the lack of immediate realization of
cash against the goods sold. Therefore, sufficient working capital is
necessary to sustain sales activity. Technically, this is referred to as the
operating or cash cycle. The operating cycle can be said to be at the heart of
the need for working capital. ‘The continuing flow from cash to suppliers, to
inventory, to accounts receivable and back into cash is what is called
the operating cycle’. In other words, the term cash cycle refers to the
length of time necessary to complete the following cycle of events:

1. Conversion of cash into inventory;

2. Conversion of inventory into receivables;

3. Conversion of receivables into cash.

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

Phase 3 Receivables


Phase 2

Phase 1

By Anonymous MP FAN 35
The operating cycle consists of three phases. In phase 1, cash gets
converted into inventory. This includes purchase of raw materials,
conversion of raw materials into work-in-progress, finished goods and finally
the transfer of goods to stock at the end of the manufacturing process.
In the case of trading organizations, this phase is shorter as there would be
no manufacturing activity and cash is directly converted into inventory. This
phase is totally absent in the case of service organizations.

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

credit sales are made to customers. Firms, which do not sell on credit, will
not have phase 2 of the operating cycle.

The last phase, phase 3 represents the stage when receivables are
collected. This phase completes the operating cycle. Thus, the firm has
moved from cash to inventory, to receivables and to cash again.

Motives For Holding Cash

The term “Cash” with reference to cash management is used in two senses.
In a narrower sense it includes coins, currency notes, cheques, bank drafts
held by a firm with it and the demand deposits held by it in banks. In a
broader sense it includes “near-cash assets” such as marketable securities
and time deposits with banks. Such securities or deposits can immediately
be sold or converted into cash if the circumstances require.

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

it is held, is that it does not earn substantial return for the business. In spite
of this fact cash is held by the firm with the following motives: -

(1) Transactio n Motive

An important reason for maintaining cash balances is the transaction
motive. This refers to the holding of cash to meet routine cash requirements
to finance the transactions, which a firm carries on in the ordinary course of
business. A

By Anonymous MP FAN 36
firm enters into a variety of transactions to accomplish its objectives,
which have to be paid for in the form of cash. For example, cash payments
have to be made for purchases, wages, operating expenses, financial
charges like interest, taxes, dividends and so on. Similarly, there is a
regular inflow of cash to the firm from sales operations, returns on outside
investments, etc.

(2) Precautionar y Motive

A firm keeps cash balance to meet unexpected contingencies such as
floods, strikes, presentments of bills for payment earlier than the
expected date, unexpected slowing down of collection of accounts
receivables, sharp increase in prices of raw materials, etc. The more is the
possibility of such contingencies; more is the amount of cash kept by the firm
for meeting them.

(3) Speculativ e Motive

A firm keeps cash balance to take advantage of unexpected
opportunities, typically outside the normal course of the business. Such
motive is, therefore, of purely a speculative nature. For example, a firm may
like to take advantage of an opportunity of purchase raw materials at the
reduced price on payment of immediate cash or delay purchase of
materials in anticipation of decline in prices. Similarly, it may like to
keep some cash balance to make profit by buying securities in times
when their prices fall on account of tight money conditions, etc.

(4) Compensatio n Motive

Banks provide a variety of services to business firms, such as clearance
of cheque, supply of credit information, transfer to funds, and so on.
While for some of these services banks charge a commission or fee, for
others they seek indirect compensation. Usually clients are required to
maintain a minimum balance of cash at the bank. Since this balance cannot
be utilized by the firms for transaction purposes, the banks themselves can
use the amount to earn a return. Such balances are compensating balances.

By Anonymous MP FAN 37
Options For Investing In Surplus Funds

Companies often have surplus funds for short periods of time before they
are required for capital expenditures, loan repayment, or some other
purpose. These funds may be deployed in a variety of ways. At one end of the
spectrum is the term deposit (to be made for the minimum period of 46
days) in a bank, virtually a risk free investment that offers a relatively
modest rate of interest: at the other end of the spectrum is the
investment in equity shares, which can produce highly volatile returns.
In between lie units, public sector bonds, treasury bills, Intercorporate and
bill discounting.

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

(1) Read y Forwards

A commercial bank or some other organization may do a ready forward
deal with a company interested in deploying surplus funds on a short-term
basis. Under this arrangement, the bank sells and repurchases the same
(this means the company, in turn, buys and sells securities) at the
prices determined before hand. Hence the name ‘Ready Forward’. Ready
Forwards are permitted only in certain securities. The return on a ready
forward deal is closely linked to money market conditions.

(2) Badla Financing

A company providing badla financing is essentially lending money to a
stock market operator who wishes to carry forward his transaction
from one settlement period to another. Typically such finance is
security of shares bought by the stock market operator. For example, a
company may provide Rs.
5 crores of badla finance through a broker with an understanding that it is
only meant for the forward purchases of, say Reliance shares. Based on the
demand and supply funds, the badla financing ratio are determined on the
last day of the settlement. Badla financing offers attractive interest rates.
By Anonymous MP FAN 38
(3) Treasur y Bills
It is a type of marketable security, which is an obligation of government.
They are sold on discount basis. The investor does not receive an
actual interest payment. The return is the difference between the purchase
price and the face value of the bill.

(4) Bill Discounting

Surplus funds can be deployed to purchase/discount bills. Bills of
Exchange are drawn by seller (drawer) on the buyer (drawee) for the
value of goods delivered to him. During the pendency of the bill, if the
seller is in needs of funds, he may get it discounted. On maturity, the bill
should be presented to the drawee for payment.

Types of Marketable Securities

Marketable securities are short-term investment instruments to obtain a

return on temporarily idle funds. In other words, they are securities,
which can be converted into cash in a short period of time.

The more prominent marketable/near-cash securities available for

investment are as follows: -

(1) Treasur y Bills

It is a type of marketable security, which is an obligation of government.
They are sold on discount basis. The investor does not receive an
actual interest payment. The return is the difference between the purchase
price and the face value of the bill.

(2) Negotiabl e Certificate s of Deposit

These are marketable receipts for funds that have been deposited in a bank
for a fixed period of time. The deposited funds earn a fixed rate of interest.
When the certificates mature, the owner receives the full amount deposited
plus the earned interest.

By Anonymous MP FAN 39
(3) Commercia l paper
It refers to a short-term unsecured promissory note sold by large business
firms to raise cash. As they are unsecured, the issuing side of the
market is dominated by large companies, which typically maintain sound
credit ratings. Commercial paper can be sold either directly or through

(4) Bankers Acceptance

These are drafts (order to pay) drawn on a specific bank by an exporter in
order to obtain payment for goods he has shipped to a customer who
maintains an account with that specific bank. They can also be used in
financing domestic trade.

(5) Repurchas e Agreements

These are legal contracts that involve the actual sale of securities by a
borrower to the lender with a commitment on the part of former to
repurchase the securities at the current price plus a stated interest
charge. The securities involved are government securities and other money
market instruments.

(6) Units
The units of Unit Trust of India (UTI) offer a reasonably convenient
alternative avenue for investing surplus liquidity as (a) there is a very
active secondary market for them, (b) the income form units is tax-
exempt up to a specified amount and (c) the units appreciate in a fairly
predictable manner.

(7) Inte r Corporat e Deposits

It is also a type of marketable security. Intercorporate deposits are short-
term deposits as compared to other companies with a fairly attractive
form of investment of short-term funds in terms of rate of return, which
currently ranges between 12 to 15 per cent.

(8) Bills Discounting

Surplus funds can be deployed to purchase/discount bills. Bills of
Exchange are drawn by seller (drawer) on the buyer (drawee) for the
value of goods
By Anonymous MP FAN 40
delivered to him. During the pendency of the bill, if the seller is in
needs of funds, he may get it discounted. On maturity, the bill should be
presented to the drawee for payment.

(9) Call Market

It deals with funds borrowed/lent overnight/one day (call) money and
notice money for the period upto 14 days. It enables corporates to utilize
their float money gainfully. However, the returns (call rates) are highly

Factors Determining Cash Needs

The factors that determine the required cash balances are:

1. Synchronization of Cash Flows
2. Short Costs
3. Excess Cash Balance
4. Procurement and Management
5. Uncertainty

Synchronization of Cash Flows: The need for maintaining cash

balance arises from the non-synchronization of the inflows and outflows of
the cash: if the receipts and payments of cash perfectly coincide or
balance each other, there would be no need for
cash balances. The first consideration in determining the
cash need is, therefore, the extent of non-synchronization of cash
receipts and disbursements. For this purpose, the inflows and outflows
have to be forecast over a period of time, depending upon the planning
horizon, which is typically a one-year period with each of the 12 months
being a sub period.

Short Costs: Another general factor to be considered in determining

cash needs is the cost associated with a shortfall in the cash needs. Every
shortage of cash - whether expected or unexpected - involves a cost
‘depending upon the severity, duration and frequency of the shortfall and
how the shortage is covered. Expenses incurred as a result of shortfall are
called short costs’.
By Anonymous MP FAN 41
Following the various Short Costs:

Transactio n costs associated with raising cash to tide over the shortage.
This is usually the brokerage incurred in relation to the sale of some
short-term near-cash assets such as marketable securities.

Borrowin g cost s associated with borrowing to cover the shortage.

These include items such as interest on loan, commitment charges
and other expenses relating to the loan.

Loss of cash discount , that is, a substantial loss because of a

temporary shortage of cash.

Cost associate d wit h deterioratio n of the credi t rating , which is

reflected in higher bank charges on loans, stoppage of supplies,
demands for cash payment, refusal to sell, loss of image and the attendant
decline in sales and profits.

Penalt y rate s by banks to meet a shortfall in compensating balances.

Excess Cash Balance Costs: The cost of having excessively large

cash balances is known as the excess cash balance cost. If large funds are
idle, the implication is that the firm has missed opportunities to invest those
funds and has thereby lost interest, which it would otherwise have
earned. This loss of interest is primarily the excess cost.

Procurement and Management: These are the costs associated

with establishing and operating cash management staff and activities.
They are generally fixed and are mainly accounted for by salary,
storage, handling of securities, and so on.

Uncertainty and Cash Manage ment: The impact of uncertainty on

cash management strategy is also relevant, as cash flows cannot be
predicted with

By Anonymous MP FAN 42
complete accuracy. The first requirement is a precautionary cushion to
cope with irregularities in cash flows,
unexpected delays in collections and disbursement, defaults
and unexpected cash needs.

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

mitigated through:

1. Improved forecasting of tax payments, capital expenditure,

dividends, and so on; and

2. Increased ability to borrow through overdraft facility.

Working Capital

Working capital is defined as the excess of current assets over

current liabilities. Current assets are those assets which will be
converted into cash within the current accounting period or within the next
year as a result of the ordinary operations of the business. They are cash
or near cash resources. These include:
 Cash and Bank balances
 Receivables
 Inventory
• Raw materials, stores and spares
• Work-in-progress
• Finished goods
 Prepaid expenses
 Short-term advances
 Temporary investment

The value represented by these assets circulates among several items. Cash
is used to buy raw materials, to pay wages and to meet other
manufacturing expenses. Finished goods are produced. These are held as
inventories. When these are sold, accounts receivables are created. The
collection of accounts receivables brings cash into the firm. The cycle starts

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Current liabilities are the debts of the firms that have to be paid
during the current accounting period or within a year. These include:
 Creditors for goods purchased
 Outstanding expenses i.e., expenses due but not paid
 Short-term borrowings
 Advances received against sales
 Taxes and dividends payable
 Other liabilities maturing within a year

Working capital is also known as circulating capital, fluctuating capital

and revolving capital. The magnitude and composition
keep on changing continuously in the course of business.

Permanent and Temporary Working Capital

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

working capital viz, ‘Permanent’ and ‘Temporary’. Permanent working capital
represents the assets required on continuing basis over the entire year,
whereas temporary working capital represents additional assets required at
different items during the operation of the year. A firm will finance its
seasonal and current fluctuations in business operations through short
term debt financing. For example, in peak seasons
more raw materials to be purchased,
more manufacturing expenses to be incurred, more funds will be
locked in debtors balances etc. In such times excess requirement of
working capital would be financed from short-term financing sources.

The permanent component current assets which are required throughout

the year will generally be financed from long-term debt and equity.
Tandon Committee has referred to this type of working capital as ‘Core
Current Assets’. Core Current Assets are those required by the firm to
ensure the continuity of operations which represents the minimum levels
of various items of current assets viz., stock of raw materials, stock of
work-in-process, stock of finished goods, debtors balances, cash and bank
etc. This minimum level of current

By Anonymous MP FAN 44
assets will be financed by the long-term sources and any fluctuations over
the minimum level of current assets will be financed by the short-term
financing. Sometimes core current assets are also referred to as ‘hard
core working capital’.

The management of working capital is concerned with maximizing the return

to shareholders within the accepted risk constraints carried by the
participants in the company. Just as excessive long-term debt puts a
company at risk, so an inordinate quantity of short-term debt also increases
the risk to a company by straining its solvency. The suppliers of permanent
working capital look for long- term return on funds invested whereas the
suppliers of temporary working capital will look for immediate return and
the cost of such financing will also be costlier than the cost of permanent
funds used for working capital.

Gross Working Capital

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

with current assets alone. It is the value of non-fixed assets of an
enterprise and includes inventories (raw materials, work-in-progress,
finished goods, spares and consumable stores), receivables, short-term
investments, advances to suppliers, loans, tender deposits, sundry
deposits with excise and customs, cash and back balances, prepaid
expenses, incomes receivable, etc.

Gross Working Capital indicated the quantum of working capital

available to meet current liabilities.

Thus, Gross Working Capital = Current Assets

Net Working Capital

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

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This concept of working capital is widely accepted. This approach,
however, does not reflect the exact position of working capital due to
the following factors:
 Valuation of inventories include write-offs
 Debtors include the profit element
 Debts outstanding for more than a year likewise debtors which
are doubtful or not provided for are included as asset are also placed
under the head ‘current assets’
 Non-moving and slow-moving items of inventories are also
included in inventories, and
 Write-offs and the profits do not involve cash outflow

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

to exclude the non-moving and obsolete items from inventories. Working
Capital thus arrived at is termed as ‘Tangible Working Capital.’

Working Capital Cycle

Alternatively known as ‘Operating Cycle Concept’ of working capital.

This concept is based on the continuity of flow
of funds through business operations. This flow of value is caused
by different operational activities during a given period of time. the
operational activities of an organization may comprise of:
 Purchase of raw materials
 Conversion of raw materials into finished products
 Sale of finished products and
 Realization of accounts receivable.

Material cost is partly covered by trade credit from suppliers and

successive operational activities also cash flow. If the
flow continues without any interruption, operational
activities of the company will also continue smoothly. Movement of cash
through the above processes is called ‘circular flow of cash’.

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The period required to complete this flow is called ‘the operating period’ or
‘the operating cycle’.

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

a year is to be calculated. This is calculated by dividing the number of days
in a year by the length of the cycle. Total operating expenses of a year
divided by the number of operating cycles in that year is the amount of
working capital required.

Short Term Sources of Finance

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

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

Lette r of Credit : Suppliers, particularly the foreign suppliers insist that

the buyer should ensure that his bank would make the payment if he
fails to honour its obligations. This is ensured
through letter of credit (LC) arrangement. A bank
opens a LC in favour of a customer to facilitate his purchase of goods. If
the customer doesn’t pay to the supplier within the credit period, the bank
makes the payment under the LC arrangements. This arrangement
passes the risk of supplier to the bank. Bank charges the amount for opening
LC. It will extend such facilities to the financially sound customers.

Cash Credit: cash credit is the arrangement under which a customer is

allowed an advance upto certain limits against credit granted by the bank.
Under this arrangement, a customer need not borrow entire amount of
advance at one go, he can only draw to the extent of his requirement
and deposits his surplus funds in his account. Interest is charged not on the
full amount of advance but on the amount actually availed by him.
Generally cash credit limits are sanctioned against the security of goods by
way of pledge or hypothecation.

Overdraft: Overdraft arrangement is similar to the cash credit

arrangement. Under the overdraft arrangements, the customer is permitted
to overdraw upto
By Anonymous MP FAN 47
a prefixed limit. Interest is charged on the amounts overdrawn subject to
some charge as in the case of cash credit arrangements. Overdraft account
operates against security in the form of pledging of share security,
assignment of the LIC policies and sometimes even mortgage of fixed assets.

Bills Discounting : Under this system, a borrower can obtain credit from
the bank against the bills. The amount provided under this system is
covered within the overall cash credit or overdraft
limit. Before purchasing or discounting the bills, the
bank satisfies itself as to the creditworthiness of the drawer. Though the
term “bills payable” implies that the bank becomes owner of the bills but in
practice the bank holds bills as security for the credit. A bill discounted, the
borrower is paid the discounted amount of the bill. A bank collect full
amount of maturity.

Factoring: A factor is the financial institution, which offer services related

to management and financing of debts arising from credit sales. Factoring
provide resources to finance receivables which could help company in short
period to finance their working capital.

Commercial Paper : Commercial paper represents short-term unsecured

promissory notes issued by firms, which enjoy a fairly high credit
rating. Generally, large firms with considerable financial strength are
able to issue commercial paper. The important features of commercial paper
are as follows:

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

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

and redeemed at its face value. Hence, the implicit interest
rate is a function of the size of the discount and the period of

iii. Commercial paper is either directly placed with investors or

sold through dealers.

iv. Investors who intend holding it till its maturity usually buy
commercial paper. Hence, there is no
well-developed secondary market for
commercial paper.
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Inte r Corporate Deposits: A deposit made by one company with
another, normally for a period up to six months, is referred to as inter
corporate deposit. Such deposits are usually of three types;
a) Call Deposits : A call deposit is withdrawable by the lender on giving
a days notice. In Practice, however the lender has to wait for at
least three days. The interest rate on such deposit may be around
16% p.a.
b) Three Month s Deposit: These are more popular in practice.
These deposits are taken from borrowers to tide over a short
term cash inadequacy that may be caused by one or more of the
following factors: disruption in production, excessive imports of
raw materials, tax payment, delay in collection, dividend payment
and unplanned capital expenditure. The interest rate on such deposits
is around 18% p.a.
c) Six Month s Deposits: Normally, lending companies do not
extend deposits beyond this time frame. Such deposits usually made
with first class borrowers. These deposits carry an interest rate of
around 20% p.a.

Long Term Sources of Finance

Equity Share Capital : Equity shareholders are the owners of the

business. They enjoy the residual profits of the company after having paid
the preference shareholders and other creditors of the company an their
liability is restricted to the amount of share capital they contributed to the
company. The advantage of equity capital to the issuing firm is that without
any fixed obligation for the payment of dividends, it offers permanent
capital with limited liability for repayment. However, the cost of equity
capital is higher than other capital. Firstly, since the equity dividends
are not tax-deductible expenses and secondly, the high
costs of issue. In addition to thissince the equity
shareholders enjoy voting rights, excess of equity capital in the firms’
capital structure will lead to dilution of effective control.

The book value of an equity share is equal to:

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Paid-up equity capital + Reserves and surplus
Number of outstanding equity shares

Preference Share Capital : Preference shares have some attributes similar

to equity shares and some to debentures. Like in the case of equity
shareholders, there is no obligatory payment to the
preference shareholders and the preference dividend is not
tax-deductible (unlike in the case of the debenture holders, wherein
interest payment is obligatory). However similar to the debenture
holders the preference holders earn a fixed rate of return for their
dividend payment. In addition to this, the preference shareholders
have preference over equity shareholders to the post-tax earnings in the
form of dividends and assets in the event of liquidation.

Other features of the preference capital include the call feature, wherein
the issuing company has the option to redeem the shares, (wholly or partly)
prior to the maturity date, at a certain price. Prior to the Companies
Act, 1956 companies could issue preference shares with voting rights.
However, with the commencement of the Companies Act, 1956 the issue of
preference shares with voting rights has been restricted only to the following

a) There are arrears in dividends for two or more years in case

of cumulative preference shares.

b) Preference dividend is due for a period of two or more

consecutive preceding years, or

c) In the preceding six years including the immediately preceding

financial year, if the company has not paid the preference dividend for
a period of three or more years.

Term loans: Term loans are directly from the banks and financial
institutions in India. Term loans are generally obtained for financing
large expansions, modernization, and diversification projects. Therefore, this
method of financing is also called as project financing. Term loans have
majority of more than one year. Financial institutions provide term loans for
the period of six to ten years
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and in some cases a grace period of one to two years is also
granted. Commercial banks advance term loans for the period of three to five

Debentures : Another way of raising a loan is to issue a financial

instrument called “debentures”. A debenture is the loan raised by the
company from the capital market against which, assets of the company
are mortgaged with the trustees. Debentures carry a fixed rate of
interest. Debenture holders are the creditors of the company. There exist
obligation on the part of the company to pay contractual interest as well
as to repay the principle amount. Debenture finance is also cheaper than
share capital. It also command a tax benefit as a debenture interest is
allowed as deductible business expenses.

Types of Debentures:
1. Registered Debentures
2. Bearer
3. Mortgage or Secured
4. Simple
5. Redeemable
6. Irredeemable
7. Convertible
8. Non-Convertible

Lease Financing : A lease is a form of financing employed to acquire

the economies use of assets for a stated period without owing them.
Every lease involves two parties: the lessee and the lessor. Leasing is
the contractual arrangement between the lessor and lessee; where in
companies can enter into a lease deal with the manufacturer of the
instrument or through some intermediary. This deal will give the company,
the right to use the asset till the maturity of the lease deal and can later
retain the asset or buy it from the manufacturer. During the lease
period the company will have to pay lease rentals, which generally be at
negotiated rate and payable every month.
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Hire purchase : Finance company usually offers the facility of leasing as well
as hire purchase to the clients. The features of hire purchase are given as

 The hiree purchases the assets and gives it on hire to the hirer.
 The hiree pays regularly the hire purchase installments cover interest
as well as repayment of the principle amount. When the hiree pays the
last installments, the title of the asset is transferred to the hirer.
 The hiree charges interest on a flat basis. This means a certain rate
of interest usually around 14% is charged on the initial investment and
not on diminishing balance.
 The total interest collected by the hiree is allotted over various years.
this purpose ‘sum of years digits’ method is commonly employed.
Retaine d Earnings : Retained earnings represent the internal sources of
finance available to the company. Retained earnings represent the only
internal source of financing, expansion and growth. Infact they are an
important source of long- term finance for corporate enterprises.

Global Depositor y Receip t (GDR): GDR is a new financial instrument. It

made its appearance in 1991 and become an instant success. It all
started when companies in countries like South Korea and Malaysia
began attracting investors from Europe and USA. Inspite of the investor
interest companies faced difficulties. A novel way was found and it works in
this way.

A bank in Europe acquires the shares of such a company and then issues its
own “receipts” or “certificates” to the investors. This bank is also
“depository” and such certificates are called “GDR”. These GDR’s can be
traded on the European exchange or in private placement in USA. A GDR is
a dollar denominated instrument tradable on a stock exchange in Europe
or private placement in USA. A GDR represents one or more shares of
the issuing company.

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Reliance was the first Indian company to issue GDR’s in May 1992. To raise US
$100 million. The bookings were about five times the size of issue and
reliance retained US $150 million.

Arvind mills issued GDR’s worth US $125 million in February 1994. The issue
price of GDR was $9.78. One GDR represent one share of Arvind mills.

America n Depositor y Receipt s (ADR): ADR is an instrument similar to

GDR. It is issued in the capital markets of USA alone. Generally, far mare
stringent rules and regulation prevail for bringing out an ADR issue.

ADR is defined as, “a receipt or the certificate issued by the bank,

representing title to the specified number of shares of a non-US company.
The US bank is the depository in this case. ADR is the evidence of
ownership of underlying shares. ADR is freely traded in the US without
actual delivery of underlying non-US shares.

In this case the issuing company actively promotes the company’s ADR in
USA. A single depository bank is normally chosen and the ADR are routed
through this bank.

The organization with ADR’s with Security Exchange Commission (SEC) is

not compulsory. Technically ADR’s are different from GDR’s. The size of
ADR’s can be expanded or reduced, generally it depends upon demand
as depository banks can issue or withdraw corresponding shares in the local

Fixed Deposits: Fixed deposits are of two types: -

 Banks Fixed Deposits and
 Corporate Fixed Deposits

Banks Fixed Deposit provides interest at specified rate depending upon

the tenure. Banks also provide loan facility, which is known as demand loan
to the

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investor for which extra interest of 2% is charged in addition to the
principle amount.

Corporate fixed deposits are the fixed deposits given by the companies.
Interest is depending upon the company policy and regulations.
Generally, it differs from company to company.