Capital Gearing Ratio:

Closely related to solvency ratio is the capital gearing ratio. Capital gearing ratio is mainly used to analyze the capital structure of a company.The term capital structure refers to the relationship between the various long-term form of financing such as debentures, preference and equity share capital including reserves and surpluses. Leverage of capital structure ratios are calculated to test the long-term financial position of a firm. The term "capital gearing" or "leverage" normally refers to the proportion of relationship between equity share capital including reserves and surpluses to preference share capital and other fixed interest bearing funds or loans. In other words it is the proportion between the fixed interest or dividend bearing funds and non fixed interest or dividend bearing funds. Equity share capital includes equity share capital and all reserves and surpluses items that belong to shareholders. Fixed interest bearing funds includes debentures, preference share capital and other long-term loans.

Formula of capital gearing ratio:

[Capital Gearing Ratio = Equity Share Capital / Fixed Interest Bearing Funds]

Example:
Calculate capital gearing ratio from the following data: 1991 500,000 300,000 250,000 250,000 1992 400,000 200,000 300,000 400,000

Equity Share Capital Reserves & Surplus Long Term Loans 6% Debentures

Calculation:
Capital Gearing Ratio 1992 = (500,000 + 300,000) / (250,000 + 250,000) = 8 : 5 (Low Gear) 1993 = (400,000 + 200,000) / (300,000 + 400,000) 6 : 7 (High Gear) It may be noted that gearing is an inverse ratio to the equity share capital. Highly Geared------------Low Equity Share Capital Low Geared---------------High Equity Share Capital

Significance of the ratio:

Capital gearing ratio is important to the company and the prospective investors. It must be carefully planned as it affects the company's capacity to maintain a uniform dividend policy during difficult trading periods. It reveals the suitability of company's capitalization

Limitations of Financial Statement Analysis:

Although financial statement analysis is highly useful tool, it has two limitations. These two limitations involve the comparability of financial data between companies and the need to look beyond ratios.

Comparison of Financial Data:

Comparison of one company with another can provide valuable clues about the financial health of an organization. Unfortunately, differences in accounting methods between companies sometimes make it difficult to compare the companies' financial data. For example if one firm values its inventories by LIFO method and another firm by the average cost method, then direct comparison of financial data such as inventory valuations and cost of goods sold between the two firms may be misleading. Sometimes enough data are presented in foot notes to the financial statements to restate data to a comparable basis. Otherwise, the analyst should keep in mind the lack of comparability of the data before drawing any definite conclusion. Nevertheless, even with this limitation in mind, comparisons of key ratios with other companies and with industry average often suggest avenues for further investigation.

The Need to Look Beyond Ratios:

An inexperienced analyst may assume that ratios are sufficient in themselves as a basis for judgment about the future. Nothing could be further from the truth. Conclusions based on ratios analysis must be regarded as tentative. Ratios should not be viewed as an end, but rather they should be viewed as starting point, as indicators of what to pursue in greater depth. they raise many questions, but they rarely answer any question by themselves. In addition to ratios, other sources of data should be analyzed in order to make judgment about the future of an organization. The analyst should look, for example, at industry trends, technological changes, changes in consumer tastes, changes in broad economic factors, and changes within the firm itself. A recent change in a key management position, for example, might provide a basis for optimization about the future, even though the past performance of the firm (as shown by its ratios) may have been mediocre.

19.3 Long Term Finance Its meaning and purpose 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.

Purpose of long term finance: Long term finance is required for the following purposes: 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. 3. To finance growth and expansion of business: Expansion of business requires investment of a huge amount of capital permanently or for a long period. Factors determining long-term financial requirements : The amount required to meet the long term capital needs of a company depend upon many factors. These are : (a) Nature of Business: The nature and character of a business determines the amount of fixed capital. A manufacturing company requires land, building, machines etc. So it has to invest a large amount of capital for a long period. But a trading concern dealing in, say, washing machines will require a smaller amount of long term fund because it does not have to buy building or machines. (b) Nature of goods produced: If a business is engaged in manufacturing small and simple articles it will require a smaller amount of fixed capital as compared to one manufacturing heavy machines or heavy consumer items like cars, refrigerators etc. which will require more fixed capital. (c) Technology used: In heavy industries like steel the fixed capital investment is larger than in the case of a business producing plastic jars using simple technology or producing goods using labour intensive technique. 19.4 Sources of long term finance The main sources of long term finance are as follows: 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.

19.5 Shares

Issue of shares is the main source of long term finance. Shares are issued by joint stock companies to the public. A company divides its capital into units of a definite face value, say of Rs. 10 each or Rs. 100 each. Each unit is called a share. A person holding shares is called a shareholder. Characteristics of shares: The main characteristics of shares are following: 1. It is a unit of capital of the company 2. Each share is of a definite face value. 3. A share certificate is issued to a shareholder indicating the number of shares and the amount. 4. Each share has a distinct number. 5. The face value of a share indicates the interest of a person in the company and the extent of his liability. 6. Shares are transferable units. Investors are of different habits and temperaments. Some want to take lesser risk and are interested in a regular income. There are others who may take greater risk in anticipation of huge profits in future. In order to tap the savings of different types of people, a company may issue different types of shares. These are: 1. Preference shares, and 2. Equity Shares. Preference Shares : Preference Shares are the shares which carry preferential rights over the equity shares. These rights are (a) receiving dividends at a fixed rate, (b) getting back the capital in case the company is wound-up. Investment in these shares are safe, and a preference shareholder also gets dividend regularly. Equity Shares: Equity shares are shares which do not enjoy any preferential right in the matter of payment of dividend or reppayment of capital. The equity shareholder gets dividend only after the payment of dividends to the preference shares. There is no fixed rate of dividend for equity shareholders. The rate of dividend depends upon the surplus profits. In case of winding up of a company, the equity share capital is refunded only after refunding the preference share capital. Equity shareholders have the right to take part in the management of the company. However, equity shares also carry more risk.

Following are the merits and demerits of equity shares: (a) Merits (A) To the shareholders: 1. In case there are good profits, the company pays dividend to the equity shareholders at a higher rate. 2. The value of equity shares goes up in the stock market with the increase in profits of the concern.

3. Equity shares can be easily sold in the stock market. 4. Equity shareholders have greater say in the management of a company as they are conferred voting rights by the Articles of Association. (B) To the Management: 1. A company can raise fixed capital by issuing equity shares without creating any charge on its fixed assets. 2. The capital raised by issuing equity shares is not required to be paid back during the life time of the company. It will be paid back only if the company is wound up. 3. There is no liability on the company regarding payment of dividend on equity shares. The company may declare dividend only if there are enough profits. 4. If a company raises more capital by issuing equity shares, it leads to greater confidence among the investors and creditors. Demerits : (A) To the shareholders 1. Uncertainly about payment of dividend: Equity share-holders get dividend only when the company is earning sufficient profits and the Board of Directors declare dividend. If there are preference shareholders, equity shareholders get dividend only after payment of dividend to the preference shareholders. 2. Speculative: Often there is speculation on the prices of equity shares. This is particularly so in times of boom when dividend paid by the companies is high. 3. Danger of overcapitalisation: In case the management miscalculates the long term financial requirements, it may raise more funds than required by issuing shares. This may amount to overcapitalization which in turn leads to low value of shares in the stock market. 4. Ownership in name only : Holding of equity shares in a company makes the holder one of the owners of the company. Such shareholders enjoy voting rights. They manage and control the company. But then it is all in theory. In practice, a handful of persons control the votes and manage the company. Moreover, the decision to declare dividend rests with the Board of Directors. 5. Higher Risk : Equity shareholders bear a very high degree of risk. In case of losses they do not get dividend. In case of winding up of a company, they are the very last to get refund of the money invested. Equity shares actually swim and sink with the company. B) To the Management 1. No trading on equity : Trading on equity means ability of a company to raise funds through preference shares, debentures and bank loans etc. On such funds the company has to pay at a fixed rate. Liquidity Ratio Analysis =============== What It Measures: Liquidity ratios are a set of ratios or figures that measure a companys ability to pay off its short-term debt obligations. This is done by measuring a companys liquid assets (including those that might easily be converted into cash) against its shortterm liabilities. There are a number of different liquidity ratios, which each measure slightly different types of assets when calculating the ratio. More conservative measures will exclude assets that need to be converted into cash. Why It Is Important:

In general, the greater the coverage of liquid assets to short-term liabilities, the more likely it is that a business will be able to pay debts as they become due while still funding ongoing operations. On the other hand, a company with a low liquidity ratio might have difficulty meeting obligations while funding vital ongoing business operations. Liquidity ratios are sometimes requested by banks when they are evaluating a loan application. If you take out a loan, the lender may require you to maintain a certain minimum liquidity ratio, as part of the loan agreement. For that reason, steps to improve your liquidity ratios are sometimes necessary. How It Works in Practice: There are three fundamental liquidity ratios that can provide insight into short-term liquidity: current, quick, and cash ratios. These work as follows: Current Ratio This is a way of testing liquidity by deriving the proportion of assets available to cover current liabilities, as follows: Current ratio = Current assets Current liabilities Current ratio is widely discussed in the financial world, and it is easy to understand. However, it can be misleading because the chances of a company ever needing to liquidate all its assets to meet liabilities are very slim indeed. It is often more useful to consider a company as a going concern, in which case you need to understand the time it takes to convert assets into cash, as well as the current ratio. The current ratio should be at least between 1.5 and 2, although some investors would argue that the figure should be above 2, particularly if a high proportion of assets are stock. A ratio of less than 1 (that is, where the current liabilities exceed the current assets) could mean that you are unable to meet debts as they fall due, in which case you are insolvent. A high current ratio could indicate that too much money is tied up in current assetsfor example, giving customers too much credit. Cash Ratio: This indicates liquidity by measuring the amount of cash, cash equivalents, and invested funds that are available to meet current short-term liabilities. It is calculated by using the following formula: Cash ratio = (Cash + Cash equivalents + Invested funds) Current liabilities The cash ratio is a more conservative measure of liquidity than the current ratio, because it only looks at assets that are already liquid, ignoring assets such as receivables or inventory. Quick Ratio: The third liquidity ratio is a more sophisticated alternative to the current ratio, which measures the most liquid current assetsexcluding inventory but including accounts receivable and certain investments. Quick ratio = (Cash equivalents + Short-term investments + Accounts receivable) Current liabilities The quick ratio should be around 0.71, with very few companies having a cash ratio of over 1. To be absolutely safe, the quick ratio should be at least 1, which indicates that quick assets exceed current liabilities. If the current ratio is rising and the quick ratio is static, this suggests a potential stockholding problem.

The Purpose of a Cash Budget

At its most basic level, a budget is a plan. It is a plan for owners and managers to achieve their goals for the company during a specific time period. The preparation of a cash budget is an important management task. While some small businesses may be able to survive for a time without budgeting, savvy business owners will realize its importance. A cash budget can protect a company from being unprepared for seasonal fluctuations in cash flow or prepare a company to take advantage of unexpected quantity discounts from suppliers. While there are other types of budgets that can be prepared, such as projected or pro forma financial statements, a cash budget is a management plan for the most important factor of a companys viability its cash position. A companys cash position determines how suppliers will be paid, how a banker will respond to a loan request, how fast a company can grow, as well as directly influencing dividends, increases to owners equity, and profitability.
The creation of a cash budget requires you to make estimates (or best guesses) about many different aspects of your company and the environment in which it operates. Future sales will be contingent on many things, such as competition, the local economic climate, and your own internal operations and capacity. In addition, after sales are estimated, potential costs must also be derived. The important thing to keep in mind while arriving at these figures is that past experience is important, but so is intuition. The estimates you will need to develop must be based in reality and yet contain a dose of creativity and, if warranted, optimism. There are budgets, other than the cash budget, that are important for your company. However, the cash budget is a good first step if you are new to budgeting. A cash budget cannot be created in a vacuum. Before and during the budgeting process, business owners must consult with line managers, suppliers, and key personnel to make the best guess possible about the relationship between the goals for the period and their effect on cash receipts and cash expenditures.

Why Prepare a Cash Budget?

A cash budget is important for a variety of reasons. For one, it allows you to make management decisions regarding your cash position (or cash reserve). Without the type of monitoring imposed by the budgeting process, you may be unaware of the cash flow through your business. At the end of a year or a business cycle, a series of monthly cash budgets will show you just how much cash is coming into your company and the way it is being used. Seasonal fluctuations will be made clear.
A cash budget also allows you to evaluate and plan for your capital needs. The cash budget will help you assess whether there are periods during your operations cycle when you might need short-term borrowing. It will also help you assess any long-term borrowing needs. Basically, a cash budget is a planning tool for management decisions.

There are three main components necessary for creating a cash budget.
Time period Desired cash position Estimated sales and expenses

Time Period
The first decision to make when preparing a cash budget is to decide the period of time for which your budget will apply.
That is, are you preparing a budget for the next three months, six months, twelve months or some other period? In this Business Builder, we will be preparing a three-month budget. However, the instructions given are applicable to any time period you might select.

Cash Position
The amount of cash you wish to keep on hand will depend on the nature of your business, the predictability of accounts receivable, and the probability of fast-happening opportunities (or unfortunate occurrences) that may require you to have a significant reserve of cash.
You may want to consider your cash reserve in terms of a certain number of days sales. Your budgeting process will help you to determine if, at the end of the period, you have an adequate cash reserve.

Estimated Sales and Expenses

The fundamental concept of a cash budget is estimating all future cash receipts and cash expenditures that will take place during the time period. The most important estimate you will make, however, is an estimate of sales. Once this is decided, the rest of the cash budget can fall into place.
For example, if an increase in sales of 10 percent is desired and expected, various other accounts must be adjusted in your budget. Raw materials, inventory and the costs of goods sold must be revised to reflect the increase in sales. In addition, you must ask yourself if any additions need to be made to selling or general and administrative expenses, or can the increased sales be handled by current excess capacity. Also, how will the increase in sales affect payroll and overtime expenditures? Instead of increasing every expense item by 10 percent, serious consideration needs to be given to certain economies of scale that might develop. In other words, perhaps, a supplier offers a discount if you increase the quantities in which you buy a certain item; or, perhaps, the increase in sales can be easily accommodated by the current sales force. All of these types of considerations must be taken into account before you start budgeting. Each type of expense (as shown on your income statement) must be evaluated for its potential to increase or decrease. Your estimates should be based on your experience running your business and on your goals for your business over the time frame for which the budget is being created. At a minimum, the following categories of expected cash receipts and expected cash payments should be considered:

Expected Cash Receipts:

Cash balance Cash sales Collections of accounts receivable Other income

Expected Cash Expenses:

 Raw material (inventory) Payroll

Other Direct Expenses:

Advertising Selling expenses Administrative expense Plant and equipment expenditures Other payments

Expected Cash Receipts:

Cash balance - The cash balance is your cash on hand. This includes what is in your checking accounts, savings accounts, petty cash and any other cash accounts that you might have. Cash sales - After arriving at a base figure of cash sales, it must be adjusted for any trade or other discounts and for possible returns. As stated previously, the base level of sales (and of accounts receivable) will be determined by the companys projections, goals and past experience. Collections of accounts receivable - After a base level of accounts receivable is established (based on sales projections), it must be adjusted to reflect the amount that will actually be paid during the time period. Typical adjustments for a small business might be to assume that 90 percent of accounts receivable will be collected in the quarter in which the sales occur, nine percent will be collected in the following quarter, and one percent will remain uncollectible. Of course, past experience will be the most reliable indicator for making these adjustments. Other income - Your cash position may be affected positively by income other than sales. Perhaps there are investments, dividends, or a loan that will be introducing cash to the company during the time period. These types of cash sources are referred to as other income.

Definition of 'Discounted Cash Flow - DCF'

A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one. Calculated as:

The discounted cash flow (DCF) analysis represents the net present value (NPV) of projected cash flows available to all providers of capital, net of the cash needed to be invested for generating the projected growth. The concept of DCF valuation is based on the principle that the value of a business or asset is inherently based on its ability to generate cash flows for the providers of capital. To that extent, the DCF relies more on the fundamental expectations of the business than on public market factors or historical precedents, and it is a more theoretical approach relying on numerous assumptions. A DCF analysis yields the overall value of a business (i.e. enterprise value), including both debt and equity. Key Components of a DCF

Free cash flow (FCF) Cash generated by the assets of the business (tangible and intangible) available for distribution to all providers of capital. FCF is often referred to as unlevered free cash flow, as it represents cash flow available to all providers of capital and is not affected by the capital structure of the business. Terminal value (TV) Value at the end of the FCF projection period (horizon period). Discount rate The rate used to discount projected FCFs and terminal value to their present values.

Steps in the DCF Analysis The following steps are required to arrive at a DCF valuation: Project unlevered FCFs (UFCFs)

Choose a Calculate Calculate TV to net Calculate

discount rate the TV the enterprise value (EV) by discounting the projected UFCFs and present value the equity value by subtracting net debt from EV

Review the results

Free cash flow is the cash left to the company after all the operating cash expenses are paid. Free cash flow enhances value to shareholders and can be used for R&D, paying out dividend or for buying back shares. We have examined the calculation of free cash flow in cash flow statement analysis. You should first forecast the future operating costs. The easiest way to do that is to look at historic operating costs margin, expressed as proportion of revenues. Then adopt the future operating cost margin if needed. Taxation is another figure to forecast. Be aware that companies with high capital expenditures do not have to pay taxes in year of investments. Therefore, it makes sense to calculate average taxation rate for the past few years and apply it to the future (average annual income tax paid divided by profits before income tax). The next figure to forecast is net investment or capital invested in property, plants and equipment to sustain future growth. Calculate net investment as capital expenditures (from cash flow statement) minus non-cash depreciation (from income statement). Compare this figure with income to get investment ratio and then apply this figure to the future. Check competitors; if they are investing more aggressively, you can expect the company will have to invest at higher rate also. The last figure in calculating future free cash flows is change in working capital. It represents the cash needed for day-to-day operations, to maintain current assets, such as inventory. Calculate working capital as current assets minus current liabilities; you can find both figures in balance sheet. Afterwards calculate the net change in working capital

by comparing figures between two consecutive years. Take into consideration that normally increase in sales requires higher working capital to finance bigger investment in inventory and receivables. At the end, calculate Free Cash Flow for every year of forecasted period by the following formula: Free Cash Flow (FCF) = Sales Revenue - Operating Costs - Taxes - Net Investment - Change in Working Capital

Importance of Discount Rate in FCF Calculation

- Step 3 of Discounted cash flow valuation

At this stage, we know the predicted future free cash flows of the company for every year of the forecasting period. Now we have to calculate the net present value of these future free cash flows and to do that, we need to determine the discount rate. This is one of the crucial factors in discounted cash flow valuation, because a very small difference in discount rate has a big impact on the company's fair value. Different methods of determining discount rate exist, but the weighted average cost of capital (WACC) is most commonly used. WACC is a function of debt to equity and cost of both of them. While the cost of debt is very straight forward (the current market rate at which the company is paying back its debt), there are more open questions regarding the cost of equity. The most common way of calculating cost of equity is to sum risk free rate and premium for equity markets. The latest number is additionally multiplied by beta, which is representing the above or below average risk for the industry, a company operates in. This method of calculating cost of capital is called CAPM model (capital asset pricing model) and has won a Nobel prize. Here are all the formulas needed for calculation.

The WACC calculation looks simple, but in practice, it rarely happens that two analytics derive the same WACC, because of all the variables in the formula. Advantages and Disadvantages of DCF Valuation Model Advantages

Useful method when use of multiples to compare stocks makes no sense (if the whole sector or industry is under- or overvalued for example). The method is based on free cash flow (FCF), which is a trustworthy measure compared to some other figures and ratios calculated out of income statement or balance sheet.

Disadvantages

The FCF method is only as good as its assumptions are. The result can fluctuate widely with just a small change in your estimations about free cash flows, discount rate or growth rates. Use conservative scenario next to realistic one. The method is not so useful when analysts have problems with visibility of the company's trends (sales, costs, prices, etc.). Finally, be aware that DCF model is not suitable for short-term trading; it is only useful for long-term investments.