CHAPTER 7

A SUMMARY OF FINDINGS, CONCLUSIONS AND SUGGESTIONS

Introduction

Financial management is primarily concerned with the optimal use

of finance - the most notable scarce resource in modern societies. Financial

management decisions can be grouped into four broad categories namely,

investment decision, capital structure decision, working capital decision

and dividend policy decision. All these decisions aim at maximizing the

return and minimizing the risk. To ensure this, each of the above decisions

is related to the objectives of financial management, viz., maximization

of the wealth of the owners in private sector corporate enterprises.

A cooperative society is a unique form of business organization.

It fundamentally differs from a private corporate enterprise. The latter 's

wealth maximization objective is not relevant to a cooperative society.

A cooperative is a service-oriented organization. Its primary objective is

to render service to its members at the minimum cost. This can be achieved

by minimizing the cost of administration which includes cost of capital.

The objective of financial management in cooperatives, therefore, is to bring

down the cost of capital.

269

Financial management decision in cooperatives should aim at reducing

the cost of capital. Capital structure decision is thus a significant decision.

In a private enterprise, increasing the proportion of debt - otherwise known

as financial leverage - helps in bringing down the overall cost of capital

because debt is the cheapest source of finance. Various theories on capital

structure decision support this fct. But in a cooperative, equity is considered

as the cheaper source of finance because equity in cooperatives command

only a limited interest and they are not traded in stock exchanges and further

they are not considered as a form of investment. Leverage or increase

in the proportion of debt in the capital structure would increase the cost

of capital and thus leverage is detrimental to cooperatives. The present

study principally aims at testing the nature of relationship between capital

structure and cost of capital and the factors which influence this relationship.

The study is confined to all the cooperative sugar and spinning mills

in Tamil Nadu, which commenced production prior to 1983-'8f.

A Review of Working of Sample Cooperative

Sugar and Spinning Mills

Findings

Tamil Nadu ranks third in the country in terms of sugar output as

well as sugarcane production. There are 25 sugar mills in Tamil Nadu of

which 12 are in cooperative sector, 9 in private sector and the rest in public

sector.

270

The cooperative spinning mills were organised in early 50's. Tamil Nadu

was the first to start spinning mills in cooperative sector and each district

has a cooperative spinning mill.

Objective : The objective of the cooperative sugar mills is to

manufacture sugar and its by-products to the best advantage of members,

whereas the objective of cooperative spinning mills is to promote the interests

of weavers and growers of cotton and to industrialise the backward regions.

Age of the Mill : Around 70 percent of the cooperative sugar mills

are of long standing ones. Around two-third of cooperative spinning mills

fall under the age group of 15-20 years. The average age was around 20.

Membership : The membership of the cooperative sugar mills is

composed of sugrcane growers, cooperative institutions and government.

The membership registered a spectacular growth recording eighteen-fold

increase over a period of 23 years. The average rate of annual growth for

the industry as a whole was 58.18 percent. Such a sharp increase in member­

ship was maianly due to the establishment of new sugar mills in the co­

operative sector, expansion of the exisitng mills, membership drive to meet

the increasing demand for sugarcane and the growers' desire to find a better

market for their cane.

The membership of the cooperative spinning mills which primarily

consists of primary weavers cooperative societies, cotton growers, handloom

•"I -T t

weavers and cooperative institutions had registered a six-fold increase over

the study period. But the ra te of growth was slow especially between 1963-'64

and 1968-'69.

Funds : The major sources of long-term funds for both the types

of mills are term lending institutions, State Cooperative Bank and National

Cooperative Development Corporation and the State Government. The working

capital is raised through cash credit accommodation from Central Cooperative

Banks and Commercial Banks and 'ways and means' advance from the State

Government.

Management : The bye-laws of the cooperative sugar mills provide

for the constitution of board of management consisting of 15 members.

Sixty percent of them are nominated representatives of external organizations.

Elected representatives constitute only 40 percent in the board of management.

Even this has not been given a proper trial. The committees of management

of the mills were superseded in 1976. Since then they were managed by

special officiers.

The cooperative spinning mills were managed by the democratically

elected board of management till August, 1975. Since then the boards were

reconstituted thrice and they consist of officials only.

Organizational Structure : The organizational structure is almost

the same in all the cooperative sugar and spinning mills. It remains without

much change over a period despite their growth and development. There

was no finance department in both the types of mills. The accounts

272

department looks after routine finance functions and the mills have not

given due attention to finance management proper. The authority is highly

centralised in cooperative spinning mills than in sugar mills.

Production : The growth of the sugar mills largely depends upon

the price of the input and output. This can neither be manipulated nor

controlled as it is fully influenced by the government policy. However factors

like installed capacity, capacity utilization, manufacturing cost, and recovery

can easily be manipulated to the best advantage of the mills.

All the sugar mills are now operating with a crushing capacity of

1250 TCD or above, the average being 1695 TCD.

The average capacity utilization of the mills widely fluctuates. It

was as high as 110 percent in 1964-'65 and as low as 58.15 percent in 1980-'81.

The average capacity utilization was lower than All-India average.

On an average each sugar mill has to crush cane for 172 days in a

season to achieve 100 percent utilization. The average number of cane-crushed

days was 214 in 1964-'65. This has steadily declined over a period and stood

at 120 days in 1983-'84. Many of the mills, especially in the latter part

of the period under review, could not crush cane even for the minimum

number of days. The major reasons for the fall in the number of days

cane crushed are fall in sugarcane production and diversion of registered

cane to the manufacture of gur and khandasari.

273

Recovery is a measure of technical performance of the sugar industry.

A sugar recovery of 8.5 percent is considered satisfactory. All the mills

have exceeded the minimum of 8.5 percent. The average recovery has risen

from 8.42 percent to 9.64 percent over a period of time. The rise in recovery

is attributed to cane development activities undertaken by the mills. Another

measure of technical efficiency is the rate of extraction of sucrose from

the cane. The extraction rate has consistently exceeded the norm of 84.32

percent and was; higher than the All India average.

The total production of sugar by the mills has increased from 2.74

lakh quintals in 1961-'62 to 17.63 lakh quintals in 1983-'84 ; whereas tine

average production per mill recorded fluctuations.

In the case of cooperative spinning mills, a minimum installed capacity

of 25,000 spindles is essential for a mill to operate as an economically viable

unit. Most of the mills at the time of their establishment did not have

this minimum capacity. Subsequently the capacity of the mills was expanded

and now all the mills have the capacity to operate as economically viable

units.

Majority of the cooperative spinning mills recorded poor utilization

of the capacity with less than 85 percent of the installed capacity upto

1977. In the subsequent years the situation improved a lot and many mills

were found to have achieved the norm of 95 percent. This was mainly due to

revised standards of working hours and days. The major reasons for the

under-unitization of the capacity were power shortage and shortage of skilled

labourers.

27*

The average production of yarn per spinning m i l h has increased from

6.56 lakh kgs of yarn in 1961-'62 to 20.83 lakh kgs of yarn in 198*. The

expansion of the capacity, higher capacity ut i l izat ion especially in the lat ter

part of the period under review and modernization of plant were responsible

for the increase in production.

Cost of Production : The average cost of production in the cooperative

sugar mil ls has increased f rom Rs.73.52 to 352.72 per quintal - nearly f ive- fo ld

increase over a period of 20 years. The rise in cost of production is witnessed

in al l the mills under study. An analysis of the cost of production of sugar

shows that the cost of raw material consituted 60 to 70 percent and interest

on borrowings 3 to 10 percent of the total cost of production.

In the case of cooperative spinning mil ls, count-wise costing provides

a base for deciding appropriate product mix. Unfortunately, mills in co­

operative sector have not given due at tent ion to this. The conversion of

production figures to yarn of 40's shows that the cost of production per

kg of yarn has increased from Rs.7.42 in 1968-'69 to Rs.28.26 in 1984 -

registering more than four- fold increase. The break-up of the cost of

production reveals that raw material alone accounted on an average for

about 62 percent of the yarn selling price. The proportion of salary and

wages ranged between 13.28 percent and 17.61 percent.

Sales : The sale of sugar is influenced by government's policy and

control over sugar. The Government has adopted a dual pricing policy under-

which 65 percent of the output is acquired at a f ixed low price by the

275

government for the public distribution system and the remaining output

is allowed to be sold in the open market. The average selling price of sugar

has increased from Rs.l 10.32 per quintal in 1961-'62 to Rs.392.58 in 1980-'81 -

recording a three-fold increase. This is lower than the average cost of

production. In some mills the cost of production has exceeded the selling

price. This has resulted in losses.

The price of yarn in cooperative spinning mills is fixed by the yarn

price sub committee constituted by the government. Yarn is mainly sold

to the weavers' cooperative societies. Surplus, if any, is sold in the open

market through brokers. Selling prices were invariably fixed below the cost.

The periodical revision in selling rates was not commensurate with the

increase in the various items of overhead. The value of yarn marketed

by the mills recorded an impressive growth. The average annual growth

ranged between Rs.0.67 crores to Rs.2 crores.

Financial Performance : The profitability of an enterprise depends

among other things on the effective utilization of resources. The utilization

of resources was measured through total assets turnover, fixed assets turnover,

inventory turnover and net working capital turnover ratios. The first three

turnover ratios in the case of cooperative sugar mills were below the standard

norms, which indicate ineffective utilization of total assets, fixed assets

and inventory. The net working capital turnover of the sugar mills was

more than the standard norm and thus it could be said that the mills were

efficient in utilizing the short-term funds.

276

The average total assets turnover for the cooperative spinning mills

had increased from 0.52 to 1.19 over the years. The average fixed assets

turnover had increased from 1.24 in 1964-'65 to k.\7 in 1984, but it was

well below the norm throughout the period under review. The inventory

and the working capital turnovers of the spinning mills were on the higher

side.

The gross profit of the cooperative sugar mills registered an upward

trend. The net profit was low except in 1980-'81 and 1983-'84. Gross

operating margin was less than the norm of 30. Net operating margin was

fairly good in many of the years under review. Sales margin and return

on investment were poor except in 1980-'81 and 1983-'8'f. By and large

the rate of profitability of the mills was found to be unsatisfactory.

The average gross profit of the cooperative spinning mills ranged

from 3.07 lakhs to Rs.17.87 lakhs. Since 1964-'65 many mills suffered losses.

The ra te of profitability of the spinning mills in terms of gross operating

margin, net operating margin, sales margin and return on investment was

far from satisfactory.

The liquidity of the mills was measured through current and quick

ratios. The current ratio of the cooperative sugar mills came down from

W5 percent in 1961-'62 to 109 in 1980-'81. The quick ratio was less than

50 percent in many years indicating poor liquidity of the cooperative sugar

mills.

277

The current ratio of the cooperative spinning mills was found to be

good whereas the quick ratio of 75 percent of the mills was less than 100

percent which indicates their poor liquidity position.

Sickness in Cooperative Spinning Mills : The South India Textile

Research Association's norm for measuring the sickness in spinning industry

was applied in the study. The results show that the mills had vast scope

for improving their profit and profitability. There is no chance for any

mill to become sick.

Financial Management : Analysis of financial management practices

is not the objective of this study. Yet, the researcher could identify certain

lacunae in the financial management practices of the mills. Personal

observation also helped him to understand certain pitfalls. They are stated

below.

Capital budgeting system is in vogue in both the categories of mills.

But investment proposals are evaluated only on the basis of traditional

methods like pay-back period. Modern methods of evaluation - 1RR and

NPV - were not adopted. Thus the mills were not taking financing decisions

in a scientific way. Budgetary control was not practiced. This had led

to delay in completion of the projects on time and thereby led to escalation

in the cost of project.

It was also observed that the mills followed some crude methods

of estimating working capital requirements. Cash flow estimates were not

278

systematically prepared well in advance to find out the sources from which

the working capital was anticipated to flow. This has seriously impaird

the working capital position of many of the mills, which in turn has forced

the mills very often to go in for 'ways and means' advances from the

government to meet and make up the deficit in working capital.

Both the sugar and spinning mills did not have proper organizational

set-up for financial management functions such as financial planing and

control. Budgets were prepared in a traditional way. No scientific system

was introduced. Cost standard and budgetary control systems will be of

much use for exercising proper financial control. But unfortunately, mills

seemed to have paid very little attention to these systems.

Conclusion

The overall performance of the sugar mills was not satisfactory, in

spite of their better technical performance in terms of recovery and reduced

overall extraction of sugar. This was mainly due to under-utilization of

production capacity, unsound pricing policy and inefficient financial

management of the mills.

Majority of the cooperative spinning mills were running at loss. The

major reasons for loss are under-utilization of the capacity, increase in cost

of production, inefficient financial management, lack of sound management

and want of democratic participation.

279

Suggestions

The findings and conclusions on the performance of the cooperative

sugar and spinning mills emphasize the need for better capacity utilization,

bringing down the cost of production, improving the financial management

practices and financial performance, redesigning the organizational structure

and revival of democratic management. In cooperative sugar mills, besides

the above aspects, there is an urgent need to review the policy relating

to pricing of sugarcane and sugar.

Better Capacity Utilization : The estimation of cane production

should be realistically made at the time of selection of site for the installation

of factory as well as at the time of expansion. The cooperative sugar mills

should develop meaningful relationship with the members. Only then would

they be able to have a legitimate claim on their loyalty. This in turn.wonl.d

help in the flow of sugarcane to the factory on a regular and continuous

basis. Agricultural development measures like liberal credit facitlity and

effective agricultural extension service to the cane growers are necessary

to improve the productivity and production of sugarcane. This in turn would

assure regular supply of sugarcane to the cooperative sugar mills. The

plant should also be kept in a state of efficiency in order to achieve fuller

utilization of the capacity.

Full capacity utilization in cooperative spinning mills is a formidable

task. Various steps need to be taken for achieving full capacity utilization.

280

Some of them are : i) Data regarding capacity installed and utilized in

respect of each production cost centre should be periodically checked to

locate the degree of under-utilization and the reasons therefor, ii) To solve

the problems of power shortage and power cut, generators should be installed.

All the mills should make stand-by arrangements for generating electricity

and thereby avoid adverse effects of power cuts that the State may impose

from time to time. The State may also think of exempting cooperative

spinning mills from power cut. iii) Many of the cooperative spinning mills

are situated in rural areas at isolated places and do not have adequate

residential facilities both for technical personnel and the workers. Unless

this deficiency is removed, many mills may not, perhaps, be in a position

to attract talented personnel. The mills may therefore take up housing

programme with the financial assistance from HUDCO. iv) Frequent strikes

and lockouts have also caused idleness in spindles. The strained relation

between employer and employees could be reduced to a greater extent by

associating the workers in vital areas of management such as production

programmes, utilization of capacity, quality improvement and productivity

improvement. They need to be educated on the imperative of regular

attendance, reduction in waste, increase in spinning efficiency and so on.

The spinning mills should also concentrate on the provision of welfare measures

like better canteen facilities, recreational facilities, medical. ; care etc.

This would go a long way in promoting labour efficiency.

Bringing down the Cost of Production : The sugar mills may have no

control over cost of sugarcane, an important component in cost of production

281

61 sugar, as sugarcane price is fixed by the government. Hence the areas

where the cooperative sugar mills need to bestow their attention are better

capacity utilization, recovery, improving the productivity of workers and

administrative personnel, reduction in the cost of maintenance and repair

and modernization of machinery.

The economy of the cooperative spinning mills depends on the

availability of cotton in the required quality and quantity at reasonable

price. Eventhough the centralised procurement of cotton facilitates the

purchase of quality cotton at a reasonable price, still there is vast scope

for reducing the proportion of raw material cost in total turnover by

appropriate mixing of cotton. Generally for production of any yarn no one

single variety of cotton is used. The properties of different types of cotton

vary in respect of staple length, fineness, maturity, strength and thrash

content. An optimum blending of different varieties of cotton has to be

determined taking into consideration the price of cotton, vis-a-vis its different

properties. Hence in a way it is the optimum combination of economics

and technology which helps to determine the right type of mixing for the

particular count of yarn or group of counts of yarn to be manufactured.

The quantum of waste that takes place during conversion process from cotton

to yarn in the case of different varieties is also a material factor to be

considered in the selection of cotton for the purpose of mixing, as it ultimately

determines the expensiveness or inexpensiveness of the clean cotton cost

in yarn. Thus avoiding of wastage, increasing the recovery of yarn and

appropriate mixing of cotton may help in reducing the proportion of raw

material cost in the total cost.

282

Another area which deserves attention is labour cost. The cooperative

spinning mills in addition to the permanent strength of workers engage a

few temporary workers in each department depending on the fluctuation

in work load. In order to exercise proper control on the productive utilization

of labour force, records should be maintained showing the number of persons

engaged per 1000 spindles shifts.

Improving Financial Management : Flexible budgets for various levels

of capacity utilization should be prepared in a more scientific way and the

actual performance should be reviewed against the estimates at periodic

intervals to set right the deviation, if any. This requires the installation

of budgetary control system in each mill. The techniques of ratio ; analysis

and performance budgeting may be used by the department of finance to

monitor the financial performance of the mills.

A pragmatic financing policy for the mills would be to finance their

ongoing operations with funds generated internally. This calls for strategic

and operational measures to increase the internally generated cash surpluses.

Adoption of' scientific planning and control of inventories, receivables, cash

and continuous evaluation of mill's product-line by such techniques like

contribution margin could go a long way to improve the cashflow situation

on a lasting basis. Cashflow forecasts have to be prepared regularly and

methodically and cashflow budgets drawn up on the basis of cashflor forecasts.

All these presuppose the availability of correct and reliable data and

a systematic feedback. It is, therefore, necessary that the cooperative sugar

283

and spinning mills should take steps to develop financial information system

that can generate the required financial information for the purpose of

financial planning and control. This also presupposes that the orientation

of the accounts department must change from one of conventional accounting

to that of financial management. All these necessitate the instalation of

computers for processing management information.

Revival of Democratic Control : The principle of democratic control

which is the cardinal principle of cooperation should be restored in Tamil Nadu

without any further delay. The special officers should be replaced by elected

boards of directors in the cooperative sugar and spinning mills. The number

of nominated directors in the Boards should not exceed 25 percent of the

total directors. Nominated members should have no voting rights. Member

education programmes should be launched in order to create awareness

and enlightenment among the members.

Reorganising Organization structure : The organizational set-up should

be reorganized with reference to the requirements of effective professional

management with a separate department for finance. This department should

be manned by persons with professional qualifications and expertise in financial

management. A costing section may be an integral part of the finance in

each mill.

Blending Democratic Control with Professional Management : The

bye-laws may suitably be amended so as to redefine the powers and functions

of the elected board and the chief executive. While the board should

284

concentrate on policy making and evaluation of performance of the effective

management, the chief executive should be vested with adequate authority

to discharge his managerial, operational and technical responsibilities.

Pricing of Sugarcane : The unsound price policy should be replaced

by a rational policy based on a proper balance between the interests of

the growers and the consumers. An initial minimum price based on the

minimum price fixed by the Central Government adjusted to local cost of

cultivation may be paid to the growers at the time of delivery. Later,

patronage dividend on supply may be paid out of the profits in proportion

to the value of sugarcane supplied by the members. The payment of price

according to the weight of sugarcane supplied is not a very sound strategy.

The quality of cane in terms of sugar recovery should also be considered

in fixing prices. It is desirable to promote the cultivation of high recovery

varieties of sugarcane.

Pricing of Sugar : The price of levy sugar should be related to the

cost of production in different sugar zones.

Capital Structure

Findings

The major sources of capital for cooperative sugar and spinning mills

are share capital from members and government and borrowings from term-

lending institutions, the State Cooperative Bank and the State Government.

285

The shares in cooperative sugar mills are issued to members and the

government. The ceiling on the contribution of share capital by the government

is around 50 percent of the total paid-up share capital. Every producer

member has to take at least one share for every one acre under sugarcane

cultivation. The value of a share ranges from Rs.200 to Rs.250. The co­

operative sugar mills augment the share capital by converting the non­

refundable deposits of members into share capital. The non-refundable

deposits from the members are collected at the rate of Rs.7.50 per tonne

of sugarcane supplied by the producer-members to the mills. Dividend

payable to members is also converted into shares.

Cooperative spinning mills issue shares to apex and primary weavers

cooperative societies, other cooperative institutions and the government.

The value of share is Rs.100.

Both the categories of mills raise, long-term loans to meet the capital

expenditure. Both the types of mills were not permitted to issue bonds

or debentures.

The cooperative sugar and spinning mills involve huge capital outlay.

But their equity base is thin because they are organizations of economically

weaker sections. Hence they have to rely heavily on long-term loans. The

proportion of debt has been found to be as high as 75 percent in the capital

structure of some of the mills especially during the initial years and periods

of expansion. When the term loans were repaid in instalments by these

mills, the proportion of debt declined and the proportion of equity in the

capital structure increased. The average proportion of debt in the capital

286

structure of the cooperative sugar mills was 56.06 percent in 1961-'62 which

came down to 23.73 percent in 1983-'84. The proportion of equity has

increased from 43.97 to 76.27 percent during the same period. Similar trend

was observed in cooperative spinning mills. But the cooperative sugar mills

were able to bring down the proportion of debt to the lowest possible level

by repaying the instalments of loans regularly, whereas the cooperative

spinning mills could not do so because of their poor financial performance.

The reserves are weak in both the types of mills. Most of the mills

had no reserves especially during the period from 196i-'62 to 1972-73.

The situation has improved in the subsequent period. But the proportion

of reserves in equity was less than 10 percent in many of the mills. The

position of reserves in cooperative spinning mills was much worse.

The average proportion of Government's contribution in the paid-up

share capital of cooperative sugar and spinning mills ranged from 25 to 45

percent and between 75 to 95 percent respectively. Thus the cooperative

spinning mills have heavily relied upon State Government for their share

capital.

Conclusion

The analysis of the capital structure of the selected cooperatives

revealed that there was no set capital structure for the mills. The norm

for debt-equity in early 60's and 70's was 2 : 1 . It was revised to 1 : 1

in the beginning of the current decade. But this norm was not maintained in

287

many of the mills. There were variations within the industry and between

the industries. Some mills had zero level of debt at some point of time

whereas some have a debt proportion of more than 75 percent. Some had

found it difficult to bring down the proportion of debt and therefore the

debt was hovering at a high level.

Suggestions

The norms of debt equity ratio laid down for cooperative sugar and

spinning mills should be strictly adhered to. Each mill should calculate its

debt-equity ratio periodically keeping in mind the norms. All possible steps

should be taken to strengthen the equity base. (For details, see the section

on "Factors influencing and relationship between capital structure and cost

of capital")

Cost of Capital

Findings

The estimation of cost of capital in cooperative is different from

that in a private enterprise. The shares of cooperatives have unique features.

They are not transferable and are not traded in stock exchanges. They carry

only a fixed nominal rate of interest depending on the amount of surplus

available for distribution. Therefore the procedure for equating the market

value with the present value of the expected benefits by a discount rate

as followed in corporate sector cannot be adopted in cooperatives. Similarly,

288

the formula to calculate the cost of debt capital cannot be applied to co­

operative because cooperatives borrow from several sources, at different

rates and on different terms and conditions. Keeping these special aspects,

a different appropriate approach was developed in this study for computing

the cost of equity and debt.

The cost of share capital in cooperatives is the average rate of dividend

paid over the study period. The cost of debt is the weighted average cost

of debt. The cost of retained earnings is calculated on the basis of opportunity

cost, that is, the average rate of dividend that has been paid to the share­

holders. The weighted average cost of capital is the summation of all the

costs associated with acquiring cooperative capital.

The cost of debt is costlier than the cost of share capital in both

the categories of mills. The cost of debt ranged from 8 to 12 percent in

both the mills. The average cost of debt for the cooperative sugar mills

as a whole was 10.40 percent and for spinning mills it was 10.44 percent.

The average specific cost of share capital for cooperative sugar mills was

6.U percent and that for cooperative spinning mills was 6.39 percent. Thus

the average specific cost of debt was higher than that of share capital.

The overall cost of capital was hovering around 6 to 10 percent in

cooperative sugar mills and 4 to 8 percent in cooperative spinning mills

at the initial stage. This has subsequently declined due to repayment of

debt in instalments. Similarly the overall cost of capital was on the higher

side in both the types of mills at the time of expansion and modernization,

289

but it declined later. It was also observed that many of the sugar mills

were able to bring down the cost of capital at a quicker pace than the spinning

mills.

Conclusion

The cost of debt was costlier than the cost of share capital and retained

earnings. The overall cost of capital was found to be high at the initial

stage and at the time of the expansion of capacity and modernization of

plant. The behaviour of the cost of capital is influenced by financial leverage.

Suggestions

Suggestions for reducing the cost of capital are discussed in the section

on "Factors influencing the relationship between capital structure and the

cost of capital",

Relationship Between Capital Structure

and the Cost of Capital

Findings

Capital structure decision is concerned with the composition of

capitalization, the relative proportions of various long-term sources of capital

and the financial leverage. Financial leverage refers to the use' of fixed

charge sources of funds such as debt and preference share capital in the

capital structure. The basic logic behind financial leverage is that the owners

of the firm will have the benefit of a higher rate of return on their capital

290

than that earned by the firm on its total capital through the use of fixed

sources of funds, provided the rate of fixed charges is less than overall

rate of return on the firm's total capital. Thus, financial leverage has a

significant bearing on the composition of capital structure and the cost

of capital. A firm can bring about a change in the cost of capital through

changes in debt equity proportion in the total capital.

The analysis of relationship between the capital structure and the

cost of capital in sample cooperatives shows that there is a direct positive

association between these variables. In the mills under study, the overall

cost of capital tended to increase with a rise in the proportion of debt

in the total capital ; and it recorded a declining trend with a fall in the

proportion of debt, because in cooperatives debt is the costliest source of

fund. The cost of debt is higher than the cost of share capital and retained

earnings. Further the cost of debt is constant whereas the cost of share

capital and retained earnings tend to reach zero level whenever the co­

operatives pay no dividends. A rise in the proportion of debt, therefore,

tends to increase the overall cost of capital.

Conclusion

Cost of capital in cooperative is a function of financial leverage.

Cost of capital tends to rise with a rise in proportion of debt and it falls

with a fall in proportion of debt in the capital structure.

291

Factors Influencing the Relationship Between the

Capital Structure and the Cost of Capital

Findings

The cooperatives need to bring down the cost of capital in order

to fulfill their objectives of extending services to their members at a

reasonable cost. The cost of capital is greatly influenced by financial

leverage, which in turn, is determined by several direct and indirect factors.

The two direct factors which determine leverage are 'need for funds' and

'internal financing'.

The Influence of 'Need for Funds' on Leverage : The need for funds

arise when a firm is promoted ; when it is expanded/modernized ; and when

it incurs social expenditure.

The investment made during the establishment of a firm is called

initial investment. The initial investment depends upon the capital intensive-

ness of the firm. The cooperative sugar and spinning mills are capital

intensive in nature, requiring a huge capital outlay. The establishment of

a cooperative sugar mill with a crushing capacity of 1250 TCD involved

an outlay of Rs.256.26 lakhs in 1971-72. The cost has increased steadily

over a period of time and it stood at Rs.1020 lakhs in 1983-'84. Similarly

the cost of establishing a cooperative spinning mill with a capacity of 12,000

spindles has increased from Rs.61 lakhs in 196<f-'65 to Rs.265 lakhs in

1984-'85. Thus the establishment of cooperative sugar/spinning mill requires

huge amount of capital outlay which could not be met out of owned funds.

292

Hence the mills had to rely upon debt capital. Naturally the leverage was

higher in the initial stages varying from 60 to 75 percent in the case of

cooperative sugar mills and 60 to 67 percent in cooperative spinning mills.

The remaining portion represents share capital only due to the absence of

any reserves. An examination of composition of share capital revealed that

a major chunk of share capital had been contributed by the government.

Moreover, there was cost overrun in some mills to the extent of

Rs.6 to 10 lakhs because of delay in completing the project. Thus, delay

in commencing the production operations of the mills did have some, though

not dramatic, effect on leverage.

The additional investment depends upon the growth rate. The growth

rate is influenced by expansion and modernization. Expansion/modernization

also involves a considerable amount of capital expenditure. Higher growth

rate would mean high amount of capital and greater proportion of capital

has to be derived from debt sources. Thus, there is a positive association

between growth rate and leverage. The results of the correlation also run

in the expected direction, but the association is rather weak. The reason

is that the selected mills have been able to finance their expansion/

modernization partly through internally generated funds during latter stages.

The need for debt capital at the time of expansion/modernization is less

when compared to the initial period.

293

Cooperative sugar mills were found to have launched various social

welfare programmes like promotion of education, health and medical care

within the area of operation of the mills. Spinning mills have not undertaken

such activities. The expenditure incurred on social welfare by the cooperative

sugar mills was financed mainly out of earnings before depreciation and

also the Area Development Fund. As such the expenditure on social welfare

does not affect leverage.

The Influence of Internal Financing on Leverage : Internal financing

is negatively correlated to leverage in the mills under study and this means

the mills with retained earnings have been able to bring down the level

of leverage and the mills which do not have retained earnings are operating

at a higher level of leverage.

Retained earnings or internal financing depends upon the profitability

of the mills. Mills earning profits are able to generate internal funds. Thus

profitability indirectly influences the level of leverage. Profitability itself,

in turn, is influenced by a set of factors.

Factors Affecting Profitability : The five variables considered

for the indepth analysis are : i) capacity utilization ; ii) degree of operating

leverage ; iii) total assets turnover , iv) fixed assets turnover and v) inventory

turnover.

29<f

fixed assets turnover and inventory turnover. This association is not quite

unexpected. Whereas, in the case of cooperative spinning mills capacity

utilization and fixed assets turnover are the only two factors associated

with profitability.

Multiple Correlation and Regression Analysis : The five variables

namely capacity utilization, degree of operating leverage, total assets turnover,

fixed assets turnover and inventory turnover, to which correlation analysis

was applied, are also subjected to multiple correlation and regression analysis.

The results show that the contribution of above factors to profitability was

21.30 percent in cooperative suga'r mills. They also show that individually

when other variables are kept constant only two variables namely fixed

assets turnover and inventory turnover significantly influence profitability

and these factors together account for 20.50 percent of variations in

profitability. Also, the standard regression coefficient indicates that fixed

asset turnover is the most important followed by inventory turnover in the

case of cooperative sugar mills. But in the case of cooperative spinning

mills, the results of multiple correlation and regression analysis reveal that

the percentage contribution of the five factors was only 7.3. Further-more

the test of controlled association shows the fixed assets turnover only

significantly influences profitability.

Factors Influencing Gross Operating Margin : It was found that

there was a close positive association between gross operating margin and

profitability. Gross operating margin in turn is influenced by a set of variables,

295

namely, recovery, rate of change in cost of productio, rate of change in

selling price and variability in sales in the case of cooperative sugar mills.

The analysis shows that recovery is positively associated with gross operating

margin as expected. The rate of change in cost of production is negatively

correlated, as expected. The correlation between variability in sales and

gross operating margin is negative and significant ; but it runs against the

expectation. The rate of change in selling price had a weak association

with gross operating margin.

Multiple Correlation and Regression : All the four variables were

also subjected to multiple correlation and regression analysis. The total

contribution of four variables to gross operating margin was around 25 percent.

The analysis also indicated that individually when other variables are kept

constant, only three factors namely recovery, rate of change in cost of

production and variability in sales significantly influenced gross operating

margin and these factors together account for 23.6 percent of the variation

in gross operating margin. The standard regression coefficient indicated

that recovery is the most important factor followed by rate of change in

cost of production and variability in sales.

In cooperative spinning mills, only two variables namely rate of change

in cost of production and variability in sales were analysed in the above

fashion. The rate of change in cost of production did not correlate well

with gross operating margin, whereas variability in sales had a positive and

significant association with gross operating margin. When these two variables

were put into multiple correlation and regression analysis, the total

296

contribution of these two variables to gross operating margin was only 7.H

percent.

Age and Leverage :

Age is also determinant of leverage. A younger cooperative may

require more amount of debt capital because of high cost of setting up a

business coupled with low equity. On the other hand an older firm may

be operating at a lower level of leverage because of successful operation

and solvency. Age and leverage are negatively correlated in cooperative

sugar mills indicating that younger firms have high debt level and the older

firms have low debt level. But in cooperative spinning mills age and leverage

are positively correlated. This was mainly because of the fact that many

of them had unsuccessful operation and they were not successful in bringing

down the level of debt over the years.

Leverage in a Successful Cooperative

A firm successful in its operation may retire its debt early thus bring

down leverage level. The relation between successful operation and leverage

revealed that a successful cooperative has attained lower leverage in lesser

number of years than an unsuccessful cooperatives. Success was measured

by profitability. This corroborates the fact that profitability and leverage

are negatively correlated.

Conclusion

The findings of the study demonstrate that the cost of capital increases

297

as the leverage increases*. , Many cooperatives were found to be operating

at a higher level of leverage, hence the high cost of capital. High cost

of capital coupled with poor profitability has rendered many of the mills

under study financially weak. A financially weak cooperative cannot fulfill

its objective of providing effective service at a reasonable cost. Thus there

is an urgent need for bringing down the cost of capital. This can be done

only by bringing down the level of debt in the capital structure. The level

of debt or leverage is primarily influenced by the need for funds and the

internal financing. Behind each of these variables as we have seen a host

of other variables indirectly affect leverage. The mills need to bestow

adequate attention to these variables in order to bring down the leverage.

Presented below are some suggestions for bringing down the leverage and

hence the cost of capital.

Suggestions

1. Before launching a cooperative sugar/spinning mill or before expanding

its capacity or before modernizing plant, the debt capacity of the

mill has to be carefully studied by cashflow analysis. If the expected

net cashflow is large enough to meet the estimated debt servicing

cost it may resort to debt ; otherwise it may try to reduce the debt

level as much as possible. This exercise was not carried out by many

of the mills studied.

298

On completion of the projects, the mills never bothered to find out

the deviations from the original cost estimate. Escalation of cost

is bound to affect the leverage. Hence the mills need to conduct

a post-project audit to analyse the cause of deviations and their

effects ion future cashflow, debt servicing cost and the cost of capital.

Such an analysis would help the management to know where exactly

things have gone wrong and what remedial actions should be made.

The Directorate of Sugar and the Directorate of Handloom and Textiles

which have trained technical personnel may be entrusted with the

responsibility of such a post-project audit.

The mills relied heavily on debt at the time of their promotion.

Such a high level of debt adversely affected their cost of capital

and profitability. Hence it is suggested that the borrowings for fixed

assets at the initial stages should not exceed 60 percent of the value

of such fixed assets. The cost of capital at this debt level would

be around 6 percent. The expansion and modernization may be financed

by internally generated funds to the extent possible and borrowings

for these purposes should not exceed 50 percent of the estimated

outlay. The approximate cost of capital at this debt level would

be around 5 percent.

As any project overrun in cost and time adversely affects the earnings

and the cost of capital, there should be an effective monitoring of

project implementation.

299

Long-term loans raised for financing capital expenditures should be

repaid as early as possible so as to reduce the level of leverage and

the overall cost of capital.

Some mills have resorted to 'ways and means' advance from the

government in order to meet debt servicing cost. Such a practice

has not only added to the debt burdens of the mills but also seriously

affected their liquidity and working capital position. Hence it is

absolutely necessary that the mills should meet fixed charges only

out of their earnings.

The ability of the mills to tolerate leverage depends on the stability

of the net operating income. Mills with unstable income should try

to avoid debt as much as possible.

As low gearing i.e. a lower proportion of debt in the capital structure

is a means for minimizing the cost of capital in cooperatives, they

should aim at low gearing at least over a period of time. This could

be achieved by collecting additional share capital from members in

proportion to the value of their patronage (cane supplied/yarn purchased

as the case may be), conversion of dividend on share capital and

patronage into share capital with members' consent, and allocation

of higher percentage of profits to reserves. Recurring and fixed

deposits from the public may . also be accepted, as cost of this source

is lower than that of borrowings.

300

9 Ownership and control should always be vested with members. Excessive

state support in the form of share capital contribution to cooperative

sugar and spinning mills has led to a dependency syndrome, affecting

the democratic character and autonomy of the mills. Therefore mills

should try to redeem the share capital subscribed by the government.

A Share Capital Redemption Fund may be created in each mill to

redeem the share capital contributed by the government.

10. The location of the mills especially sugar mills should be carefully

considered. Their success largely depends on regular availability of

adequate quantity of sugarcane throughout the season. The inadequate

availability of raw material results in under-utilization of production

capacity and this inturn affects the financial viability of the mills.

Hence careful selection of site assumes greater significance.

11. Each mill should calculate the overall cost of capital in financing

a project and compare it with the expected rate of return. But,

no mill under study has given serious attention to this important aspect.

The promoters of the new mills should get this exercise done through

consultants. The viability of expansion/modernization should be

scientifically evaluated by the finance department of the mill, if

necessary, with the help of financial consultants.

12. The mills should take inflationary conditions into account and create

Replacement Fund in addition to normal depreciation, in order to

provide for adequate funds for replacing fixed assets when they go

out of use.

<'jf

301

13. The mills should try to improve their profitability by adopting effective

methods of management and cost control techniques in order to bring

down the cost per unit and increase profit margin. An improvement

in financial performance would facilitate early redemption of debt

and strengthening owned capital.

14. Mill should have sufficient working capital to operate the plant. Lack

of sufficient working capital may lead to ineffective utilization of

fixed assets, which, in turn, would affect profitability and thus leverage.

Similarly mills should not seriously deplete its working capital at

the time of expansion/modernization.

Suggestions for Further Research

Research studies in financial management in cooperatives are rare.

There is vast scope for conducting research in financial management in

cooperative organizations. Some of the areas for research in financial

management in cooperatives are :

1. The status of financial management in various types of cooperatives

and their financial management practices may be studied with a view

to suggesting better approaches and methods.

2. In order to evaluate the financial performance of different types

of cooperatives, norms for liquidity, operational efficiency etc. have

to be established. Such norms are required for intra-firm and inter-firm

comparisons.

302

3. Intensive studies of cashflow pattern in different types of societies

may be made in order to develop models for determining cash balances

to be maintained.

*f. Liquidity management is important in large sized cooperatives. Research

studies to determine the optimal structure of current assets and to

plan the investment of excess cash balance may be undertaken.

Similarly studies for determining the optimal financing mix for financing

current assets may be made.

5. Another area of research is financing of replacement and modernization.

What should be the mode of financing replacement/modernization ?

How tax and other incentives available for capital expenditure influence

financing decision relating to replacement/modernization ? These

issues call for an indepth study. The findings of such studies may

be of great help in setting guidlines for future action on replacements

in older cooperatives.

6. Government plays a major role in promoting, developing and controlling

cooperative organizations. The policies of the government particularly

licensing, taxation, fiscal, control of prices of input and output have

an important bearing on financial decision in cooperatives. What

is the impact of such policies on the financial decisions ? How do

they promote or retard cooperative growth ? These issues invite

an indepth analysis.