CAPITAL BUDGETING When in long run a firm shift from a smaller to a larger plant size then what the firm will have to do to made such shift, changeover to a bigger plant size requires investment in new capacity. Even keeping to the same plant size over time, requires replacement of worn-out plant. All these require investment of resources.

Investment is defined as the acquisition of durable productive facilities in the expectation of a future gain. It normally consists of physical capital like plant, equipment, building, machinery etc. it may also include non- physical capital like training of personnel etc.

Investment or capital expenditure usually involves a large sum of money (although the amount need not be huge) incurred at a point of time where as benefit are realized at different point of time in future but it is very natural, investment decision becomes vital to almost organization.

So how well this activity is planned and implemented. The value of investment lies on potential profit. If a firm acquires a capital asset which gives less revenue than its cost the business will definitely suffer setback. Hence a correct estimation of the worth of investment is essential before the investment is undertaken.

Capital Budgeting Decision: Project which keep on generating return for a long period (i.e. more than a year) are known as capital project.

e.g. - factory building, transport vehicles, new plant.

The capital budgeting process can be classified into three broad categories:-

1. Investment selection 2. Financing investment 3. Allocation of funds among project

1) Investment selection :-

It involves decision regarding both the amount of investment in the planning period and selection of project.

It consist of

Expansion of firm production facilities (to meet growing demand for the product of the company)

Replacement decision : (Replacing damaged or obsolete plant and machinery by more efficient one.

New improved product decision (to bring new or changed product in the market, certain investment are needed like expenditure on R & D, market research, advertisement etc.

Make or buy decision :- To produce the product or to purchase it from vendor (supplier)

Lease or buy decision :- A firm may decide to lease equipment rather than invest sizeable funds for buying equipment.

2) Financing investment :-

There are certain norms against which the benefits are to be judged from the long term investment.

E.g.:- minimum rate of return, required rate of return.

Sources of capital to the firm are presumed to be:

a) External sources (the capital market) b) Internal sources (retained earning)

Each specific sources of capital has its own cost, which becomes a component part of overall cost of capital to the firm.

3) Allocation of fund among project :-

Factors influencing investment decision;

a) Technological change: - new technology which is relatively more efficient, takes place of old technology. However in taking decision of this type, the mgmt has to consider the cost of new equipment, salvage value of replaced equipment.

b) Competitors strategy:- many a times a investment taken to maintain the competitive strength of the firm. If the competitors are installing new equipment to expand output or to improve quality of their product the firm under consideration will have no alternative but to follow suit(go with).

c) Demand forecasting:- the long run forecast of demand is one of the determinant of investment decision. If it is found that there is market potential for the product in the long run, the dynamic firm will have to take decision for capital expansion.

d) Types of management:- whether capital investment would be encouraged or not depend

to a large extent on the view point of the management.

If mgmt is modern & progressive then innovation is encouraged.

e) Fiscal policy:- various tax policies of the government have favorable or unfavorable

influence on capital investment. E.g. excise duties, method of allowing depreciation.

f) Cash flow:- every firm makes a cash flow budget. Its analysis influence capital investment decision. With its help the firms plans funds for acquiring the capital asset.

g) Return expected from the investment:- in most of the cases, investment decision are made in anticipation of increased return in future. While evaluating investment proposal, it is therefore essential for the firm to estimate future return or benefit accruing from the investment.

Steps in capital project evaluation:-

In order to evaluate a project we need to have three kind of information:

1. List of investment proposals (developing investment proposals) 2. Estimate cash flow of each of these proposals. 3. Knowledge about the various criteria used for project evaluation.

1) Developing investment proposal: The capital budgeting process begins with the generation of capital investment proposals. A firm growth and development depend upon a constant flow of new investment ideas. Many investment opportunities reveals themselves in ordinary course of business (e.g.

need to replace worn-out machinery) Various corporate strategies are made by the business acquisition to achieve competitive

edge over it competitors project. Which are not compatible with corporate strategy are rejected and those that are essential to implement, the strategy are accepted. It must be noted that the strategy is not static - as time passes and circumstances changes, new strategies involve. Thus the first step is screening process is to assemble a list of proposed new investment, together with the data necessary to evaluate them.

This data include: a) Estimating investment requirement of the project. b) Forecasting cash inflow of the project. c) The mgmt attitude towards risk. d) Time value of money.

2) Estimating cash inflow:-

In capital expenditure proposal analysis the most important and difficult step is to estimate cash flow associated with the project. Cash flow is of two kinds:-

Cash outflows (Associated with building and equipment the new production facility)

Cash inflow The annual cash inflows the project will generate after it goes into operation. A large no. of variables are involved in the cash flow forecast and many individual and departments participate is developing them.

Guidelines for estimation of cash flows:-

a) Cash flow must be constructed on incremental basis. ( only the difference of cash flow due to acceptance of the project are relevant for inclusion in investment analysis).

b) Indirect cash flow must be taken. e.g. the impact of a new product on the sales revenue of the existing product.

c) Cash flow should be constructed on an after tax basis (because that represents net Flow from the point of view of the firm).

3) Evaluation of project:- Capital project have a finite life over which the project yield a stream(flow) of annual receipt. A fundamental concept that must be understood while taking as out stream of annual receipt is the notion of time value of money. The investment in projects occurs only in initial years of the project. The net return from the project comes in stream of annual receipt.So net return from the project can be scientifically calculated only when the cash inflow and outflow are expressed in terms of common denominator.

I.e. when the stream of annual cash flows is disconnected to find the present value. Evaluation of project

Traditional method Time adjusted method

ARR P B Period NPV PI IRR

1) Return on investment or , average rate of return (ARR) :- ARR = Average profit

Average investment * 100 Where, Average profit is = total profit during the life of the project Number of years

2) Pay back period:- Pay back period means period required to get back initial investment. Less the pay back period better the project.

Modern techniques of investment:

1) Net present value:- This method is based on the economic reasoning of discounting future cash flow

to make comparable. NPV is calculated by discounting all future flows to present and subtracting. The

present value of all cash out flow from the present value of all inflows. If NPV of project is positive, this indicates that project add more to revenue than

it adds to cost. Therefore accepted. NPV (+) = accepted

If NPV of project is negative the project should be rejected. NPV (-) = rejected

If NPV is zero than by any other evaluation method to evaluate the project.

NPV = nt=1 Rt _ Co (1 + r )t

t = time period ( 0 to n year) Rt = cash inflow in period t Co = initial investment or cash outflow R = discount rate (cost of capital) N = last period of project

1) TIME VALUE OF MONEY: - Time value of money means that value of a unit of money is different in different time periods. The concept of time value of money refers to fact that the money received today is different in its worth from the money receivable at some other time in future. In other words, the same principal can be stated as that the money receivable in future is less valuable than the money received today.

The main reason for the time preference of money is to found in the reinvestment opportunities for funds which are received early. The funds so invested will earn a rate of return; this would not be possible if the fund is received at a later time.

Example: Suppose a firm is selling a machine for RS. 20,000 .The buyer offers to pay Rs.20, 000 either now or after one year. The seller firm naturally accepts the first choice. i.e. to receive Rs. 20000 now. In this case firm reinvest the amount in fixed deposit account for one year and get return 2000 @10%. So in first case co. net income is 22,000 where as in second option co. income is 20,000. In this case interest amount is time value of money.

So we can say that T.V.M. for the money is its rate of return which the firm can earn by reinvesting its present money. This rate of return can also be expressed as a required rate of return to make equal the worth of money of two different time periods.

CHAPTER NO.:-3

CAPITALIZATION

Meaning: - Capital Structure ordinarily implies the proportion of debt and equity in the total capital of a company. Since company can tap any one or more source of funds to meet its total financial requirement .The total capital of a company may thus be composed of all such tapped sources.

Capital may be defined as long term funds of the firm.

Capital is the aggregation of the items appearing on the left hand side of balance sheet minus current liabilities (total liabilities current liabilities).

Capital is also be expressed as total asset minus current liabilities. (Total asset Current liabilities).

Types of Capital:-

Equity Capital:-

Why its necessary to study the capital structure theories :

The basic objective of the financial management is to maximize the shareholders wealth and therefore all financial decision in any firm should be taken in light this objective. The decision regarding the capital structure or the financial leverage or the financial mix should also be based on the objective of achieving the maximization of shareholder wealth. The capital structure theories attempt to analyze the relationship between capital structure and the value of the firm in terms of different theories and models on the subject matter.

Concept of value of the firm: - The value of firm depends on the earning of the firm and earning of the firm depends upon the investment decision of the firm. The earnings of the firm are capitalized at a rate equal to the cost of capital in order to find out the value of the firm.

Thus the value of the firm depends on two basic factors.

i. The earning of the firm ii. Cost of capital

The operating profit (i.e. EBIT) of the firm is mainly divided into three claimants

A. Debt Holders (debenture, banks loan .Others loan,) :- By way of interest. B. Government : - By way of taxes. C. Shareholders : - By way of dividend.

If we talk about size of EBIT, it is depend on investment decision of the firm.

While capital structure of the firm determine how EBIT is to be sliced among three above claimants.

The total value of the firm is sum of its value to the debt holder and to its shareholders and is determine by the amount of EBIT going to them respectively. Therefore the investment decision can increase the value of the firm by increasing the size of the EBIT where as the capital structure mix can affect the value only by reducing the share of the EBIT going to the Government in the form taxes.

Capital structure or financial leverage or financing mix of the firm does not affect the total earning of firm. However earnings available to the shareholders may be influenced by capital structure of the firm. For a given level of earnings lower the cost of capital, the higher would be the value of firm. But, what is the relationship between financing mix, cost of capital and the value of the firm? Is there any optimal capital structure? Can value of the firm be maximized by affecting the financing mix or by affecting the cost of capital? If leverage affects the cost of capital and the value of the firm, then the firm should try to achieve an optimal capital structure or optimal financing mix and minimizing the cost of capital .is there really a capital structure which may be called the optimal capital structure?

Factors Determining Capital Structure

1) Control: - The mgt. control over the firm is one of the major determinants of capital structure decision.

The equity shareholders are considered as the real owner of the company, since they can participate in decision making through the elected body of representatives called Boards of Director.

The preference shareholders and debenture holder cannot participate in decision making.

When the promoters do not wish to dilute their control, the company will rely more on debt fund. Any fresh issue of shares will dilute the control of the existing shareholders.

2) Risk: - Mainly two risks are involved in capital structure decision

(a) Business Risk (BR) (it is influenced by demand, price, input, competition in market, fixed cost, etc.)

(b) Financial Risk (FR represents the risk from financial leverage )

FR is least if the project is financed by equity capital, since equity dividend is payable only when there is sufficient fund for appropriation and equity capital need not to refunded during the life time of the company.

FR is high if the proportion of debt fund is more in capital structure, since the interest is to be paid to the financer even if profit is low and borrowed fund is to be paid off to them after certain period or at the time of maturity.

3) Income: - Increase of return on equity shareholders depends on the method of financing and its impact. (Explain at the time of theories of capital structure).

4) Tax consideration: - Under provision of income tax

Equity & preference dividend paid to the shareholder are not eligible for deduction under income tax act. However interest paid for borrowed fund is deductible expenditure before calculation of income tax. The tax saving on interest charge reduces the cost of debt fund.

5) Cost of Capital :-

6) Trading on equity:-The firms wealth is increased, if after tax earning is increased. A co. can raise debt at low cost with a view to enhance the earning of equity share holder. The cost of debt is less due to tax advantage.

7) Investor attitude: - All investor have different expectation from their investment, so co. should tap that investor whose return expectation is low, so that it will decrease total cost of capital.

8) Flexibility: - One very important feature of debt fund is that debt fund may be raised and can be paid off as when desired. But in case of equity, once the fund is raised through issue of equity shares, it cannot ordinarily be reduced except permission of court and after by doing lot of compliances.

9) Timing: - Economic condition is also one of important consideration need to be take care at the time of capital structure decision. At the time of recession the equity share holder will not show much of interest in investing. But at the time of boom it would be easier for firm to raise equity capital.

10) Legal provision:-The legal formalities required before issuing equity share is more complicated than raising debt.

11) Profitability: - A co. with higher profitability will have low reliance on outside debt fund and it will meet its additional requirement through internal generation.

12) Growth rate: - The growing co. requires more and more funds for its expansion schemes which will meet through raising debt. The fast growing co. will rely more on debt fund than equity or internal earning.

13) Government policy: - Increase in lending rate by govt. may cause the companies to raise finance from capital market.

Meaning of optimal capital structure:-

The optimal capital structure is the capital structure at which the weighted average cost of capital is minimum and there by maximum value of the firm. It also may be defined as the capital structure or combination of debt and equity that leads to the maximum value of the firm.

Over capitalization & under capitalization

Over capitalization:-

Generally over-capitalization implies that the capital of the company exceeds its requirements. A company is overcapitalized when its earning capacity does not justify the amount of capitalization. In other words, a company is said to be overcapitalized when its actual profits are not sufficient to pay interest (on debentures and borrowings) and dividends (on share capital) at fair rates.

A concern is said to be over-capitalized if its earnings are not sufficient to justify a fair return on the amount of share capital and debentures that have been issued.

It is said to be over capitalized when total of owned and borrowed capital exceeds its fixed and current assets i.e. when it shows accumulated losses on the assets side of the balance sheet.

A company is said to be overcapitalized, when its total capital (both equity and debt) exceeds the true value of its assets. It is wrong to identify overcapitalization with excess of capital because most of the overcapitalized firms suffer from the problems of liquidity.

Causes of Over Capitalization: Some of the important reasons of over-capitalization are:

1. Idle funds: The Company may have such an amount of funds that it cannot use them properly. Money may be living idle in banks or in the form of low yield investments.

2. Over-valuation: The fixed assets, especially good will, may have been acquired at a cost much higher than that warranted by the services which that asset could render.

3. Fall in value: Fixed assets may have been acquired at a time when prices were high. with the passage of time prices may have been fallen so that the real value of the asset may also have come down substantially even though in the balance sheet the assets are being shown at book value less depreciation written off. Then the book values will be much more than the economic value.

4. Inadequate depreciation provision: Adequate provision may not have been provided on the fixed assets with the result the profits shown by books may have been distributed as dividend, leaving no funds with which to replace the assets at the proper time.

5. Lack of reserves 6. High rate taxation 7. Borrowing money at high rates of interest 8. High promotional expenses

Disadvantage of over capitalization from Investor's or shareholder's point of View:

1) Loss in the value of investment (shares) 2) Loss of easy marketability 3) Irregular, uncertain and lower earnings on the investment (dividend on

shares) 4) Speculation is encouraged 5) Reduction in the liquidity of investment 6) Shares cannot be mortgaged easily as their utility as collateral security is

reduce 7) Loss due to reorganization

The point of view of the Society:

1) Increase in prices or reduction in quality of goods 2) Wage cuts or retrenchment of workers

3) Increase in unemployment 4) Encouragement to reckless speculation 5) Misutilization and wastage of resources 6) Reduced efficiency of the management 7) Loss of public confidence in investment etc.

Remedies for overcapitalization 1) Reduction of debt burden(debt capital) 2) Negotiation with term lending institutions for reduction in interest

obligation. 3) Redemption of preference share through a scheme of capital reduction. 4) Reducing the face value and paid-up value of equity shares. 5) Initiating merger with well managed profit making companies interested

in talking over ailing company. Advantages or merits of overcapitalization are:

1) Increase in the competitive power of the company. 2) Easy expansion of the company's activities. 3) Morale of the management is raised. 4) Risk-taking capacity is increased. 5) No fear of shortage of capital. 6) Power to face depression period is increased.

Example:- Under capitalization:-

Leverage

Meaning (dictionary) : an increased means of accomplishing some purpose (Leverage allows us to accomplish certain things which are otherwise not possible ,viz; lifting of heavy object with the help of leverage). Meaning (in financial mgt.): the term leverage is used to describe the firm ability to use fixed cost asset or funds to increase the return to its owners. The fixed cost (also called fixed operating cost) and fixed charges (called financial cost) remaining constant irrespective of change in volume of output of sales. Thus employment of an asset or source of fund for which the firm has to pay a fixed cost or return has considerable influence on the earning available for equity shareholders.

Example: As per the Income statement of XYZ Ltd. Sales is Rs.4, 00,000 .Variable cost is60%.Fixed cost is Rs.50, 000

Then EBIT is = Sales = 4, 00,000 Less: Variable cost = 2, 40,000

Contribution = 1, 60,000 Less: Fixed cost = 50,000

(Operating profit) EBIT 1 =1, 10,000

If due to some reason sales is increased by 100% (doubled)

Then EBIT will be = Sales = 8, 00,000 Less: Variable cost = 4, 80,000

Contribution = 3, 20,000 Less: Fixed cost = 50,000

(Operating profit) EBIT 2 = 2, 70,000

In above income statement you see the advantage of fixed cost in total cost is that, if the sales are double than operating profit will be more than double .this is happening due to sales work as lever to carry fixed cost, by increase in sales the distribution of fixed cost per unit start declining and it increases profit. That is known as leverage effect.

The advantages of leverage

1. If the sales are doubles operating profit will be more than double.

2. If the operating profit is the double then EBT to more than double.

This to advantage also associated with leverages in case of following & also the operating profit will decrease more than decrease in sales.

3. If the EBIT is decrease than EBT will decrease more than decrease of EBIT.

The first effect due to fixed cost is known as operating leverages &the second effect due to fixed interest is known as financial leverages the formulas are as below

1. Operating leverage = Contribution EBIT

2. Financial leverage = EBIT EBT

3. Combined leverages = Contribution EBT Operating Leverage is the responsiveness of the firms EBIT to the changes in sales value. It referred to the sensitivity of operating profit before interest and tax to the changes in quantity produced and sold. The firm OL is higher if the firm has quantum of fixed cost and low variable cost. The firm OL is low if the firm higher variable cost.low fixed cost and higher variable cost. Cost of capital: - We are raising long term fund from various sources and we have to return these principal amount as per term and condition. In addition to this we are also paying some periodical payments to the supplier of funds these periodical payments we are paying because we are using these funds.

Cost of capital is nothing but the periodical payments (other than principal amount) to the supplier of capital on account of use of capital.

I. Cost of Debt capital (Kd)

Kd = I (1- T) Amount Received Cost of debt is calculated as annual interest paid divided by actual amount received multiplied by (1- T).Cost of the debt is less than interest rate because when we pay interest we get advantage in the amount of tax reduced due to payment of interest. And i.e. the reason when cost of debt is less than the amount of interest paid. 2) Cost of preference Share (K p) Kp = Preference Dividend paid Amount Received Amount received = Issue price discount on issue of share + Premium on issue of share In case preference share capital we dont get any advantage of tax benefit because dividend is paid after payments of tax and so cost of preference share is some as dividend rate for preference share.

3) Cost of equity capital (K e) Ke = (i) E.P.S. M.P.S. (ii) D.P.S M.P.S. (iii) D.P.S. g M.P.S

4) Cost of retained earnings (Kre) is same as cost of equity

Trading on equity :-

CHAPTER NO.:-1

FINANANCE MANAGEMENT

(I) Approaches to Finance Management. Or,

Functions to Finance Management. Or,

Functions of finance manager.

Traditional View

Traditional View of finance, management looks into the following function, that finance manager of business firm will perform.

(i) Arrangement of short term and long term fund for financial institution. (ii) Mobilization of funds through financial instrument like equity shares,

preference shares, debenture, bonds.etc. (iii) Orientation of finance functions with accounting function and

compliance of legal provisions relating to funds procurement, use distribution.

Modern View

Due to globalization & liberalization of economy the function of finance manager in any organization becomes vary diversified.

In today scenario finance manger is expected to do

(i) The total funds requirement of the firm. (ii) The assets to be required and (iii) The pattern of financing the asset.

Thus finance manager of modern business firm role is divided among three basic claimants.

(1) Investment Decision (2) Finance Decision

(3) Dividend Decision

Investment Decision: - The investment decision of a finance manager covers the following areas

(i) Ascertainment of total volume of funds (ii) Selection of capital investment proposal.

(iii) Measurement of risk and uncertainty in the investment proposal. (iv) Prioritization of investment decision (v) Fund allocation and rationing (vi) Determination of fixed assets to be required (vii) Determine the level of investment in current asset (viii) Buy or lease decision (ix) Asset replacement decision (x) Security analysis and portfolio Decision.

Finance Decision:-

The finance manager involve in the following finance decision:

(i) Determine of degree or level of gearing. (ii) Determine of financing pattern of long term funds requirement (iii) Determine of financing pattern of short term funds requirement (iv) Raise funds through issue of financial instrument (equity shares,

preference share, debenture, bonds, etc. (v) Arrangement of fund through Banks and financial institution(Banks ) (vi) Arrangement of finance for working capital requirement. (vii) Portfolio Management (viii) Calculation of interest burden of the organization. (ix) Evaluation of alternative use of fund. (x) Maintenance balance between owners capital and borrowed capital (xi) Setting budget and review of budget.

Dividend Decision:-

The dividend decision of finance manager is mainly concerned with

(a)The amount paid to shareholder as dividend to influence them (b)The amount of profit retained for internal investment which maximize the value of firm The investment, finance, dividend decision are interrelated to each other and therefore finance manager while taking any decision should consider the impact from all three angles simultaneous.

(II) Objectives Objectives of finance or Objectives of Finance Manager in any Corporate

Diagram Showing Changes in objectives of finance Manager with change in market condition.(i.e.in earlier time it was profit maximization ,than wealth maximization and currently value maximization.)

It is necessary to set objective or goals for measuring performance and control. The setting of physical targets to be achieved within a set of time period provides the basis of conversion of the targets into financial objectives. The primary financial objectives of a firm are as follows:

(i) Return to capital employed (ii) Value addition and profitability (iii) Growth in earning per share and price / earnings ratio (iv) Growth in the market value of the shares (v) Growth in dividends to share holders (vi) Optimum level of leverage (vii) Survival & growth of the firm (viii) Minimization of financial charges (ix) Efficient utilization of short, medium, long term sources of fund.

Profit Maximization Objective

Traditionally the size of firms are small, owned managed and they are competing with same size of firm, thats why profit maximization was rational objective of firm. The profit of the firm became the income of the owner. Maximizing profit the ensured the self interest of the owner/manager, who both decide actions of the firm and ensured that these are carried out. The force of competition imposed profit maximization upon the firm to survive in business.

The profit maximization objective of firm is criticized for the following reason (1) The concept of profit maximization is vague and narrow (2) It ignores the risk factor, as well as timing of return. (3) It may allow decision to be taken at the cost of long run stability and

profitability of the concern (4) It emphasize the short run profitability and short term project (5) It may cause decrease in share price (6) It only thinks for owner where as other stake holder also participates for

growth of organization. (Stake holder such as, share holder, creditors, debtors, debenture holder, government, banks, etc.)

(7) It fails to consider social responsibility of business, because it moves around owner only.

Wealth Maximization Objective As the owner of the company is its share holder, the primary objective of corporate finance is usually stated to be maximization of share holder wealth .Since share holder receives their wealth through dividends and capital gains the shareholders wealth is maximize by maximizing the value of dividends and capital gains that share holder receive overtime Wealth maximization goal is advocated on the following ground

(i) It takes into consideration long run survival and growth of the firm (ii) It is consistent with the object of the owners economic welfare (iii) It suggest the regular and consistent dividend payment to the share

holder (iv) The financial decisions are taken with a view to improve the capital

appreciation of the share. (v) It consider risk and time value of money (vi) It consider future cash flows, dividends and earnings per share (vii) Maximization of firm value is reflected in the market price of share,

since it depends on shareholders expectation as regards profitability, long run prospects, risk, return, distribution of return.

(viii) Profit maximization partly enables the firm in wealth maximization (ix) The share holders always prefers wealth maximization rather than

maximization of inflow of profits.

Value Maximization Objective The goal of firm is to maximize the present wealth of owner, i.e. equity share holder in a company. A company equity shares are actively traded in the stock markets, the wealth of the equity share holders is represented in the market value of equity shares. The firm cash flow and its impact on the value maximization is shown in below figure.

Short Term Fund Long Term Fund

Acquiring temporary working capital

Acquiring fixed Asset and Permanent working Capital Generate Cash

inflows from Operation

Service Department Obligation

Retained Earnings available for re investment

Dividend Distribution

Firm Wealth Maximization

Value Maximization of equity share holders through increase in stock market

Other Objective are

1) Sales Maximization 2) Maximization of ROI 3) Social Objective.

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Ratio Analysis Financial Statement analysis means study of relationship among various factors in a business disclosed in financial statement of firm

The basic objective of financial statement is as follows To judge financial health of the firm To evaluate the profitability of the enterprises To gauge the debt servicing capacity of firm To understand long term and short term solvency of the firm To know the return on capital employed or invested

Methods of Analyzing Financial Statement The method of analyzing of financial statement Ratio are the mathematical tool for comparing the two relative figures .One absolute figure is not much informative but when compare one figure with other we get more information.

Ratio Analysis is defined as systematic use of ratio to analyse and interprate the financial statements that the strength and weakness of the firm is clearly known.

Similarly by using the ratio we can do the comparative study. A single figure by itself has no meaning but when we expressed in term of related figure we get the significant figure.

Four types of comparison are done:

i) Trend Analysis: It is comparing the present ratio with the past ratio

ii) Inter firm Comparison: It is comparing our ratio with the competitors ratio.

iii) Comparison with standards:

iv) Comparison with plans:

Advantages of Ratio Analysis

The importance of ratio Analysis is the fact that it presents the information on comparative basis and helps the decision maker to decide the future plans.

Following is the list of certain advantages

1) Liquidity position of the company is clearly known.(by using current ratio ,liquid ratio)

2) Long term Solvency is clearly shown by ratio analysis.

3) Operational efficiency is in clearly known i.e. how efficiently you are using your stocks, debtors. etc.

4) Profitability of the organization is known by using Gross profit, net profit ratio.

5) Inter firm comparison is possible

6) Comparison with plan and standard is possible

7) Investment decision or disinvestment decision can be taken by using ratio analysis.

8) Ratio analysis highlights the weakness and strength of the organization.

Types of ratios

For the sake of facilitation of Calculations and interpretation, ratios may be classified

according to different basis. One of the ways of classification is according to the financial

statements. In this method, ratios are calculated on the following basis.

(i) Trading A/C ratios

(ii) Profit and Loss A/C ratios

(iii)Balance Sheet ratios

However, the classification according to the following basis will be more effective for

analyzing and interpreting the financial statements.

(i) Profitability ratios (ii) Turnover ratios

(iii)Financial ratios

(iv) Leverage ratios

Profitability Ratios:

These ratios give an idea about the profitability of a business firm. Profit and profitability

differ from each other as profit is the difference between income and expenditure. While

profitability is measured by comparing the profit with some other parameter like sales, capital

employed the total assets etc. The ratios are falling under this category are usually expressed in

percentage. The following are the ratios under this category:

(i) Gross Profit Ratio:

Gross profit is the difference between the net sales [sales less

sales returns] and the cost of goods sold. This ratio is calculated with the help of the following

formula:

This ratio shows the margin left after meeting the purchases and manufacturing costs. It

measures the efficiency of production as well as pricing. A high gross profit ratio means a high

margin for covering other expenses like administrative, selling and distribution expenses. I.e.

other than the cost of goods sold therefore, higher the ratio, the better it is. It is important for a

business to maintain this ratio on a higher side, otherwise it will be difficult to cover other

expenses. A firm should compare its gross profit ratio with the industry average to find out

where it stands. A firm can also compare its own ratio of the past with the current years, ratio to

find out its performance. This is known as intra-firm comparison.

(ii) Net profit ratio:

This ratio shows the earning left for shareholders [ equity and

preference ] as a percentage of net sales . it measures overall efficiency of all the functions of a

business firm like production, administration, selling, financing, pricing, tax management etc.

This ratio is very useful for prospective investors because it gives an idea of overall efficiency of

the firm. This ratio is calculated as follows:

(iii)Operating Net Profit ratio:

This ratio establishes the relationship between the net

sales and the operating net profit. The concept of operating net profit is different from the

concept of net profit. Operating net profit is the profit arising out of business operations only.

This is calculated as follows:

Alternatively, this profit can also be calculated by deducting only operating expenses

from gross profit. This ratio is calculated with the help of the following

Thus, higher this ratio, the lower is the margin of operating profit .this ratio can be further

analyzed to find out the percentage of each type of expenses to sales.

(iv) Return On capital Employed :

This ratio indicates the percentage of net

profits before interest and tax total capital employed .the capital employed is calculated as

follows

Capital employed =equity capital + preference capital +Reserves and surplus

+Long term debt fictitious Assets

This ratio is considered to be a very important one because it reflects the overall efficiency

with which capital is used the ratio of a particular business should be compared with other

business firms in the same industry to find out the exact position.

(v) Return on equity:

This ratio, also known as return on shareholders funds or

return on proprietors funds or return on net worth, indicates the percentage of net profit

available for equity shareholders to equity shareholders funds. In other words, this ratio

measures the return only on equity shareholders funds and not on total capital employed like

ratio number (v). The formula for calculation is as follows:

Note: equity shareholders funds = equity capital + reserve and surplus

This ratio indicates the productivity of the owned funds employed in the firm. However, in

judging the profitability of a firm, it should not be over looked that during inflationary periods,

the ratio may show an up word trend because the numerator of the ratio represents current values

whereas the denominator represents historical values.

(vi) Return on total asset:

This ratio compares the net profit after tax with the total

asset. The formula for calculations of this ratio is as follows:

(vii) Earnings per share:

This is one of the important indicators of performance of a

company. Earning capital per share indicates the amount of profits available for distributions

amongst the equity shareholders. This ratio is calculated as shown below:

As mentioned above, EPS is one of the important criteria for measuring the performance

of a company. If EPS increases, the possibility of a higher dividend per share also increases.

However, the Dividend payment depends on the policy of the company. Market price of shares

of a company may also show an upward trend if the EPS is showing a rising trend. However, it

should be remembered that EPS of different companies may vary from company to company due

to the following different practices by different companies regarding stock in trade, depreciation,

source of rising finance, tax-planning measures etc.

(viii) Price Earnings ratio :

This ratio is calculated with the help of the following

Formula:

(ix) Dividend payout ratio:

EPS described above indicates the amount of profit

available for equity shareholders. Dividend payout ratio indicates the percentage of profit

distributed as dividends to the shareholders. A higher ratio indicates that the organization is

following a liberal policy regarding the dividend while a lower ratio indicates a conservative

approach of the management towards the dividend. The ratio is calculated as shown below:

(x) Dividend Yield ratio :

This ratio compares the dividend per share with the market

This ratio is price of the shares. The formula for calculation is a follows very important for

investors who purchase their shares in a open market. They will evaluate their return against their

investment, i.e. the market price paid by them. The higher the ratio, the more attractive are their

investment.

Turnover ratios:

These ratios are also known as activity ratios or asset management ratios. These ratios are

very important for a business concern to find out how will the facilities at the disposal of the

concern are being used. These ratios are usually calculated on the basis sales or cost of goods

sold. High turnover ratios indicate better utilization of resources. The important turnover ratios

are discussed below.

(i) Working capital turnover ratio:

This ratio compares the net sales with net

working capital of the business firm. The indication given by this ratio is the number of times

working capital is turned around in a particular period. The ratio is calculated with the help of the

following formula.

(Net Working capital = Current asset Current liability)

The higher this ratio, the better is the utilization of the working capital and also indication

of lower working capital. However, a very high working capital turnover ratio is a sign of over

trading and a firm may face shortage of working capital. A firm should compare this ratio with

the ratio of other firm in the same industry and also with the industry average to find out its

position as compared to other firm.

(ii) Debtors turnover ratio:

One of the important decision regarding financial

management is about the credit to be granted to the customers. There should be a well-defined

credit policy, which should be followed carefully by the firm. The credit policy followed by a

firm is indicated by this ratio. This ratio is calculated with the help of the following formula.

(Average Account receivables = Opening balance of debtors + Closing balance of debtors / 2

and Opening balance of Bills receivables + Closing balance of Bills receivables / 2)

(iii) Creditors Turnover Ratio:-

Debtors Turnover Ratio as described above indicates

the credit period allowed by the firm to its customers. Creditors turnover Ratio indicates the

credit period allowed by the creditors to the firm. In other words, it is exactly apposite the above

ratio. Formula is below:

( Average Accounts Payable = Opening Balance of Creditors + Closing Balance of Creditors

/ 2 And Opening Balance of Bills payables + Closing Balance of Bills payables / 2)

(iv) Inventory / Stock Turnover Ratio:-

This ratio establishes a relationship between the

cost of goods sold during given period And the average amount of inventory held during that

period. The indication given by this ratio is the number of times the finished stock is turned over

during a given accounting period. The formula is given bellow:

.

(v) Fixed Asset Turnover Ratio:-

This ratio indicates the amount of sales realized per

rupee of investment in fixed assets. Fixed assets are those assets, which are not acquired for re-

sale. In other words, they are meant for utilization in the business for the purpose of improving

its earning capacity. Whether this purpose is being fulfilled or not is indicated by this ratio. The

formula is given bellow;

Cost of goods sold may be taken in place of sales

Net fixed assets = Cost Depreciation

(vi) Sales to capital Employed:-

This ratio is also known as Capital Turnover Ratio

and indicates sales per rupee of capital employed. The formula is bellow

Capital employed = Shareholders funds + long term Liabilities

Financial Ratios:-

As the name suggest, these ratios are calculated to judge

financial position firm from the long term as well as short term angle. The Following

ratios are included in this category.

(i) Current ratio: -

This ratio is calculated by dividing current assets by current

liability. Current ratio is also known as Solvency ratio as it indicates how the expected current

claims are covered by current assets. The formula is bellow

Current asset means assets, which have been purchased in order to convert them into cash or

into other current assets within a period of normally one year.

(ii) Liquid / Quick / Acid Test Ratio: -

This ratio is a better tool to measure the ability

to honor day to day commitments. It is the ratio between the liquid assets and liquid liabilities.

From The balance sheet, liquid assets are calculated by deducting inventories and prepaid

expenses from current assets. liquid liabilities are current liabilities less Bank overdrafts. The

formula is bellow.

(iii)Debt-Equity Ratio:-

This ratio is calculated to measure the comparative proportion

of borrowed funds and Shareholders funds invested in the firm. A firm raises funds through

owned funds, which are also called as Shareholders funds, or Proprietors funds as well as

borrowed funds. The proportion between these two sources should be properly balanced;

otherwise the firm may face problems. The formula is bellow

(iv) Proprietary Ratio:-

It is primarily the ratio between the proprietors funds and total

assets. The formula is bellow

(v) Debt Ratio The Debt Ratio refers to the ratio of long-term debt to the total of

external and internal funds (capital employed or net assets). It is computed as follows:

Capital employed is equal to the long-term debt + shareholders fund.

Alternatively, it may be taken as net assets which are equal to the total non-fictitious assets

current liabilities

Significance: Like debt equity ratio, it shows proportion of long-term debt in capital

employed. Low ratio provides security to creditors and high ratio helps management in

trading on equity. In the above case, the debt ratio is less than half which indicates

reasonable funding by debt and adequate security of debt. It may be noted that Debt

Ratio can also be computed in relation to total assets. In that case, it usually refers to the

ratio of total debt (long-term debt + current liabilities) to total assets, i.e. total of fixed

and current assets (or shareholders funds + long-term debt + current liabilities), and is

expressed as Debt Ratio = Total Debt / Total Assets

(vi) Current Assets to Fixed Assets:-

This ratio shows the proportion of current assets

to fixed assets. As described in current ratio, current assets are held for converting them into cash

in a short period of time while fixed assets are held for long term purposes, i.e. to enhance the

earning capacity of the firm. This ratio indicates the proportion between the two and is calculated

with the following formula

Leverages Ratios:-

In this category, the following ratio is significant.

(i) Capital Gearing Ratio :-

The ratio indicates the proportion between fixed Charge bearing security and equity capital. A firm raises finance through owned funds and borrowed funds. Owned funds include equity capital, preference capital and retained earnings while borrowed funds include term loans and debentures. In case of equity capital, it is not compulsory to pay dividend as it depends on the profit position and also on the discretion of the board of directors.

Capital Gearing Ratio: - Fixed charges capital / Equity Capital

Working Capital management is the management of assets that are current in nature. Current assets, by accounting definition are the assets normally converted in to cash in a period of one year. Hence working capital management can be considered as the management of cash, market securities receivable, inventories and current liabilities. In fact, the management of current assets is similar to that of fixed assets in the sense that is both in cases the firm analyses their effect on its profitability and risk factors, hence they differ on three major aspects:

1. In managing fixed assets, time is an important factor discounting and compounding aspects of time play an important role in capital budgeting and a minor part in the management of current assets.

2. The large holdings of current assets, especially cash, may strengthen the firms liquidity position, but is bound to reduce profitability of the firm as ideal car yield nothing.

3. The level of fixed assets as well as current assets depends upon the expected sales, but it is only current assets that add fluctuation in the short run to a business.

To understand working capital better we should have basic knowledge about the various aspects of working capital. To start with, there are two concepts of working capital:

Gross Working Capital Net Working Capital

1. Working capital, sometimes called gross working capital, simply refers to current assets used

in operations.

2. Net working capital is defined as current assets minus current liabilities.

3. Net operating working capital (NOWC) is defined as operating current assets

minus operating current liabilities. Generally, NOWC is equal to cash, accounts

Receivable, and inventories, fewer accounts payable and accruals.

The term working capital originated with the old Yankee peddler, who would load

up his wagon with goods and then go off on his route to peddle his wares.

WORKING CAPITAL MANAGEMENT

Working Capital

Capital required for a business can be classified under two main categories via,

1) Fixed Capital

2) Working Capital

Every business needs funds for two purposes for its establishment and to carry out

its day- to-day operations. Long terms funds are required to create production facilities

through purchase of fixed assets such as p&m, land, building, furniture, etc.

Investments in these assets represent that part of firms capital which is blocked on

permanent or fixed basis and is called fixed capital. Funds are also needed for short-

term purposes for the purchase of raw material, payment of wages and other day to-

day expenses etc.

These funds are known as working capital. In simple words, working capital

refers to that part of the firms capital which is required for financing short- term or

current assets such as cash, marketable securities, debtors & inventories. Funds, thus,

invested in current assts keep revolving fast and are being constantly converted in to

cash and this cash flows out again in exchange for other current assets. Hence, it is also

known as revolving or circulating capital or short term capital.

CONCEPT OF WORKING CAPITAL

There are two concepts of working capital:

1. Gross working capital

2. Net working capital

The gross working capital is the capital invested in the total current assets of the

enterprises current assets are those

Assets which can convert in to cash within a short period normally one accounting

year.

CONSTITUENTS OF CURRENT ASSETS

1) Cash in hand and cash at bank

2) Bills receivables

3) Sundry debtors

4) Short term loans and advances.

5) Inventories of stock as:

a. Raw material

b. Work in process

c. Stores and spares

d. Finished goods

6. Temporary investment of surplus funds.

7. Prepaid expenses

8. Accrued incomes.

9. Marketable securities.

In a narrow sense, the term working capital refers to the net working. Net working

capital is the excess of current assets over current liability, or, say:

NET WORKING CAPITAL = CURRENT ASSETS CURRENT LIABILITIES.

Net working capital can be positive or negative. When the current assets exceeds the

current liabilities are more than the current assets. Current liabilities are those

liabilities, which are intended to be paid in the ordinary course of business within a

short period of normally one accounting year out of the current assts or the income

business

CONSTITUENTS OF CURRENT LIABILITIES

1. Accrued or outstanding expenses.

2. Short term loans, advances and deposits.

3. Dividends payable.

4. Bank overdraft.

5. Provision for taxation, if it does not amt. to app. Of profit.

6. Bills payable.

7. Sundry creditors.

The gross working capital concept is financial or going concern concept whereas net

working capital is an accounting concept of working capital. Both the concepts have

their own merits.

The gross concept is sometimes preferred to the concept of working capital for the

following reasons:

1. It enables the enterprise to provide correct amount of working capital at correct time.

2. Every management is more interested in total current assets with which it has to

operate then the source from where it is made available.

3. It take into consideration of the fact every increase in the funds of the enterprise

would increase its working capital.

4. This concept is also useful in determining the rate of return on investments in

working capital. The net working capital concept, however, is also important for

following reasons:

It is qualitative concept, which indicates the firms ability to meet to its operating

expenses and short-term liabilities.

IT indicates the margin of protection available to the short term creditors.

It is an indicator of the financial soundness of enterprises.

It suggests the need of financing a part of working capital requirement out of the

permanent sources of funds

CLASSIFICATION OF WORKING CAPITAL

Working capital may be classified in to ways:

On the basis of concept.

On the basis of time.

On the basis of concept working capital can be classified as gross working capital and

net working capital. On the basis of time, working capital may be classified as:

Permanent or fixed working capital.

Temporary or variable working capital

PERMANENT OR FIXED WORKING CAPITAL

Permanent or fixed working capital is minimum amount which is required to ensure

effective utilization of fixed facilities and for maintaining the circulation of current

assets. Every firm has to maintain a minimum level of raw material, work- in-process,

finished goods and cash balance. This minimum level of current assets is called

permanent or fixed working capital as this part of working is permanently blocked in

current assets. As the business grow the requirements of working capital also increases

due to increase in current asset

TEMPORARY OR VARIABLE WORKING CAPITAL

Temporary or variable working capital is the amount of working capital which is

required to meet the seasonal demands and some special exigencies. Variable working

capital can further be classified as seasonal working capital and special working

capital.

The capital required to meet the seasonal need of the enterprise is called seasonal

working capital. Special working capital is that part of working capital which is

required to meet special exigencies such as launching of extensive marketing for

conducting research, etc.

Temporary working capital differs from permanent working capital in the sense that is

required for short periods and cannot be permanently employed gainfully in the

business.

IMPORTANCE OR ADVANTAGE OF ADEQUATE WORKING CAPITAL

SOLVENCY OF THE BUSINESS: Adequate working capital helps in maintaining the

solvency of the business by providing uninterrupted of production.

Goodwill: Sufficient amount of working capital enables a firm to make prompt

payments and makes and maintain the goodwill.

Easy loans: Adequate working capital leads to high solvency and credit standing can

arrange loans from banks and other on easy and favorable terms.

Cash Discounts: Adequate working capital also enables a concern to avail cash

discounts on the purchases and hence reduces cost.

Regular Supply of Raw Material: Sufficient working capital ensures regular supply of

raw material and continuous production.

Regular Payment of Salaries, Wages and Other Day TO Day Commitments: It leads to

the satisfaction of the employees and raises the morale of its employees, increases

their efficiency, reduces wastage and costs and enhances production and profits.

Exploitation of Favorable Market Conditions: If a firm is having adequate working

capital then it can exploit the favorable market conditions such as purchasing its

requirements in bulk when the prices are lower and holdings its inventories for higher

prices.

Ability to Face Crises: A concern can face the situation during the depression.

Quick And Regular Return On Investments: Sufficient working capital enables a

concern to pay quick and regular of dividends to its investors and gains confidence of

the investors and can raise more funds in future.

High Morale: Adequate working capital brings an environment of securities,

confidence, high morale which results in overall efficiency in a business.

EXCESS OR INADEQUATE WORKING CAPITAL

Every business concern should have adequate amount of working capital to run its

business operations. It should have neither redundant or excess working capital nor

inadequate nor shortages of working capital. Both excess as well as short working

capital positions are bad for any business. However, it is the inadequate working

capital which is more dangerous from the point of view of the firm.

DISADVANTAGES OF REDUNDANT OR EXCESSIVE WORKING CAPITAL

1. Excessive working capital means ideal funds which earn no profit for the firm and

business cannot earn the required rate of return on its investments.

2. Redundant working capital leads to unnecessary purchasing and accumulation of

inventories.

3. Excessive working capital implies excessive debtors and defective credit policy

which causes higher incidence of bad debts.

4. It may reduce the overall efficiency of the business.

5. If a firm is having excessive working capital then the relations with banks and other

financial institution may not be maintained.

6. Due to lower rate of return n investments, the values of shares may also fall.

7. The redundant working capital gives rise to speculative transactions

DISADVANTAGES OF INADEQUATE WORKING CAPITAL

Every business needs some amounts of working capital. The need for working capital

arises due to the time gap between production and realization of cash from sales. There

is an operating cycle involved in sales and realization of cash. There are time gaps in

purchase of raw material and production; production and sales; and realization of cash.

Thus working capital is needed for the following purposes:

For the purpose of raw material, components and spares.

To pay wages and salaries

To incur day-to-day expenses and overload costs such as office expenses.

To meet the selling costs as packing, advertising, etc.

To provide credit facilities to the customer.

To maintain the inventories of the raw material, work-in-progress, stores and spares

and finished stock.

For studying the need of working capital in a business, one has to study the business

under varying circumstances such as a new concern requires a lot of funds to meet its

initial requirements such as promotion and formation etc. These expenses are called

preliminary expenses and are capitalized. The amount needed for working capital

depends upon the size of the company and ambitions of its promoters. Greater the size

of the business unit, generally larger will be the requirements of the working capital.

The requirement of the working capital goes on increasing with the growth and

expensing of the business till it gains maturity. At maturity the amount of working

capital required is called normal working capital.

There are others factors also influence the need of working capital in a business.

FACTORS DETERMINING THE WORKING CAPITAL REQUIREMENTS

1. NATURE OF BUSINESS: The requirements of working is very limited in public

utility undertakings such as electricity, water supply and railways because they offer

cash sale only and supply services not products, and no funds are tied up in inventories

and receivables. On the other hand the trading and financial firms requires less

investment in fixed assets but have to invest large amt. of working capital along with

fixed investments.

2. SIZE OF THE BUSINESS: Greater the size of the business, greater is the requirement

of working capital.

3. PRODUCTION POLICY: If the policy is to keep production steady by accumulating

inventories it will require higher working capital.

4. LENTH OF PRODUCTION CYCLE: The longer the manufacturing time the raw

material and other supplies have to be carried for a longer in the process with

progressive increment of labor and service costs before the final product is obtained.

So working capital is directly proportional to the length of the manufacturing process.

5. SEASONALS VARIATIONS: Generally, during the busy season, a firm requires

larger working capital than in slack season.

6. WORKING CAPITAL CYCLE: The speed with which the working cycle completes

one cycle determines the requirements of working capital. Longer the cycle larger is

the requirement of working capital.

fig no- 1.1(Operating Cycle)

7. RATE OF STOCK TURNOVER: There is an inverse co-relationship between the

question of working capital and the velocity or speed with which the sales are affected.

A firm having a high rate of stock turnover will needs lower amount of working capital

as compared to a firm having a low rate of turnover.

8. CREDIT POLICY: A concern that purchases its requirements on credit and sales

its product / services on cash requires lesser amt. of working capital and vice-versa.

9. BUSINESS CYCLE: In period of boom, when the business is prosperous, there is

need for larger amt. of working capital due to rise in sales, rise in prices, optimistic

expansion of business, etc. On the contrary in time of depression, the business

contracts, sales decline, difficulties are faced in collection from debtor and the firm may

have a large amt. of working capital.

10. RATE OF GROWTH OF BUSINESS: In faster growing concern, we shall

require large amt. of working capital.

11. EARNING CAPACITY AND DIVIDEND POLICY: Some firms have more

earning capacity than other due to quality of their products, monopoly conditions,

etc. Such firms may generate cash profits from operations and contribute to their

working capital. The dividend policy also affects the requirement of working

capital. A firm maintaining a steady high rate of cash dividend irrespective of its

profits needs working capital than the firm that retains larger part of its profits and

does not pay so high rate of cash dividend.

12. PRICE LEVEL CHANGES: Changes in the price level also affect the working

capital requirements. Generally rise in prices leads to increase in working capital.

Others FACTORS: These are:

Operating efficiency.

Management ability.

Irregularities of supply.

Import policy.

Asset structure.

Importance of labor.

Banking facilities, etc.

MANAGEMENT OF WORKING CAPITAL

Management of working capital is concerned with the problem that arises in

attempting to manage the current assets, current liabilities. The basic goal of working

capital management is to manage the current assets and current liabilities of a firm in

such a way that a satisfactory level of working capital is maintained, i.e. it is neither

adequate nor excessive as both the situations are bad for any firm. There should be no

shortage of funds and also no working capital should be ideal. WORKING CAPITAL

MANAGEMENT POLICES of a firm has a great on its probability, liquidity and

structural health of the organization. So working capital management is three

dimensional in nature as

1. It concerned with the formulation of policies with regard to profitability, liquidity

and risk.

2. It is concerned with the decision about the composition and level of current assets.

3. It is concerned with the decision about the composition and level of current

liabilities.