BBA13

BBA-13
Vardhaman Mahaveer Open University, Kota
Financial Management
BBA-13
Vardhaman Mahaveer Open University, Kota
CONTENTS
Unit No. Name of Unit
Unit - 1 Financial Management: An Introduction
Unit - 2 Financial Statements
Unit - 3 Techniques of Financial Statement Analysis
Unit - 4 Ratio Analysis
Unit - 5 Funds Flow Statement
Unit - 6 Cash Flow Statement
Unit - 7 Management of Working Capital
Unit - 8 Management of Inventories
Unit - 9 Management of Cash and Marketable Securities
Unit - 10 Cost of Capital
Unit - 11 Capital Budgetings
Unit - 12 Dividend Policy
Unit - 13 Operating and Financial Leverages
Unit - 14 Capital Structure: Theories
Unit - 15 Capital Structure: Planning
Unit - 16 Sources of Long-term Finance

Unit - 1 : Financial Management: An Introduction
Structure of Unit:
1.0 Objectives
1.1 Meaning and Definition of Financial Management
1.2 Nature or Characteristics of Financial Management
1.3 Objectives of Financial Management
1.4 Approaches of Financial Management
1.5 Scope or Functions of Financial Management
1.6 Importance of Financial Management
1.7 Limitations of Financial Management
1.8 Functions of Chief Financial Officer
1.9 Changing Role of Financial Manager
1.10 Summary
1.11 Keywords
1.12 Self Assessment Questions
1.13 Reference Books
1.0 Objectives
After completing this unit, you would be able to:
 Know the meaning and nature of financial management.
 Understand the approaches of financial management.
 Know the functions of financial management.
 Understand the role of financial manager.
1.1 Meaning and Definition of Financial Management

Production, marketing and finance are three important line functions of an organisation but finance is the
most important function which is treated as the life blood of any organisation. Without effective utilization of
finance, no business can survive long. Meaning of Financial Management can be best described by the
words ‘Effective Utilization of Funds’.Financial Management is mainly a part of general management
which utilizes available financial funds in optimum way for smooth functioning of business. It starts with
planning, administration and control of funds. The nature of Financial Management refers to its function,
scope and objectivity. Finance is required till business is running and without proper management of funds
survival becomes a difficulty. Long run business requires huge capital fund for their business and without
proper discipline it becomes difficult to procure and allocate funds. Anything to do with cost, finance,
money, capital are all covered under the ‘financial management’. By implementing proper system of financial
management business can invest in profitable avenues which yields high returns. Financial management also
takes into account the future requirement of funds and keeps proper arrangements in present for the same.
Hence the financial management is the study of income, expenses, capital investments, capital issues etc.
In the words of Ezra Soloman, “Financial Management is concerned with the efficient use of an important
economic resource, namely capital fund”.
Weston and Brigham states that “Financial Management is an area of financial decision making harmonizing
individual motives and enterprise goals.”
Joseph L. Massie states that “Financial Management is the operational activity of a business that is responsible
for obtaining and effectively utilizing the funds necessary for efficient operations.”
Financial Decision Investment Decision Dividend Decision
Capital Working capital Capital Current Assets

Structure Financing Expenditure or Working
Decision (Long (Short Term Decisions Capital
Term Sources) Sources) Management
Cost Of Capital
Figure - 1.1
Source: M.R. Agarwal, “Financial Management”
1.2 Nature or Characteristics of Financial Management

With the help of the following points we can understand the nature of financial management
1. Financial Management is a broader concept. It is not justabout accounting of finance. It starts with
procurement of funds as per the requirement and their best allocation. Financial planning is required
till the business survive. It is an essential part of the business.
2. It is the integral part of management. Financial planning is the part of top level
Management. Financial policies are drafted by top level mangers and then it is executed by other
levels.
3. Effective financial management helps in maximizing profits. Financial management helps in selecting
the best alternate available. Funds are raised in a perfect combination of debt and equity which
bears less cost of capital and are invested in best profitable avenues for higher returns.
4. It is scientific and analytical as it starts right from the beginning of business and continues till its
survival. Financial management works on certain basic principles. It helps in selecting the best
method of financing with less risk and higher returns. It helps in understanding the behavior and
pattern of finance.
5. Financial Management is different from accounting. In accounting only collection of financial and
related data is done whereas in financial management, analysis and decision making are main
functions.
6. Financial Management is useful in every organisation whether it is sole proprietorship or corporate,
manufacturing or service. It is applicable in non – profit organisation also.
7. Financial Management is helpful for top management in decision making.
1.3 Objectives of Financial Management

Objectives may be expressed as goals, purpose, targets, aims to be attained over a period of time. They
also provide the standards to be judged or evaluate the performance of a business.
The main purpose of financial management is to help the firm in achievement of its predetermined objectives.
The objectives of financial management can be explained with the help of following figure:
Objectives of Financial Management
Basic Objects Operational Social Objects Research

Objects Objectives
- Profit Maximization - Timely availability - Timely payment of
- Wealth Maximization of requisite finances interest - Research into new
- Most Effective - Payment of reasonable and better sources
Utilization of finance dividend of finance
- Safety of investment - Timely payment of
growth of the wages
enterprises - Fixing settlement
with suppliers
- Timely payment of
taxes
- Maintaining relations
with financiers
Figure - 1.2
Source: R.V. Badi and N.V. Badi, “Business Ethics”
only basic objectives are being explained as under:
1. Profit Maximization: Earning profit is the main objective of any business.It can be achieved by
maximizing profits.Profit is the reward for risk.It also motivates for better performance. Survival of
any business mainly depends upon its capacity of earning profits. Efficient and effective utilization of
financial funds helps in achieving this goal. This objective was supported under the traditional approach
of the financial management. Profit maximization as an objective of financial management can be
justified on the following grounds:
(a) Earning more profit indicates the economic efficiency of a business wheras loss indicates economic
inefficiency.
(b) Profit earning objective provide basis for strategic and tactical decisions. Profit is a premium for
staying in business.
(c) Maximum social welfare activities like more wages, better quality of products at cheaper rate to
customers, timely payment to creditors, more employment to society can be attain through
earning more and more profits.
(d) Profits can be said as major source of incentives in a business. If there is no profit incentives in
a business, then there will be no competition and thus all the development process will be zero.
(e) The objective of profit maximization seems rational because it is a device which stimulates
mankind into channels of useful services.
But like traditional approach it has been also criticized on some grounds which are as follows:
 It is narrow concept. It gives stress only on generating higher profits. It is not clear under this
concept as which profit should be focused like gross profit, net profit, profit before tax or profit
after tax.
 Earning profits give benefits only to its owners. It does not add much benefit to the society. Social
responsibility is not fulfilled under this concept.
 Decisions taken for earning profits sometimes endangers the stability of the long run of business.
 The biggest disadvantage of this objective is that it ignores time value of money. Profits generated
today do not have the same value as it is today. Rupee earned today has more value than its value
after one or two years.
 This concept registers progress in monetary terms only. It completely ignores qualitative aspect.
Contribution of humans is ignored under this.
 The objective of profit maximisation ignores the time value of money. Because profit received today
is not same as it received after 1 or 2 years.
 It is vague term as it do not clear that profit increase in short term or long term.
 Earning more and more profit may be immoral and leads to corrupt practices.
 Profit maximisation objective sometimes degrades human ethical values.
 The objective of profit maximisation ignores social responsibility of a business.
(f) Wealth Maximization: The profit maximisation objective is not only a vague term but it also
ignores risk and time value of money. Therefore, the wealth maximisation objective is considered as
basic objective rather than profit maximisation. According to Ezra Soloman, the ultimate objective
of financial management should be maximisation of wealth. It is modern approach of Financial
Management. It is also known as ‘Value maximizing’ or ‘Net worth Maximizing’. Financial
Management helps in effective utilisation of its assets which is viewed in terms of benefits it can
produce.Wealth maximisation objective means maximizing the wealth of the shareholders, by
increasing the value of the firm. Increasing value of the firm means increasing the market price of a
company’s share. The value of the firm is affected by many ways i.e. the firm’s growth, risk acceptable
to the investors, efficiency and effectiveness of the firm, dividend policy etc.
A firm must consider following points to increase market value of shares.
 Customer should be managed properly.
 Maintain satisfactory dividend policy.
 Increase employees satisfaction level.
 Enhance information system.
 Improve quality of the products.
 Increase the market share by launching new products.
Wealth maximizing policy advocates following objectives:-
 It ensures long run survival and growth of the business.
 It increases the value of shares as high dividends are distributed under this.
 Dividend policy is designed in such a way to satisfy shareholders.
 A perfect combination of debt and equity mix is carried out.
 It reduces risk as projects having positive net present value are selected after careful and
detailed investigation.
 Stakeholders are also satisfied as they feel connected with business.
1.4 Approaches of Financial Management

1. Traditional Approach: Success of any business depends upon profit which is directly related
with financial management. Financial Management starts with acquisition, financing and management
of business assets. By investing funds in best ventures a firm can maximize its wealth by obtaining
higher returns. Traditional concept shows one basic function of financial management i.e. procurement
of funds. Traditional approach of financial management is limited and narrow.It limits the role of
finance manager to collecting funds. According to Hunt, William and Donaldson”the finance function
was viewed as the task of providing the funds needed by the enterprise on the terms most favorable
in the light of the objective of the business.” Following are the functions of financial management
under traditional approach:
(a) Making arrangements of funds keeping in mind the short term and long term requirement of the
business. Appropriate financial institutions are selected which suits the capacity of the enterprise to
bear the cost.
(b) Making perfect combination of debt and equity as a source of internal finance. Funds are
mobilized through equity, preference, debentures, bonds etc. in a perfect combination which bears
less cost of capital.
Following are the grounds on which this approach has been criticized
 According to this approach financial management does not get involve in day to day business
activities. Under this, funds are only generated. Proper attention is not given towards their
appropriate use. Allocation of funds is not considered here.
It does not form part of integral management. Once funds are generated finance managers are
called up again only when additional funds are required for promotion, expansion, merging,
amalgamation etc.
 It makes arrangements of funds only for long term requirement. Short term requirements are
ignored. There are many day-to-day problems related with finance which are not covered
under this approach
According to Soloman ‘central issues of the financial management’ are
 Should an enterprise commit capital funds to certain purposes?
 Do the expected returns met financial standards of performance?
 How should these standards be set and what is the cost of capital funds to the enterprise?
 How does the cost vary with the mixture of financing method used?
Keeping in mind, the narrow concept of traditional approach and requirement of modern competitive
situation of business new concept was developed.
2. Modern Approach: Style of doing business has been changed for keeping pace with the competition.
Privatization and globalization made survival and growth tough. Any business can grow only if it
manages its funds in the best way possible as it the life of business. Without adequate funds business
cannot survive in long run. Each and every activity in business whether small or big requires funds.
Funds are needed for day-to-day requirements to expansion, promotion etc.. Traditional approach
can generate only funds but modern approach emphasize on its best possible use. Here, role of
finance manager is not limited to mere collection of funds but it is his duty to allocate the funds in
best possible way to obtain higher returns. It is the duty of finance manager to keep in mind the long
term as well as short term requirements of finance in the business. This approach ensures optimum
utilization of funds. According to this approach finance function is the part of integral management
and forms part of top level financial planning. Functions of financial management are as follows:
 Analyzing the need of finance required by the business.
 Searching the best available alternate of finance which suits the requirement of the business.
 Obtaining funds from best alternate and allocating it towards assets in optimum way.
 To ensure that funds generated and allocated are put to effective use and reporting to top
management.
Modern approach has much broader concept than traditional approach. It covers all the financial activities
starting from financial planning, generating, procuring and allocating of financial resources by ensuring optimum
utilization of financial resources.
1.5 Scope or Functions of Financial Management

Functions of Financial Management: Financial management includes performance of finance function
which is divided into three main functions for the sake of convenience of study (a) Primary function,
(b)Subsidiary function and (c) Incidental function. These functions are divided on the basis, type and
nature of function and duties they involve. Various activities like decision making, activities of non-recurring
nature, strategic nature etc. are involved in these functions. Details of these various functions are as below:
Functions of Financial Management
Primary or Executive Subsidiary Incidental or Routine
. Financial Planning . Maintaining Liquidity . Maintaining cash receipts and

. Financial Control . Profitability Function payments
. Acquisition of Funds . Review of Financial . Maintaining accounts and
. Allocation of Funds Function keeping records
. Co-ordination with other . Conduct internal audit
Departments . Making public relation
. Maintain governmental
regulations
Figure - 1.3
Source: M.R. Agarwal, “Financial Management”
I. Primary Or Executive Function: As the name itself speaks, this function is of executive nature
and requires lot of skills and expert advice. It generally perform activities like preparation of financial
plans, acquiring and allocation of funds, making arrangements for short term and long term
requirements and controlling financial activities. Let us study each activity performed in detail.
a) Financial Planning: This is the basic function under this. As financial plans is of primary nature
and form base for other departments. Finance manager has to draft financial plans for the enterprise.
If the business is new, a sound financial plan should be formulated keeping in mind the present and
future financial requirements. If the enterprise is on going old plans must be reviewed. These plans
should be flexible enough to be changed according to the dynamic environment. After analyzing
need for finance, finance manger plans as to which source should be opted for acquisition of funds.
How much should be borrowed from outside financial institutions and how much from internal
sources. A perfect combination of debt and equity mix is carried out by financial manager which
bears less cost of capital. Financial plans are to be reviewedfrom time to time according to the
market situation and need of the business.
b) Acquisition of Funds: This is the crucial stage of financial planning. Funds are acquired from
various sources which were decided in the primary function. All the formalities of acquiring funds
are one under this. Every source has its own cost which is to be looked upon.
c) Allocating Funds: After acquiring funds, they are allocated to various assets, activities, projects
etc. This is very important function because only after allocating funds project work will get started.
Improper allocation may cause wastage of funds. Financial manager should ensure that none activity
get more funds than they need otherwise resources will not be utilized in optimum way.
d) Financial Control: Financial control over various financial activities is necessary for smooth
execution of activities. It is very important function of financial management. Finance manager make
records, store information and make reports of various activities. This enables to make comparative
statements with past performances and finance manager can take corrective functions if he feels so.
II. Subsidiary Function: After performing primary functions, come subsidiary functions. Details are
as follows:
a) Maintaining Liquidity: Liquidity means firms financial position to meet its current liability. This
is the subsidiary function to maintain adequate liquidity of the business. Business should be strong
enough to meet its short term liabilities. Cash inflows and outflows should be balanced properly to
maintain liquidity.
b) Review of Financial Function: Financial performance should be reviewed and presented in
front of the board. This activity helps in taking corrective measures if require. Such reports made
base for comparison with past performances like inter-firm comparison, trend analysis, ratio analysis,
and cost-volume profit analysis.
c) Co-Ordination with Other Departments: Finance is required in each and every activity. Hence,
finance function is related with every other department. It is the duty of the finance manager to make
a balance between activities of every department. Additional finance required by other departments
is also looked by finance department.
III. Incidental or Routine Function: Finance is also required in day to day routine business. These
functions are necessary or supplementary to other primary or subsidiary functions. Commonly
performed incidental functions are:
 Maintaining cash receipts, payments and checking cash balances.
 Maintaining accounts and keeping records
 Conducting internal audit
 Making public relation
 Keeping in mind the present governmental regulations.
John J. Hampton has written about the following functions in Handbook for financial decision makers:
(1) Managing funds,
(2) Managing assets,
(3) Liquidity functions
(a) Forecasting cash flows
(b) Raising of funds
(c) Managing the flow of internal funds
(4) Profitability functions
(a) Cost control
(b) Pricing
(c) Forecasting future profits
(d) Measuring cost of capital
1.6 Importance of Financial Management

Maximum utilization of financial resources to earn maximum profit is the main aim of financial management.
The success of every business depends upon sufficient finance as per its requirement. The study of financial
management is indispensible for both profit earning and non – profit earning organisations. Even the industrial
progress of the country depends upon effective financial management.
In the words of Ezra Soloman, “Financial Management is properly viewed as an integral part of overall
management rather than as a staff specially concerned with fund raising operations. In addition to raising
funds, financial management is directly concerned with production, marketing and other functions within an
enterprise whether decisions are made about the acquisitions or distribution of assets.” The same views
have also been expressed by Irwin Friend who said, “a firm’s success and even survival, its ability and
willingness to maintain production and to invest in the fixed or working capital are to a very considerable
extent, determined by its financial policies, both past and present.”
Not only finance officers are related with financial management but every activity of business planning and
control has become very significant. As Husband and Dockery have said, “something must direct the flow
of economic activity that facilitates its smooth operations. Finance is the agent that produces this results.
Significance of financial management is being discussed under the following points:
a) Reduces Chances of Failure: Implementation of proper system of financial management brings
financial discipline in the organization. Every project is overlooked and carried out by detailed
investigation which reduces chances of failure. Strong financial position ensures smooth functioning
of the business.
b) Maximization of Returns: Good financial planning maximizes returns on investment as financial
management is of scientific and analytical nature. Under modern approach of financial management,
main objective is of wealth maximization. These keep shareholders and other stakeholders satisfy.
c) Broader Concept: Study of financial management has its applicability to each type of business
from sole proprietorship to large business enterprises. It covers each and every financial activity in
the business.
d) Makes Base for Planning and Control: Financial planning forms base for planning of other
departments. As it is noted that each departments depends upon financial department to starts their
functioning. Various budget plans are drafted on the basis of financial availability.
e) Optimum and Effective Utilization of Resources: Financial planning ensures optimum utilization
of financial resources. Each and every stage is carefully planned under this beginning from generating
funds to allocation and disposal of profits. Higher returns are expected for smooth functioning and
survival of the business which can be only achieved by properly managing funds.
f) Useful for Stakeholders: Various stakeholders like business managers, investors, financial
institutions, economist, politicians etc. are always interested in knownig financial position of the
company as they maintain financial relation with business in some way.
1.7 Limitations of Financial Management

Besides its above importance, it has some limitations which are as follows
a) Sometimes it becomes difficult to compute the effect of financial decisions on various other
departments. It is very complex procedure which requires careful analysis.
b) It requires deep knowledge of finance to perform various finance functions. No professional can be
expert in each and every aspect of finance behavior which limits its skills.
c) In India, financial management is still in its developing stage. We lack in expertise knowledge which
limits the full use of the subject.
d) Sometimes financial decisions may get affected by the personal point of view of the finance officer.
It is human nature which sometimes gets biased which may sometimes adversely affect the financial
decision.
e) Proper implementation of financial management is of expensive nature. It is not possible for the
small enterprise to appoint and get services of experts nor they implement proper system of financial
management
1.8 Functions of Chief Financial Officer

Every organization has finance head as ‘Chief Financial Officer’. Division of responsibility has created
post for this officer. This is also called ‘Director of Finance’. Chief Financial Officer (CFO) has different
functions depending upon the size, nature and type of business. Basic function of CFO is as follows:
 Formation of Financial Policies and Forecasting: This is the main function of CFO to make
sound financial policies keeping in mind the nature and size of the business, long term financial goals
and objectives of the business. Policies must be dynamic enough to face dynamic business environment.
It also includes analyzing the need of fund and its source from where it is to be raised.
 Managing Fund: Funds are needed to be managed for fulfilling business objective. It starts with
acquisition of funds which involve generating or mobilizing funds from various sources. Before
this, a detailed study is carried out of available alternatives and a best combination is selected having
minimum cost. After this allocation of funds is done which means effective distribution of acquired
funds to various projects. This stage is very important because if allocation or distribution is not
done properly than desired objectives will not be achieved. Utilization of funds comes after the
above which means having proper control over cash flows and inflows.
 Appropriate Disposal of Profits is very important stage under financial management as it decides
the future of the company. After generating profits, it becomes very important to invest and distribute
it in optimum way. Appropriate profits should be retained in the business for future requirements
and satistfactory amount should be distributed among shareholders to keep share price up an
shareholders happy.
 It is the primary duty of CFO to report to the top management about the financial position of the
company. Current year progress report compare with past performances must be drafted and
submitted so that an evaluation can be made and necessary steps should be taken for future course
of action.
 Keeping an Eye on Marketis another important function of done by CFO. Keeping updates of
dynamic environment helps in surviving competition. Global market makes it tough in long run
business to stand without support. A CFO makes financial plans in such a way to handle competition.
 Making Relations with Financial resourcesenables CFO to raise require funds easily from
financial institutions and other sources. Good relations with outside parties enhance credibility of the
business and also ensures steadily arrangement of funds required in future.
 CFO is not only accountable to parties from which it generates funds but he Dischargehis Duty
Towards Various Partieslike creditors , suppliers, debtors in many ways.
 Modern approach of financial management has objective of maximization of shareholders’ wealth.
CFO formulates policies in such a way to enhance shareholders wealth and thus achieving its objective.
This is also important for the image of the business in the market as it appreciates market price and
goodwill.
1.9 Changing Role of Financial Manager

In this fast changing market, role of finance manger becomes very challenging. It is in the hands of finance
manager to keep financial health of the company in good position. Future is uncertain. Unforeseen situation
demands to keep proper arrangements in case of their occurrence. Role of CFO has been changed by the
times. Earlier it was limited to accounting, auditing, budgeting, mobilizing etc. But today his role and power
has gone far beyond. Today’s world is of information technology, rapid computing and tele communication.
Globalization makes it easy to approach to latest upgrades. In the past few years role of CFO has been
criticized because of their doubtful role in scandals like Enron, Global Crossing, Tyco, WorldCom etc.
Following are the main challenges faced by CFO in present context.
1. Evaluating Financial Statements: Company’s financial statements is its face. Financial statements
shows perfect picture about financial position, mission and vision, future project etc. CFO must
ensure that financial statements are prepared in such a way that other departments and other interested
parties can avail information easily by reading them. Meaningful statements are also helpful in
performance measurement with past results.
2. Maintaining Cash Flows: A CFO should strike a balance between cash inflows and outflows for
maintaining liquidity. CFO must ensure that liquidity is maintained adequately. Proper relations should
be maintained with financial resources like banks, investors, vendors etc. so that they can also be
called at the time of emergencies.
3. Risk Management: A CFO should be aware of external and internal risks that can cause threat to
the organization. It becomes necessary to make financial plans risk proof in dynamic market situation.
A CFO must keep himself aware about the market situation and should have knowledge of risk
management tools so that he can use them when time comes.
1.10 Summary
Financial Management is the most important functional area of business management. It is mainly related
with the acquisition and profitable use of funds. Now a days it is an indispensable and in continous process.
In the changing business scenario, wealth maximisation is considered as the basic objective of financial
management, rather than profit maximisation.Sound financial management is the index of the success of an
enterprise. Financial management includes mainly three types of function viz: primary function, subsidiary
function and incidental function. Primary functions includes acquisition, allocation of funds and financial
planning and controlling. Subsidiary functions are related with review of financial function and co-ordination
with other department. Supplementary functions include maintaining accounts and keeping records. In the
field of business, functions of financial management are becoming very complex because of increasing
competition, entry of foreign institutes, globalization of business, corporate governance, corporate scandals
etc. As a result the chief financial officer has to face many challenges. He has to ensure that company is
staying financially healthy and good governance.
1.11 Key Words

 Financial Management: -financial management is the planning, organising, directing and controlling
of the procurement and utilization of funds and safe disposal of profit to the end that individual,
organizational and social objectives are accomplished.
 Profit Maximisation: - A firm should take financial decision for maximisation of profits.
 Wealth Maximization: - Wealth maximisation means to maximize the net present value of a course
of action.
 Financing Decisions: - Decide about the amount of capital required; proportion of debt and
equity and selection of the sources of funds.
 Investment Decisions: -investment decisions mean the allocation of funds with a view to acquire
assets.
 Dividend Decisions: - allocation of income between its owners.

1. What do you mean by financial management? Explain functions and importance of financial
management.
2. Discuss the scope and limitations of financial management.
3. What do you understand by financial function? Describe various finance functions.
4. Explain as to how the Wealth Maximisation objective is superior to Profit Maximisation objective.
5. “Sound Financial Management is a key to the progress for corporations”. Explain.
6. “The importance of financial management has increased in modern time”. Elucidate.
7. Discuss the objectives and goals of financial management.
8. It has traditionally been argued that the objective of financial management is to earn profit hence the
objective of Financial Management is also profit maximisation? Comment.
9. What is financial management? How does a modern financial management differs from traditional
financial management?

- Financial Management: I.M.Pandey
- Financial Management: M.R. Agarwal
- Financial Management: M.D. Agarwal and N.P. Agarwal
- Financial Management: S.N. Maheshwari
Unit - 2 : Financial Statements
Structure of Unit:
2.0 Objectives
2.1 Introduction
2.2 Objectives of Financial Statements
2.3 Nature of Financial Statements
2.4 Importance of Financial Statements
2.5 Limitations of Financial Statements
2.6 Characteristics of Ideal Financial Statements
2.7 Main Financial Statements
· Balance Sheet
· Profit and Loss Account/Income Statement
2.8 Summary
2.9 Key words
2.0 Objectives
After studying this unit, you will be able to:
 Understand the meaning of financial statements;
 Prepare Income Statement and Balance Sheet;
 Identify various types of assets and liabilities;
 Explain the importance of financial statements.
2.1 Introduction
Manager of every firm is engaged in the process of planning and decision making. In order to take right
decision at right time, he should have sufficient informations of past and future. Information that is mostly
used by a manager is known as financial information and this is taken from financial statements.
Financial statements contain summarised information about the firm’s financial affairs. It’s main purpose is
to present the firm’s financial situation to the users. The financial statements are the end-product of the
financial accounting process. These statements present financial information in concise and capsule form.
Financial statements are prepared by top management and these should be prepared in a very careful
manner.
According to Hampton John J., “A financial statement is an organised collection of data according to logical
and consistent accounting procedures. It’s purpose is to convey an understanding of some financial aspects
of business firm. It may show a position at a moment of time as in the case of a balance sheet, or may reveal
a series of activities over a given period of time, as in the case of an Income Statement”.
Thus, the term ‘financial statements’ generally refer to basic statements prepared for the purpose of external
reporting to owners, investors and creditors are (i) profit and loss or income statement (ii) balance sheet or
statement of financial position.
Two other key financial statements which are usually prepared by corporate firms are:-
(a) Statement of retained earnings
(b) Statement of changes in financial position
(a)
Financial Statements
Income Statement Balance Sheet Statement of Retained Earnings Statement of Changes in Financial Position
Figure - 2.1
The meaning, nature, and characteristics of these financial statements are being explained as under:-
1. Income Statement: According to S.N. Maheshwari “The income statement (also termed as profit
and loss account) is normally recognized to be the most useful of all financial statements. The
income statement gives a report of operations over a specified period of time, summarises the
revenue or income and the expenses or costs attributed to that period and indicates the net profit or
loss for a specified period of time. The income statement explains what has happened to a business
as a result of operations between two balance sheet dates. For this purpose it matches the revenue
and costs incurred in the process of earning revenues and shows the net profit earned or loss
suffered during a particular period.
The nature of “Income” which is the focus of the income statement can be well understood if a
business is taken as an organization that uses ‘inputs’ to ‘produce’ output. The outputs are the
goods and services that the business provides to its customers. The values of these outputs are the
amounts paid by the customers for them. These amounts are called ‘revenues’ in accounting. The
inputs are the economic resources used by the business in providing these goods and services.
These are termed as ‘expenses’ in accounting.”
2. Balance Sheet: Balance sheet is the most significant and basic financial statement of any firm. A
firm prepares Balance sheet to present a summary of financial position at a particular moment of
time. In the language of accounting, balance sheet communicates information about assets of the
firm (i.e. the resources of the firm) and the liabilities (i.e. obligations of the firm towards outsiders)
and owner’s equity of the firm as on a specific date. It may be noted that it depicts snapshot of the
financial position of the firm at the close of the firm’s accounting period.
3. Statement of Retained Earnings: It is also known as the Profit and Loss Appropriation A/C.
According to the provisions of the companies Act, 1956 it is not mandatory to prepare this statement
but most of the companies prepare income statement into two parts i.e. first part is income statement
and second part is P.&L. Appropriation A/C. The net profit amount depicted by Profit and Loss
account is transferred to P.&L. Appropriation A/C wherein it will be divided in two parts i.e. dividend
to the shareholders and profit retained in the firm. The Proforma of P.&L. Appropriation A/C is as
follows:-
Dr. Cr.
Part iculars Amou nt Part iculars Amo unt
To Gen. Reserve … …………. By Bal. b/d ……………..
To Interim Dividend … …………. By Net Profit ……………..
To Prop osed D ividend … ………… . By Transfer fro m …………......

General Reserve
To Co rp orate Divid end Tax … …………..
To Balance c/d … …………..

(Balanci ng Fig ure)
4. Statement of Changes in Financial Position: Traditionally balance sheet and income statement
are two common financial statements. As it has been explained earlier that the Balance sheet shows
financial position at a particular moment of time and the income statement discloses the net result of
operations of business over a period of time. But, both these statements do not depict the information
related to the changes in financial position and cash position over the period. For better understanding
of the financial position of the business, it is necessary to know the movement of working capital/
cash of the business. For this purpose, statement of changes in financial position may be prepared.
This statement shows how the firm generated different sources of funds and how these funds were
used during the period. The statement of changes in financial position can be prepared on two bases
which are:-
(i) Working capital basis-Funds Flow Statement
(ii) Cash basis- Cash Flow Statement
2.2 Objectives of Financial Statements

The financial statements are prepared to present an accurate picture of firm’s financial position and operating
results in a summarized manner. The financial statements are prepared by the firm to fulfil the following
objectives:-
1. To communicate with different parties regarding the financial position of the business (These parties
include the shareholders, creditors, investors, management, government, financial institutions, financial
analysts, labour etc.)
2. To analyse the operations and performance of the firm for planning.
3. To give necessary information for optimum utilisation of resources of the companies.
4. To provide necessary information for taking actions relating to public and social welfare.
2.3 Nature of Financial Statements

American Institute of Certified Public Accountants described the nature of financial statements as follows:
“Financial Statements are prepared for the purpose of presenting a periodical review or report on progress
by the management and deal with the status of the investment in the business and results achieved during the
period under review. They reflect a combination of recorded facts, accounting conventions, postulates and
personal judgements, and the judgements and conventions applied them materially. The soundness of
judgements necessarily depends on the competence and integrity of those who make them and on their
adherence to generally accepted accounting principles and conventions”.
Important terms used in the above statements are being described as follows:-
 Recorded Facts: Recorded facts means the data contained in statement which have been drawn
from the accounting records. Such data may be the amount of cash in hand and in bank, the amount
due form customers, the cost of fixed assets, the amount payable to creditors, amount of sales etc.
Some data or facts which are not recorded in financial books, might be material will not be depicted
in the financial statements. For example, fixed assets are recorded at acquiring cost not at replacement
cost. Therefore, the balance sheet does not present the financial position of a business in terms of
current economic conditions.
 Accounting Conventions: Accounting conventions imply certain assumptions and procedures
which have been sanctioned by long usage. Some of the important situations to use the conventions
are assets valuation, distribution of expenditure between capital and revenue, method to be followed
for calculation of depreciation, valuation of stock etc. For example, according to convention of
conservatism, provision is made for expected losses but expected profits are ignored.
 Personal Judgement: According to May George O., “the accounts of a modern business are not
entirely statement of fact, but are to a large extent expression of opinion based partly on accounting
conventions, partly on assumptions explicit or implicit and partly on Judgement .” Personal Judgement
are taken in deciding to use one of the several methods for the determination of the depreciation,
evaluation to inventory at cost or at the cost or market price whichever is less etc.
 Postulates: Accountant depends upon some postulates at the time of preparing financial statements.
For example: - an accountant assumes that the value of money will remain constant during whole the
year, so there will be no difference on transactions of different dates.
2.4 Importance of Financial Statements

Financial statements are useful for different related parties as given below:
1. Importance to Management: In the words of Gerstenberg Charles W., ‘Management can measure
the effectiveness of its own policies and decisions, determine the advisability of adopting new policies
and procedures and document to owners the result of their managerial efforts’. For effective and
controlling the company’s activities, management can get necessary data from financial statements.
2. Importance to Investors: Investors are mainly interested with the safety of their investment and to
earn profit from these investments with the help of financial statements. Investors create their opinion
about the company before investing. For example, some factors they considered are price earning
ratio, earning per share, future earning potential, trend of sales of past years, financial strength of the
company etc.
3. Importance to Creditors: Creditors lent their money for short period and they are keen interested
in the company’s ability to repay the loan amount on time. A creditor can compute various ratios like
current ratio, quick ratio etc. to know the company’s ability to repay. If a company earns less than
paid amount of interest, it is not safe to lend money to this company.
4. Importance to Government: Various ratios like turnover ratios, earning ratios indicate the health
of the company. To regulate various economic activities, government analyse the various ratios of
companies in one industry.
5. Importance to Others: Other related parties like labour, stock exchanges, economists, news
agencies, trade unions etc. are interested in analysis of financial statements to know the detail position
about the company and industry.
2.5 Limitations of Financial Statements

Financial statements are prepared to present a report on:
(i) Status of the investments in the business and
(ii) Results achieved during the review period.
The above objectives suffer from the following limitations:-
1. Financial Statements are Only Interim Reports: According to this, it can be said that financial
statements can not be final because exact amount of profit or loss of a business can be determined
after closing down the business. So profit depicted by Profit and Loss account and financial position
shown by Balance Sheet is not exact. So, it is necessary to prepare financial statement at relatively
short accounting period.
But this cutting off the balance sheet dates gives the problem of allocation of cost and income.
Financial statement data can not afford to remain exact under such conditions.
2. Depend Upon Accounting Concepts and Conventions: Financial statements are prepard on
the basis of certain accounting concepts and conventions. Financial position presented by these
statements may not be real. For example, the value of an asset represents the amount of asset which
is valued on the basis on “going concern concept”. This means value of fixed assets may not be
same which can be realise after the sale of asset.
3. Based on Historical Cost: The financial statements are based upon historical cost. They do not
give present value of business and any information regarding the future.
4. Disclose Only Monetary Items: Financial statements do not give true picture of the business
because they do not show those items which can not be expressed in monetary terms. For example,
goodwill of the firm, health of workers, efficiency of management etc.
5. Affected by Personal Judgement and Knowledge: Many items of financial statements are affected
by personal judgement and knowledge of accountant. Some of items e.g. stock valuation methods,
method of depreciation, capital and revenue expenditure are decided by personal decision.
2.6 Characteristics of Ideal Financial Statements

1. Financial statements must be in simple and attractive manner to understand and draw conclusion
easily from them.
2. The figures related with previous year must be given for comparison of financial statements
3. Financial statements must give perfect information to present true picture of the concern.
4. Irrelevant informations should be ignored.
5. Various required tables, footnotes, appendices must be given in financial statements
6. The financial statements must be in brief and summarised manner.
2.7 Main Financial Statements
The financial statement of a business consists of two statements:-
1. Balance Sheet: The balance sheet is prepared by a firm to present financial position at a given
point of time. Balance sheet can be titled as statement of financial position, statement of assets and
liabilities, position statement etc.
Balance sheet can be defined as:-
(i) According to Francis R. Stead, “Balance sheet is a screen picture of the financial position
of a going business at a certain moment.
(ii) According to John N. Myer, “The balance sheet is thus a detailed form of the fundamental
or structural equation, it sets forth the nature and amount of each of the various assets of
each of liabilities, and of the proprietary interest of the owners.”
Balance sheet presents the assets and liabilities of a firm at a point of time which may be shown in either of
the following order:
(i) Permanency order: In this method, the assets which are more permanent come first and which are
less permanent appear later. Similarly permanent liabilities come first and then less permanent liabilities.
(ii)Liquidity order: In this method, the assets which are more liquid appear first, followed by other
assets which are less liquid or take long time to convert into cash. Similarly liabilities which are
immediately are payable comes first followed by liabilities which are payable later.
Characteristics of Balance Sheet
1. It is a statement not an account hence the words ‘To’ and ‘By’ are not used here.
2. The balance sheet is prepared on a particular point of time so, it presents the value of assets and
liabilities of a firm on that point of time.
3. Balance sheet presents the financial value of the business on going concern value.
4. Both sides of balance sheet must be same i.e. Assets = Liabilities
5. Balance sheet is prepared by using accounting concepts, conventions, postulates and personal
judgements etc.
Proforma of Balance Sheet
Balance sheet of a company as per Performa contained in schedule VI annexed to the companies Act,
1956. is as follows.
Table - 2.1 : Proforma of Balance sheet as per the companies Act, 1956
Balance Sheet of … ……… …… …… …… …… ..
As on … …… …… …… …… …… …..
Liabil ities Amount Assets Amount
Share Capit al Fixed As sets……… ….
Reserves & Surp lus Less: Dep. … …… ……
Secured Loans Invest ment s
Unsecured Lo ans Current Asset s, Lo ans and
Advances
Current Liab ilit ies M iscellaneou s Exp .
Provis ions Pro fit and Loss A/C
In table 2.1 the balance sheet has been presented in horizontal form. Table 2.2 presents the balance sheet in
vertical form.
Table: 2.2
Proforma of Balance Sheet
Balance Sheet of ………………………….
as on …………………………………..
Amo unt Am oun t
1. So urces o f Fu nds
( i) Shareho lders fund
(a) Share Cap ital
(b) Reserves and Su rp lus
( ii) Loan fun ds
(a)Secured Loans
(b) Unsecured Lo ans
2. Ap plicat ion o f fu nds
(i) Fixed As sets
Les s: D ep
( ii)Investments
( iii)Curren t Asset s, Loans & Advances
Less: Cu rrent Liabi lities
( iv)Miscel laneous Expend iture
(v)Profit & Lo ss Accou nt
The balance sheet can be grouped into two parts: - Assets side and liabilities side.
Main items of Assets side
1. Fixed Assets
2. Investments
3. Current Assets, Loans and Advances
4. Miscellaneous Expenditure
5. Debit balance of Profit and Loss Account
Main items of Liabilities side
1. Share Capital
2. Reserves and Surplus
3. Secured Loans
4. Unsecured Loans
5. Current Liabilities and Provisions
Above terms are being explained here under:
Fixed Assets: Fixed assets include those assets which are purchased for long term. These assets are of
permanent nature and are not usually converted into cash in short period. Fixed assets are shown at historical
cost less depreciation till date. Thus these assets not present their market value or replacement cost.
Fixed assets should be presented in balance sheet in the following (permanence) order:-
1. Goodwill
2. Land
3. Buildings
4. Lease hold property
5. Plant and Machinery
6. Furniture and fittings
7. Development Property
8. Patents and Trademarks
9. Live Stock
10. Vehicle
Investments: In balance sheet, investment means Government securities, shares, debentures, bonds etc.
investments are shown at cost price in balance sheet. In words of Kohler, ‘Investment is an expenditure to
acquire property real or personal, tangible or intangible which yields income or services.’
Current assets, Loans and Advances: Current assets are those liquid assets which are convertible into
cash within a period of one year. Current assets include cash and bank balance, sundry debtors, receivables
(debtors and bills), stock (raw material, work-in progress and finished goods), marketable securities, prepaid
expenses. Loans and advances include bill of exchange, advances recoverable in cash or kind or value to be
received.
Miscellaneous Expenditure: Expenses which are not included in manufacturing, administrative and selling
expenses are knows as miscellaneous expenditure. Preliminary expenses, discount allowed on issue of
shares and debentures, development expenses, commission or brokerage paid on undertaking or subscription
of shares and debentures etc. are included in miscellaneous expenditure.
Share Capital: In liabilities side of balance sheet, share capital is shown as first item. Under the head of
share capital-authorised capital, issued capital, subscribed capital, paid up- capital are shown. Both type of
shares preference and equity shares are also given under this head.
Reserves and Surplus: Under the head of reserves and surplus, various reserves are shown e.g. capital
reserves, capital redemption reserves, proposed addition to reserves, share premium account, sinking fund,
surplus etc.
Secured Loan: Secured Loans are such type of loan against which collateral or other security is held.
Debentures, loans and advances from bank etc. are include in this.
Unsecured Loan: According to kohler, “Unsecured liability is a liability for which the creditor holds no
security.”
Short term loans, advances from banks, public loans etc. are included in this head.
Current Liabilities and Provisions: Current liabilities are such liabilities which the firm expects to pay
within a period of one year. Sundry creditors, bank overdraft, advance payments, unclaimed dividend,
acceptance, outstanding expenses etc. are current liabilities. Current liabilities are paid out of the realisations
of current assets. These liabilities are expected to be discharged within an operating cycle of the firm.
Provisions include provision for taxation, dividend etc. Provisions for contingencies are shown as foot note
in the balance sheet.
Activity A:
1. What are the fixed and current assets? Give examples.
2. Profit and Loss Account/Income Statement: The income statement is also known as profit and
loss account, statement of earnings, statement of income and expenditure, statement of profit and
loss etc. Income statement provides the summary of the operating results of the firm of a accounting
period. In this statement revenues are match with the costs and shows the difference between the
two as the net profit/loss for a specific period. In America, the profit or loss is calculated in a
statement form, so it is known as income statement. While in India, the profit or loss calculated in
account form, so, it is known here as profit and loss account. With the help of income statement we
can understand the performance of the firm for a specific period. Income statement is prepared a
particular period, no standard format for income statement is provided by Companies Act, 1956.
Some definitions of income statement are given below;
Accounting to Howard and Upton, “The summary of changes in owners’ claim or equity resulting
from operations of period of time, properly arranged, is called the profit and loss statement.”
According to Robert N. Anthony, “The accounting report which summarises the revenue items, the
expense items and the difference between them (net income) for an accounting period is called the
income statement (or the profit and loss statement, statement of earnings or statement of operations).”
The debit side of profit and loss account includes all business expenses and losses where as credit
side includes all incomes and gains. Difference of both sides is called profit or loss as the case may
be.
As the companies Act, 1956, does not state any standard format of profit and loss account. Different
business firms prepare this account according to the nature and requirement of the business. The
profit and loss account is divided into these four parts:
1. Manufacturing account
2. Trading account
3. Profit and loss account
4. Profit and loss appropriation account
Format of Income Statement: These days, instead of preparing the account form of profit and loss, the
statement form is prepared by the companies. Statement is may be of two types-
I. Single-step Income Statement
II. Multi step Income Statement
R e ve nue Rs Rs
Sa le s l es s re turns …… …… …… .
Ot he r inc o me …… …… …… .
Tot a l R eve nu e
C ost a nd Exp e nse s …… …… ….
Cos t o f sa l es *
Ad min ist rat ion a nd G e ne ra l Exp e nse s …… …… …… .
D ep re c ia t ion …… …… …… .
Int e rest …… …… …… .
…… …… …… .
N on-ope ra ting Expe n ses
Prov isio n for ta x …… …… …… .
Tot a l Co st and Expe ns es …… …… …… .
N e t P rofit (a ft er t a x) … … … … … ...
Propo se d D ivide nd
Inco me R et a ine d i n Bu sin es s … … … … … ..
… … … … … ..
… … … … … ..
*Cost of Sales = opening Stock + Purchases-closing stock
Multi-step Income Statement
……………………. Company Ltd.
Profit and Loss Account
For the year ended ……………………………
Rs Rs
Sales Revenue:
Gross Sales … …… …… …. .
Less: Sales Ret urns and Allo wnces … …… …… …. .
Net Sales …… …… …...
Cost of Goo ds Sold:
Beginn ing inventory
Purchases less Ret urns … …… …… …. .
Go ods Avai lable for sales … …… …… …. .
Less: clos ing invent ory … …… …… …. . …… …… …..
Gros s Profit o n Sales: … …… …… …. . …… …… …...
Op erating Expen ses:
Ad min ist rative and General Exp enses
Pro vis ion fo r Depreciat ion … …… …… …. .
Sellin g Exp enses … …… …… …. . …… …… …..
… …… …… …. .
Operatin g Profit:
Add: ot her Revenue:
Interest, Rent et c. …… …… …..
Dividends
Less: ot her E xpenses … …… …… …. .
Interest et c. … …… …… …. .
Profit b efore Int erest and Tax
Less: Inco me Tax … …… …… …. . …… …… …..
… …… …… …. .
Net Profit aft er T ax
Disp os itio n of Incom e …… …… …..
Preference Div idend
Equity D ividend …… …… …..
Ret ained Profit … …… …… ….

… …… …… ….
…… …… …..
…… …… …...
Activity B:
Give a specimen of multistep income statement using imagining figures.
Illustration 1. The following figures are retated to Mauli Ltd. For the year ending 31st Dec. 2012
Rs. Rs.
Cas h 2430 0 E quit y Share Capit al (Rs. 10 .00 each) 50 0000

Build ing s 4 0000 0 Propo sed equ ity d ivid end for 2 012 (Net)
General Res erve 5000 0 Ad vance payment of t ax 4 3125
Plant an d Machin ery 2 7200 0 P& L A/C bal an ce
Payment in ad van ce 3100 0 T rad e Inv est ment 5 0000
B/R 1130 0 N et Sales 10 8500
Sto ck 1 3640 0 B/P 1 0000
Secured Debent ures 1 2500 0 Prov isio n for taxat ion 109 1200
Trade Cred ito rs 2 0287 5 N et Pro fit for the year 2 012 before 9000
Bank ov erdraft 2600 0 d ividend and tax 13 2000
Debto rs 2 6150 0 16 3915
Yo u are required to prepare balance sheet i n st atement fo rm.
Solut ion : M auli Ltd.

Balance Sheet (as o n 31 st Dec.,2 012)
Fixed A ssets
Buil ding s 4 00000
Plant and Machin ery 2 72000 672 000
Trade in ves tm ents 10 000
To tal Fixed Asset s 682 000
Net cu rrent Assets
Current Ass et s:
B/R 1 1300
Sto ck 1 3640 0
Sundr y Debtors 2615 00
Cash 2 4300
Payment in Ad vance 31 000
Advance Payment of Tax 500 00 5 14500
Less: current L iab ilities:
Ban k overdraft 2600 0
Cred ito rs 202 875
B/P 900
Pro v. for t ax at ion 1 3200 0
Pro pos ed Divid end 431 25 4 13000 101 500
Total capit al Emplo yed 783 500
Shareho lders Fund s
Eq uity Sh are Cap ital 5 00000
General Reserve 50000
P&L A/C 1 08500 658 500
Lo an fu nds
Secu red D ebentures 125 000
Tot al 783 500
Illustration 2. The following data are related to Anshuman Ltd. for the year ending 31st March 2012
Rs. Rs.
Opening stock 220000 Selling and Dist. Exp.
Purchases 1400000 Salaries 36000
Closing stock 280000 Travelli ng 10000
Sales 2000000 Adverti sing 14000
Sales Returns 80000
Admi nistrative Exp: Divi dend receive 36000
Salaries 60000 Loss on sale of shares 6000
Rent 12000
St ationery 4000
Depreciation 20000
Other charges 40000
Prov. for taxation 140000
Soluti on: Profit and Loss Account

st
for the year ending 31 March 2012
Rs. Rs.
Sales Revenue
Gross Sales 2000000
Less: Ret urns 80000 1920000
Cost of Sales
Opening stock 220000
Add: Purchases 1400000
Less: closing stock 1620000
Gross Profit on Sales 280000 1340000
Operating Expenses 580000
Admi nistrative Expenses:
Salaries 60000
Rent 12000
Stationery 4000
Depreciation 20000 96000
Selling & Dist. Exp:
Sal aries 36000
Advertising 14000
Travelling 10000 60000
Other charges 40000
Total operating Exp. 196000
Operating Profit 384000
Other Revenues:
Non-operating income
Dividend Recei ved 36000
Less: Loss on sale of s hares 6000 30000
Profi t before t ax 414000
Provision for tax 140000
Net income after tax 274000
2.8 Summary
A manager obtains financial information from financial statements to take right decision at right time. Financial
statements are prepared by the top management and present financial information in concise and capsule
form. The term financial statements refer to Profit and Loss Account or Income Statement, Balance sheet,
and sometimes statement of Retained Earning and statement of changes in financial position. The Income
statement gives a report of operations over a specified period of time, summarises the revenue or income
and the expenses or cost attributed to that period and indicates the net profit or loss for a specified period
of time. The Balance sheet presents a summary of financial position at a particular moment of time. The net
profit depicted by Profit and Loss account is transferred to Profit and Loss Appropriation account wherein
it will be divided in two parts i.e. dividends to shareholders and profit retained in the firm. Statement of
changes in Financial Position depicts how the firm generated different sources of funds and how these funds
were used during the period. It comprises Fund Flow Statement and Cash Flow Statement.
The financial statements are prepared to communicate with different parties regarding the financial position
of the business and to analyse the operations and performance of the firm for planning. Financial Statements
reflect a combination of recorded facts, accounting conventions, postulates and personal judgements. Financial
statements are important to management, investors, creditors, government and other stakeholders. Financial
statements are only interim reports, depend upon accounting concepts and conventions based on historical
cost. Financial statements disclose only monetary items and affected by personal judgement and knowledge.
Financial statements must be in simple and attractive manner. Irrelevant informations should be ignored.
Various required tables, footnotes, appendices must be given in financial statement.
2.9 Key Words

 Balance Sheet: It is a statement of financial position of a business at a specified point of time. It
represents all assets owned and the claims of the owners and outsiders against those assets at that
time.
 Current Assets: Current assets are the liquid assets of the firm and are convertible into cash within
a period of one year.
 Current Liabilities: The current liabilities are those liabilities which the firm expect to pay within a
period of 1 year.
 Fixed Assets: Fixed assets are those assets which are of permanent nature relatively less liquid
and are not usually converted into cash in the short run.
 Profit and Loss Account: Profit and loss account summarizes the revenues and expenses of the
firm for an accounting period.

1. Explain the meaning of the term “Financial Statements”. State their nature and limitations.
2. What are financial statements. Why are these prepared?
3. Discuss the utility and importance of financial statements for the various parties interested in a
business concern.
4. Explain the essential qualities financial statements.
5. Explain the statement “Financial Statements reflect a combination of recorded facts, accounting
conventions and personal judgement.”
6. Following is the Profit and Loss account of ABC Ltd. You are required to redraft it in statement
(vertical) form.
Profit and Loss Account
for the year ending 31st March 2012
R s. i n 000
To sto ck: B y S ales 400 0
M at erial 180 B y S to ck :
W IP 80 M at erial s 180
Fi nis hed Goo ds 240 500 F inis hed Go ods 320
To Pu rchase o f M aterial 1700 WIP 120 62 0
To firel and P owel 80 B y Di vidend 60
To wages 560 B y S ale of S crp . 16
To Mis c. Facto ry Exp. 220
To offi ce s alari es 160
To Mis . Exp . 180
To Advertis em ents 160
To Sell ing Exp. 240
To Prelim in ary Exp. 10
To Interes t 30
To Deprec iat ion:
Bu ild ing 24
Machinery 120 144
To Prov. fo r Taxatio n 340
To Propo sed D ividend 140
To Balance of P rofit 256
4696 469 6
7. Balance sheet of XYZ Ltd. is given below. You are required to prepare balance sheet in statement
form.
Balance Sheet of XYZ Ltd.
(Rs. i n 000 )
as on 31st March 2012
Li ab ilities Amo unt Assets Am ount
Eq uit y share capi tal 100 0 T rade Invest ment s 4 00
Di v. Equ alisat ion Res. 14 0 Patent s 60
Gen. Res. 22 0 Buil din gs (at cos t) 6 40
P&L A/C 38 0 M ach inery 13 00
6% Deb ent ures 50 0 Bank bal. 1 76
Bank ov erdraft 30 0 Sto ck: Rs.
Staff Pro v. fund 16 0 Materials 180
Cred ito rs 42 0 WIP 120
Unpai d Div idend 20 Fin. Go ods 32 0 6 20
Proposed Divi dend 12 0 Debt ors 4 60
Prov. for T ax 34 0 Less : Provi sio n 16 4 44
Prov. for D ep. 50 0 B/R 60
Staff Pro v. fund invest ment 1 60
Depo sit with cust om Au th. 60
Ad vance fo r purchase of Machin e 1 20
Preliminary E xp. 60
410 0 41 00
- Financial Management - S.N. Mahaeshwari
- Management Accounting - R.P. Rustagi
- Financial Management - M.R. Agrawal
- Financial Management - M.R. Agrawal and N.P. Agrawal
- Financial Management - I.M. Pandey
Unit - 3 : Techniques of Financial Statement Analysis
Structure of Unit
3.0 Objectives
3.1 Introduction
3.2 Objective of Financial Statement Analysis and Interpretation
3.3 Types of Financial Statement Analysis
3.4 Procedure of Financial Statement Analysis
3.5 Importance of Financial Statement Analysis
3.6 Techniques of Financial Statement Analysis
3.7 Summary
3.8 Key words
3.0 Objectives
 Understand financial statement analysis
 Know the procedure of financial statement analysis
 Prepare comparative balance sheet and profit and loss account
 Prepare common size financial statements
3.1 Introduction
Financial statements comprising the balance sheet and the profit and loss account donot provide all the
information in relation to the financial operation of a business enterprise, The balance sheet depicts the
financial position on a particular date and the profit and loss account reveals the results of financial activities
during a certain period of time. Merely figures shown in financial statements donot serve the purpose of
decision making for all stakeholders. Analysis and interpretation of financial statements help to diagnosis the
profitability and financial soundness of the business. Analysis and interpretation are two different terms.
S.N. Maheshwari states” the term analysis means methodical classification of data given in the financial
statements. The figures given in the financial statements will not help one unless they are put in a simplified
form. For example, all items relating to current assets are put at one place while all items relating to currant
liabilities’ are put another place. The term ‘Interpretation’ means explaining the meaning and significance of
the data so simplified. According to Metcalf and Titard “ The analysis of financial statements as a process of
evaluating the relationship between component parts of financial statements to obtain a better understanding
of the firm’s position and performance.” The financial analyst selects the information related to the decision
under consideration from total information available in financial statements. Thereafter he arranges the
information in a way to establish significant relationships. The last step is to interpret and to draw inferences
and conclusions. According to Spicer and pegelar” Interpretation of accounts may be defined as the art and
science of translating the figures in such a way as to reveal the financial strength and weakness ofa business
and the causeswhich have contributed therein.”
3.2 Objective of Financial Statement Analysis and Interpretation
The objectives of financial statements analysis and interpretation may differ from the point of view of different
stakeholders. Shareholders are generally interested in earning per share while debentureholders have focus
on capital structure and projected earnings. According to Anthony, Robert N. “The overall objective of a
business is to earn a satisfactory return on the funds invested in it,consistent with maintaining a sound
financial position. Hence the purpose of analysis of financial statement is a detailed cause and effect study of
profitability and financial position. Although analysis of financial statement is not an automatic and authentic
process but it helps in answering the questions of financial analyst. The main objectives of analysis and
interpretation of financial statements are being explained hereunder:
1. To measure profitability and to find out responsible factors in case of declining and improving
profitability ratios.
2. To measure financial soundness with the help of various ratios for corrective actions in case of
adverse position.
3. To measure operating efficiency through comparison of current year’s production, sales, expenses
with last year’s figures of these items.
4. To assessshortterm as well as long term solvency for creditors, debenture holders etc.
5. To show trend of various items of financial statements e.g. sales, purchases, profits, expenses and
to make strategies for future. This information will also help in budgeting and planning.
6. To conduct inter-firm and intra-firm comparison for self evaluation and for operating efficiency to
take corrective actions.
3.3 Types of Financial Statement Analysis

Financial statement analysis can be undertaken in different ways. The purpose of which the financialstatement
analysis to be undertaken and the person doing financial statement analysis are two main deciding factors of
types of financial statement analysis. Financial statement analysis may be categorised on the two main basis
which are being presented here:-
Types of Financial Statement Analysis
According to Material used According to Modus Operandi
Internal Analysis External Analysis Horizontal Analysis Vertical Analysis
Figure - 3.1
1. According to Material Used:- Financial analysis according to this type can be of two type:
(i) Internal Analysis: Executives and employees of the enterprise conduct internal analysis
because they have access to the books of accounts and all other information related to
business. Therefore, such analysis becomes more reliable and useful to management.
(ii) External Analysis: - An external analysis is done by those who are outsiders for the
business and do not have access to the detailed records of the company. Shareholders,
prospective investors, creditors, bankers, governmental agencies, researchers are outsiders
who conduct such analysis on the basis of published financial statements. Increased
governmental control over companies and governmental regulations have directed companies
to disclose more detailed informations in order to improve analysis.
2. According to Modus Operandi: This type of analysis can be classified in two categories:-
(i) Horizontal Analysis: - when financial statements for a number of years are reviewed and
analysed, it is termed as ‘Horizontal Analysis’.Under this method, figures of two or more
years regarding each items are shown with changes from the base year. Generally, the first
year is assumed as base or standard year. Increase or decrease in each item as compared
to base year is shown in percentage form. For example, creditors shown in the balance
sheet have increased or decreased as compared to the year 2011, and 2012. Horizontal
analysis is used in comparative balance sheet and profit and loss account and in trend
analysis. Area of strength and weakness from considerable insight are given to the
management by this analysis. It is also known as ‘Dynamic Analysis’.
(ii) Vertical Analysis:- It is a study of quantitative relationship of the various items in the
financial statements on a particular date. It is related to one date or one accounting period.
Therefore, it is termed as ‘Static Analysis’. Common size balance sheet and profit andloss
account are examples of vertical analysis. Totals of financial statements of a particular
accounting period are taken as 100 and then all items related to that statement are converted
into percentage. For example, each item of Balance sheet is stated as a percentage of the
total of the Balance sheet.
3.4 Procedure of Financial Statement Analysis

The analysis process of financial statements involves the compilation and study of financial and operating
data. Analytical representation and promptness are attributes of ideal financial analysis. The following
procedure has to be adopted for financial statement analysis:-
(1) Re-arrangement of Financial statements: First of all a financial statement analyst must know
the object of financial statements analysis. Profit and loss account reveals trend of progress and
Balance sheet depicts financial position. Director’s report and chairman speech are useful to know
future plans. Financial data should be presented in a condensed form according to the object.
(2) Study of Financial Statements: Detailed study of Balance sheet and Profit and loss account of
current year and past years should be made to create a comprehensive vision and to guess about
future.
(3) Approximation of Figures And Classification of Items: The figures should be approximated to
the nearest thousand or lakh of rupees to remove complexity of process. The items related to
particular heading should be put at one place. Such classification of items will help in analysis.
(4) Comparison by Establishing Relationship Between Items: Absolute figure is useless until it is
compared with another figure. Various items are taken and a relationship with other item is established
according to the object. An item of current year may be compared with its past year figures or may
be compared with an other item. For example sales of current year may be compared with last
year’s sales or may be compared with gross profit, net profit or with different assets. Figures of a
particular company may be compared with the figures of other company. All these depend on the
object of analysis.
(5) Analysis and Interpretation: On the basis of a comparative study, the analyst puts trend and
changes. It presents important facts to take corrective action and to help in decision making according
to object.
(6) Presentation: After analysis and interpretation financial analysis draws inferences. These inferences
may be presented either through report or diagrams.
3.5 Importance of Financial Statement Analysis

Financial statement analysis is useful for stakeholders because it helps in decision making form their point of
view. The importance of financial statement analysis may be understood from the points given below:-
1. Disclosure of Facts: -Financial statements presents only figure of related various items. They do
not provide information regarding solvency, requirement of working capital, liquidity position, debtor’s
collection policy etc. Analysis of financial statements helps to answer of such questions and provides
explanation about all required informations.
2. Comparative Study of Efficiency:- various items are compared with past data of the firm and
also with other firms engaged in the same business. It measures efficiency of business itself and in
comparison to others.
3. Help in Planning and Decision Making:-After analysis of financial statements, a firm may know
increasing or decreasing trend of various items. It will provide a base for future planning and remedial
measures can be planned for solution of future problems.There is no room for personal biasness in
decision making because data are scientifically analysed.
4. Effective Control: - Control can be exercised effectively in case of variations. Analysis of financial
statement provides information regarding day to day activity of business. If there is any negative
sign, corrective actions may be taken.
5. Importance to Various Stakeholders. Investor, debenture holders, employees, management,
government and researchers are various stakeholders who want to know different informations
related to them. Analysis of financial statement provides informations to various stakeholders.
3.6 Techniques of Financial Statement Analysis

Different persons undertake analysis of financial statement for different purposes. The methodology for
analysis may vary from one situation to other. Horizontal or vertical analysis of items given in financial
statements shows profitability and financial position of firm. The techniques which help to study the relationship
of horizontal and vertical analysis are termed as Techniques of Financial Statement Analysis. The main
techniques are being explained here :-
1. Comparative Financial Statements
2. Common-size Financial Statements
3. Trend Percentages
4. Ratio Analysis
5. Fund Flow Analysis
6. Cash Flow Analysis
7. Break-Even Analysis
A technique useful for one analyst may be useless for another to their different objects. It is not necessary to
use all above techniques. The analyst should adopt only these techniques which are helpful in their object of
investigation. The above techniques are being explained here in detail with suitable examples:
Activity A:
1. Prepare a list of techniques of financial statement analysis
Comarative Financial Statements: Now-a-days companies have started to provide important statistical
information in condensed form for the last so many years. Financial statements of a single period represent
only one phase of the long and continuous history of the firm, therefore data related to a period of a number
of years will be more significant and meaningful for comparative study. Comparative financial statements are
presented in a way so as to provide time perspective to the consideration of various elements of financial
position embodied in such statement. The financial data are placed in columnar form. Comparative statements
are made to show-
(i) Absolute data (money value)
(ii) Decrease or increase in absolute data in terms of money values.
(iii) Decrease or increase in absolute data in terms of percentage.
(iv) Comparison expressed in ratios
(v) Percentage of totals.
It should be kept in mind while preparing comparative financial statements that the methods of collection of
data, presentation of date, accounting policies and principles followed are same otherwise these will give
misleading results. If there is any change, it should be indicated in the footnotes. Classificationof elements of
assets and liabilities in Balance sheet and elements of income and expenditure in Profit and Loss account
should be same during the period of comparison.
Generally comparative Balance sheet and comparative Profit and Loss account are prepared. The both
comparative statements are being explained here:-
(i) Comparative Balance Sheet: Comparative Balance Sheet depicts decrease and increase in various
items of assets and liabilities. Data at the beginning and at the end of the period are taken for
comparison. A single balance sheet shows only the balance of accounts but the comparative balance
sheet shows increase or decrease in each item. The comparative Balance sheet has two columns for
the data of the original balance sheet and a third column for increase or decrease in various items.
The fourth column contains the percentage of increase or decrease.
(ii) Comparative Profit and Loss Account: A comparative profit and loss account shows the absolute
figures for two or more periods of different items, the absolute changes from one period to another
and if desired, the changes in terms of percentages form. A financial analyst can quickly ascertain
whether sales, cost of goods sold and other different items have increased or decreased and by
how much percentage.
According to The American Institute of Certified Public Accountants “The presentation of comparative
financial statements in annual or other reports enhance the usefulness of such reports and brings out more
clearly the nature and trend of current changes affecting the enterprises. Such presentation emphasizes the
fact that statements for a series of periods are for more significant than those of a single period and that the
accounts of one period are but an instalment of what is essentially a continuous history. In any one year, it is
ordinarily desired that the Balance sheet, the Income Statement and the Surplus statement be given for one
or more preceding years as will as for the current year.”
The following illustration will help to understand the preparation of comparative financial statements.
Illustration 1: Following are the Profit and Loss account and Balance Sheet of Ashu & Co. for the years
2011 and 2012. Prepare the comparative Profit and Loss Account and comparative Balance sheet for
these two years
P rof it a nd Los s Acco u nts fo r t he ye ars 2011 and 2012
Pa rt ic ula rs 2011 2012 Pa rt ic ula rs 2011 2012
(R s .) (R s .) (R s .) (R s .)
To cos t o f Good So ld 30,000 37,500 B y N et Sa le s 40,000 50,000
To Ge nera l E xpe nses 1000 1000
To Se lling E xpe nse s 1,500 2000
To N et Pro fit 7500 9500
40,000 50,000 40,000 50,000
B alance She e ts As on De c. 31
Lia bilitie s 2011 2012 As se ts 2011 2012
(R s .) (R s .) (R s .) (R s .)
C apita l 35000 35000 La nd 5000 5000
Reser ves 10000 12250 B uild ing 15000 13500
Secur ed Loa ns 5000 7500 Pla nt 15000 13500
C red itor s 10000 13750 Fur niture 5000 7000
O uts ta nd ing E xpe nse s 5000 7500 C ash 5000 7000
Debtor s 10000 15000
Stock 10000 15000
65000 76000 65000 76000
Solutio n: -
Co m pa rat ive Profit a n d Los s Accoun t
Fo r t he ye ar e nding 2011 a nd 2012
Pa rt ic ula rs 2011 2012 Cha nge in 2012 % Cha nge 2012
(R s .) (R s .) (R s .)
N et Sa les 40000 50000 10000 +25
Less :- C ost o f Good s So ld 30000 37500 7500 +25
Gross P ro fit ( A) 10000 12500 2500 +25
Less : Ge nera l E xpe nses 1000 1000 - -
Selling E xpe ns es 1500 2000 500 +33.3
Tota l E xpe nses (B ) 2500 3000 500 +20
N et Pro fit (A-B ) 7500 9500 2000 +26.7
Co m pa rat ive B alance She e t as on De c.31
2011 2012 Cha nge in 2012 % Cha nge 2012
(R s .) (R s .) (R s .)
La nd 5000 5000 - -
B uild ing 15000 13500 - 1500 - 10
Pla nt 15000 13500 - 1500 - 10
Fur niture 5000 7000 2000 +40
Tota l F ixed Asse ts ( A) 40000 39000 - 1000 - 2.5
C ash 5000 7000 2000 +40
Debtor s 10000 15000 5000 +50
Stock 10000 15000 5000 +50
Tota l C urre nt As sets (B ) 25000 37000 12000 +48
C red itor s 10000 13750 3750 37.5
O uts ta nd ing E xpe nse s 5000 7500 2500 50
Tota l C urre nt L iab ilitie s(C ) 15000 21250 6250 41.7
N et work ing C ap ita l ( B- C ) 10000 15750 5750 57.5
Tota l A ssets (A +B ) 65000 76000 11000 16.9
Interpretation: The net sales has increased by 25% which was coupled with increase in the cost of good
sold which also increased by same 25%. It can be observed that gross profit for the year 2012 has increased
by 25% over the profit of the year 2011. The increase in Net Profit by 26.7% is due to less increase in total
expenses. The comparative balance sheet shows a decrease of 2.5% in fixed assets which is result of
depreciation.
The current assets have increased by 48% and current liabilities have increased by 41.7%. increase in net
working capital by 57.5% shows that the working capital has not been managed properly. Change in
shareholders’ fund by 5% is the result of change in retained profit only because the firm has not raised
capital during the study period. The secured loans have increased by 50%.
The comparative financial statements do not depict the variation in different liabilities or different assets in
relation to total liabilities or total assets for a particular period.
Activity B:
1. Prepare Comparative Balance Sheet and Profit and Loss account with Imaginary figures
Common size Financial Statements: According to S.N. Maheshwari “Common size Financial Statements
are those in which figures reported are converted into percentages to some common base”. The common
size statements are generally called “component percentage” or “100 percent” statements. In common size
balance sheet, the total of assets and liabilities is taken as 100 and other items are expressed as its percentage.
Similarly in common size profit and loss account, sales figure is taken as 100 and each item is stated as
percentage of sales. The common size financial statement is useful for intra-firm comparison as well inter
firm comparison. The following example will help in understanding the procedure of preparation of common
size financial statements.
Illustration 2: Prepare the common size Balance Sheet and common size Profit and Loss account using
data given in Illustration 1-
Solution:
Common Size Balance Sheet
2011 2012
Amount Common size % Amount Common size %
5000 7.70 5000 6.59
Land 15000 23.07 13500 17.76
Building 15000 23.07 13500 17.76
Plant 5000 7.70 7000 9.21
Furniture 40000 61.54 39000 51.32
Total Fixed Assets (A) 5000 7.70 7000 9.20
Cash 10000 15.38 15000 19.74
Debtors 10000 15.38 15000 19.74
Stock 25000 38.46 37000 48.68
Total Current Assets (B) 65000 100 76000 100
Total Assets (A+B) 35000 53.85 35000 46.05
Capital 10000 15.38 12250 16.12
Reserves
45000 69.23 47250 62.17
Shareholders’ Fund (C)
Secured Loan 5000 7.70 7500 9.87
Creditors 10000 15.37 13750 18.09
Outstanding Expenses 5000 7.70 7500 9.87
Total Liabilities (D) 20000 30.77 28750 37.83
Total Capital+Liabilities (C+D) 65000 100 76000 100
Common Size Profit and Loss Account
2011 2012
Amount Common size Amount Common size %
%
Net Sales 40000 100 50000 100
Less:- Cost of Goods sold 30000 75 37500 75
Gross Profit (A) 10000 25 12500 25
Less:- General Expenses 1000 2.5 1000 2.0
Selling Expenses 1500 3.75 2000 4.0
Total operating Expenses(B) 2500 6.25 3000 6.0
Net Profit (A-B) 7500 18.75 9500 19.0
Interpretation: The common size balance sheet shows that proportion of fixed assets has decreased from
61.54% to 51.32% while current assets portion out of total assets has increased from 38.46% to 48.68%.
It indicates that position of current assets is far better than fixed assets. The proportion of shareholders’ fund
has reduced from 69.23% to 62.17% whereas external liabilities proportion has increased from 30.77% to
37.83%.
The common size Profit and Loss account reveals that there is no change in cost of goods sold and gross
profit percentage of sales. The operating expenses has reduced form 6.25% to 6%. It has affected net profit
which has increased from 18.75% to 19%.
The common size Financial Statements are useful to compare financial results and financial position between
two firms for the same period or for two different periods of a firm. It becomes difficult when the period to
be covered is more than two years. The common size Financial Statement is useful in only vertical analysis.
Trend Percentages: Examination of any one year’s account is not sufficient to predict the financial health
of a business. Therefore, it is necessary to study of data of two or more years. The trend percentage is
useful to conduct a comparative study of financial statement for several years. The study of trend will
indicate the direction of movement over a long time. It makes possible a horizontal study of the data. The
method of calculating trend percentage involves the calculation of percentage relationship that each item
bears to the same items in the base year. Any year may be taken as base year but it should generally be the
earliest year.
Each item of the base year is taken as 100 and on that basis the percentage for each of the items of each of
the years are calculated. Trend percentages are generally not computed for all the items given in the financial
statements as the fundamental objective is to make comparison between items having some logical relationship
to one another. The computation of trend percentage is useful to know favourable or unfavourable position
of the business.
The following points should be kept in mind while calculating trend percentages:
1. The consistency regarding accounting policies and practices should be followed for comparability.
2. The care is necessary in selection of base year. The base year must be normal and representative
year. Normally, the initial year is taken as base year but in case representative year may be considered
as base year.
3. Trend percentages should be computed for only those items which have logical relationship with
each other.
4. The figures for different years must be adjusted for variation in price level changes. For example,
increase in sales may be result of increase in selling price not of sales volume. The trend percentages
may give misleading results if price level changes are not adjusted.
Illustration 3: Calculate the trend percentages from the following figures of Manish Ltd., taking 2009 as
base year:
2009 2010 2011 2012

Net Sales 50000 47500 60000 65000
Less:- cost of Good sold 30000 29450 34800 36400
Gross Profit 20000 18050 25200 28600
Less: Expenses 5000 4850 5500 6000
Net Profit 15000 13200 19700 22600
Solution:-
Trend Pe rcentage
2009 2010 2011 2012

Net Sales 100 95.0 120.0 130.0
Less:- Cost of Good sold 100 98.2 115.8 121.3
Gross Profit 100 90.3 126.0 143.0
Less: Expenses 100 97.0 110.0 120.0
Net Profit 100 88.0 131.3 150.6
Interpretation: It can be observed that the sales have reduced by 5% but cost of goods sold and expenses
have declined by 1.8% and 3% respectively. Net profit has decreased by 12% which shows that the overall
position in2010 is bad. The position was recovered in 2011 and 2012. Although there was 20% and 30%
increase in sales of 2011 and 2012 but increase in net profit by 31.3% and 50.6% in 2011 and 2012 shows
good position of the business.
Note: The remaining techniques of financial Statement analysis have been explained in detail in the following
units.
3.7 Summary
The balance sheet depicts the financial position on a particular date and profit and loss account reveals the
results of financial activities during a certain period of time. Merely figures shown in financial statements do
not serve the purpose of decision making for all stakeholders. Analysis and interpretation of financial statements
help to diagnosis the profitability and soundness of the business. The Financial statement analysis helps to
measure operating efficiency and to assess short term as well as long term solvency of the business. Financial
statement analysis may be categorised on the two main basis viz., Material used and Modus operandi.
Financial analysis according to material used can be of two type (i) internal analysis and (ii) external analysis.
Internal analysis is conducted by executives and employees of the oranisation while external analysis is done
by those who are outsiders for the business. According to modus operandi, the analysis can be horizontal
analysis or vertical analysis. Under horizontal analysis method, figures of two or more years regarding each
items are shown with changes form the base year. Vertical analysis is related to one date or one accounting
period. Total of financial statements of a particular accounting period are taken as 100 and then all items
related to that statement are converted into percentage. The analysis process of financial statements involves
re-arrangement of financial statements, study of financial statements, approximation of figures and classification
of items, comparison by establishing relationship between items, analysis and interpretation and presentation
through report or diagrams. Financial statements analysis helps in comparative study of efficiency and planning
and decision making. It is important to various stakeholders. Comparative Financial Statements, Common
Size Financial Statements, Trend percentages, Ratio Analysis, Fund Flow Analysis, Cash Flow Analysis,
Break Even Analysis are the main financial statement analysis techniques.
3.8 Key words

 Internal Analysis: the analysis which is conducted by executives and employees of the enterprise.
 External Analysis: An external analysis is done by those who are outsider for the business and do
not have access to the detailed records of the company.
 Horizontal Analysis: When financial statements for a number of years are reviewed and analysis,
it is termed as ‘Horizontal Analysis’. Under this method. Figures of two or more years regarding
each items are shown with changes from the base year.
 Vertical Analysis: It is a study of quantitative relationship of the various items in the financial
statements on a particular date. It is related to one date or one accounting period.

1. Define ‘Analysis of Financial Statement’. Explain its objectives.
2. Explain the difference between internal and external analysis and explain its significance.
3. What are common size Financial Statements? Discuss its utility for management.
4. What do you understand by analysis and interpretation of financial statements. Explain briefly various
techniques used for financial analysis and interpretation.
5. Write short notes on the following:-
(i) Comparative financial statement analysis
(ii) Trend percentages
(iii) Horizontal analysis
(iv) Vertical analysis
6. The income statements of cheenu ltd. Are given for the years during 31st March 2011 and 2012.
Prepare a comparative income statement after re-arranging the figures.
1.
2011 (‘000) 2012 (‘000)
Net Sales 1570 1800
Cost of Goods sold 900 1000
Operating expenses:-
General and administrative expenses 140 144
Selling Expenses 160 180
Non operating expenses:-
Interest paid 50 60
Income Tax 140 160
7. Prepare a statement of comparative balance sheet from the details given below:-
Balance Sheet of Gaurav Ltd.
as on 31 March, 2011 and 2012
(Rs. in Lakh)
Liabilities Amount Assets Amount
2011 2012 2011 2012
Share Capital Fixed Assets 10400 11000
1. Equity Share Capital 1600 1600 Less:- Deperciation 3000 4000
2. Preference Share Net Fixed Assets 7400 7000
Captial 1000 1100 Capital work in-Progress 200 300
Reserve and Surplus Investments 800 800
Long-Term Borrowings 3300 5000 Current Assets:
Current Liabilities & 4000 3400 (i) Stock 1290 2000
Provisions: (ii) Receivable 600 700
(i) Current (iii) Cash and Bank 750 1700
Liabilities Balances
(ii) Provision 900 1000
240 400
11040 12500 11040 12500
8. Prepare a common size Income Statement using figures given in above question no. 6.
9. Prepare a common size balance sheet using figures given in question no. 7.
10. Compute the Trend Percentages from the following data taking 2006 as the base year
Year Sales (Rs.) Stock(Rs.)
2006 400000 40000
2007 520000 50000
2008 640000 60000
2009 620000 56000
2010 640000 54000
2011 600000 58000
2012 480000 52000

- Financial Management :I.M. Pandey
- Financial Management : M.R. Agrawal
- Financial Management : M.D. Agrawal and N.P. Agrawal
- Management Accountin: R.P. Rustagi
- Financial Management : S.N. Maheshwari
Unit - 4 : Ratio Analysis
Structure of Unit:
4.0 Objectives
4.1 Introduction
4.2 Meaning and Nature
4.3 Different Approaches of Interpretation
4.4 Advantages of Ratio a Analysis
4.5 Limitations of Ratio Analysis
4.6 Classification of Ratios
4.7 Analysis of liquidity
4.8 Analysis of Activity
4.9 Analysis of Profitability (Based on Sales, Capital)
4.10 Analysis of Longterm Solvency
4.11 Analysis of Investment
4.12 Preparation of Financial Statements from Ratios
4.13 Summary
4.0 Objectiv1es
 Under stand nature & importance of Ratio Analysis

 Know about different approaches of interpretation
 Point out the limitations and classifications.
 Analyse and intrepret liquidity of the firm
 Analyse and intrepret activity of the firm
 Analyse and intrepret longterm solvency of the firm
 To learn how ratios are useful in decision for investment
4.1 Introduction
A basic limitation of the traditional financial statement comprising the balance sheet and the profit and loss
account, provides a summarised view of the financial position and operations of a firm. Different parties are
interested in the financial statement for different purposes and look at them from different angles. For
example. the debentureholders analyse the statements in order to ascertain the ability to pay
interest and maturity amount. The prospective shareholders would like to know whether the business is
profitable and is progressing on sound lines. The management is interested in the operational efficiency as-
well-as financial position of the business. Hence, the main objective of financial analysis is to make detail
study about the cause and effect of the profitability and financial condition of the firm. Hence, ratio analysis
is a tool to predict operational as-well-as financial efficiency of business through analysis & intrepretation of
financial data.
So analysis of financial statement is a process of selection, relation and evaluation. The first task of the
financial analyst is to select the information relevant to the decision under consideration. The second step is
to arrange the information in a way to highlight significant relationships. The final step is interpretation and
drawing of inferences and conclusions.
The present chapter involves an in-depth analysis of financial statements and its use for decision making by
various parties interested in them.
4.2 Meaning and Nature

The term “Ratio” simply means one number expressed in terms of another. It describes in mathematical
terms the quantitative relationship that exists between two numbers. The term “Accounting Ratio” is used to
describe significant relationship between figures shown on a Balance Sheet, in a Profit and Loss Account.
Ratio analysis refers to the analysis and interpretation of financial statements through ratios.
Ratios are customarily presented either in the form of a coefficient or a percentage or as a proportion.
Absolute figures may be misleading unless compared, one with another. Ratios provie the means of showing
the relationship that exists between figures. However, the numerical relationships of the kind expressed by
ratio analysis are not an end in themselves but are a means for understanding the financial position of a
business. Ratios, by themselves, are meaningless, simple ratrios compiled from a single years’ financial
statements of an enterprise may not serve the real purpose. Besides, in order to reach valid conclusions,
ratios are to be worked out from the financial statement of a number of years and have to be compared with
some standards that are established after a systematic review of past experiences. A single ideal standard
cannot be applied for all types of business. Each business have its own limitations, hence ideal ratio will
differ between industries and also differ with size, capital and other factors.
4.3 Different Approaches of Interpretation

Generally, there are four different approaches are available for interpreting ratios.
(A) Interpretation of Individual Ratios: A single ratio fails to reveal the true position. If it relates to
preceeding years or compared with same type of other business or studied with reference to some
standards, may be useful. Hence this approach is to be combined with others.
(B) Interpretation by Referring to a Group of Ratios: The analysis could be made more meaningful
by computing some of the additional related ratios. A Change in one ratio may have significance
only when viewed in relation to other ratios.
(C) Interpetation of Ratios by Trend: It involves a comparison of ratios of a firm overtime. The
trend ratios indicate the directon of change over the years.
(D) Interpretation by Inter-firm Comparsions: It involves comparison of the ratios of a firm with
those of others in the same line of business or for the industry as a whole reflects its performance in
relation to its competitors.
4.4 Advantages of Ratio a Analysis

1. It is an invaluable aid to management for planning, forecasting, control and decision making.
2. Ratios enable the mass of accounting data to be summarized and simplified.
3. It facilitates better co-ordination and control of performance as-well-as control of costs.
4. It is a tool to assess important characteristics of business like liquidity, solvency, profitability
etc.
5. It is an effective tool of analysis for intra-firm and inter-firm comparisons.
6. It enables a firm to take time dimension into account by using trend analysis of ratios.
7. It enables the easy under standibility for accounting figures, for those who do not know the
language of accounting.
8. It is a effective means of communication to the owners and other parties interested therein.
4.5 Limitations of Ratio Analysis

Ratio analysis is a widely used tool of financial analysis yet it suffers from various limitations such as:
1. There are no ideal standards for comparison.
2. Ratios are calculated on the basis of financial statements, but financial statements himself suffer
from a number of limitations. Hence ratio analysis may fail to serve its purpose.
3. Impact of inflation reflects misleading results, because ratios are calculated on the basis of histori-
cal data. Hence inflationary conditions are ignored.
4. Ratios are based on historical data and it is used for future prediction. Hence, forecast for future
may be wrong.
5. Ratio is just an aid and cannot replace thinking and personal judgement employed in the decision
making process.
6. There are no standard formulae for working out ratios and it makes comparison very difficult.
7. Ratios are tools of quantitative analysis only and normal qualitative factors that may generally influence
conclusions derived are ignored while computing ratios.
8. Ratio alone is not adequate. It will be useful when it is used in a group of ratios or compare with
over a period of time.
The reliability and significance attached to ratios will largely depend upon the quality of data on which they
are based. They are as good as data itself.
4.6 Classification of Ratios

Ratios may be classified in a number of ways to suit any particular purpose. Different kinds of ratios are
selected for different types of situation. In general, the following bases of classification are in vogue.
(A) Classification According to Accounting Statement: This classification is based on the nature of
accounting statement such as Balance sheet ratios. Profit and loss Account Ratios, combined ratios
etc.
(B) Classification According to Importance: It’s like primary ratios and secondary ratios. Some of
the ratios are termed as primary and others are termed as subsidiary or supporting ratios.
(C) Classification According to Functions: ratios are grouped as liquidity, Activity, Profitability,
longterm solvency and Market analysis ratios.
From the above discussion , it may be observed that one basis of classification blends to another. We are
taking classification according to functions for description.
4.7 Analysis of liquidity
These ratios play a key role in assessing the short term financial position of a business. This type of ratios
normally indicates the ability of the business to meet current debts, the efficiency of the management in
utilizing the working capital, and the progress attained in the current financial position. The following are
liquidity ratios:
(i) Current Ratio: It may be defined as the ratio of current assets to current liabilities. It is expressed as :
Current Assest
Current Ratio 
Current Liabilities
Current assets normally includes cash in hand and at bank, marketable securities, bills receivable, Book
debts excluding provision, inventories, prepaid expenses, current liabilities include items such as outstanding
expenses, sundry creditors, bills payable, bank overdraft, provision for taxation, proposed dividend, income
tax payable, unclaimed dividend etc. Current assets means cash or those assets con vertible or expected to
be converted into cash within the accounting year and current liabilities are those liabilities to be paid within
same time.
Interpretation: It specifies that how much current assets are available to meet current liabilities. Hence
these ratios depicts the payment capacity of the concern. Thus,it is a measure of margin of safety for
creditors. A very high ratio may be indicative of lack management practices, as it may be excessive
inventories poor credit management etc. There should be reasonable current ratio, conventionally, a
current ratio of 2:1 is considered satisfactory in general condition.
Activity A:
1. A very high current ratio indicates that
(ii) Liquidity Ratio, Quick Ratio or Acid-Test Ratio: It indicates whether the firm is in a position to pay
its current liabilities in short period. It is a measure of liquidity of firm, how speedy it is able to repay its
current liabilities.
Current Assest
Current Ratio or Liquidity Ratio 
Current Liabilities
Quick assets includes all current assets excluding inventories, prepaid expenses, advance tax and advance
payments, current liabilities means as it defined in current ratio. It is a more rigorous test of liquidity than the
current ratio and, used together with current ratio, it gives a better picture of the short term financial position
of the firm.
(iii) Super Quick Ratio or Absolute Liquidity Ratio: This ratio is calculated to assess the quick ability
to pay liquid liabilities. It is the ratio between absolute liquid assets and liquid liabilities.
Cash, Book and Marketable Securities

Super Quick Ratio 
Current Liabilities  Book Overdraft
This ratio is the most rigorous and conservative test of a firms liquidity position.
Activity B:
1. Current Liabilities Rs. 2,00,000, Bank overdraft Rs. 20,000, Stock Rs. 55,000, Debtors Rs. 50,000,
Cash and Bank Rs. 60,000, Marketable securities, 30,000, Calculate Quick Ratio and super quick
Ratio.
Illustration 1: Calculate liquid ratio, current ratio and super quick ratio from the following data:
Current Assets Rs. 50000
Stock Rs. 10000
Prepaid Expenses Rs. 5000
Working Capital Rs. 30000
Bank overdraft Rs. 5000
Cash balance Rs. 10000
Marketable securities Rs. 5000
Current Assest 50000

Current Ratio    2.5 : 1
Current Liabilities 20000
Current Assest 35000
Current Ratio or Liquidity Ratio    1.75 : 1
Cash, Book and Marketable Securities 15000
Super Quick Ratio   1 : 1
Current Liabilities  Book Overdraft 15000
4.8 Analysis of Activity

A firm invest its fund into various assets if utilisation of assets are effective it reflect the sales. Hence, whether
the funds are effectively utilised, it can be determined by calculating turnover ratio. Activity of utilisation of
funds. or effeciency can be calculated by following ratios :
(i) Stock (inventory) Turnover Ratio: It is computed dividing cost of goods sold by average inventory.
Thus:
Cost of goods sold

Inventory Turnover Ratio 
Average Stock
Cost of goods sold: opening stock + purchases + direct expenses - closing stock
(or) Cost of production + opening stock of finished goods - closing stock of finished goods
(or) Sales - gross profit
Opening Stock  Clo sin g Stock

Average Stock 
2
The ratio indicates how fast inventory is sold. A high ratio is good from the view point of liquidity and vice-
versa. Low stock turnover ratio signify that excessive investment in stock, slow moving stock is higher and
market is in slack position. Whereas, higher turnover ratio specify that firm is able to earn higher profit at
lower profit margin.
No. of days / month in a year

Stock Velocity 
Stock turnover ratio
(ii) Debtors Turnover Ratio: It is determined dividing the net credit sales by average debtors, thus:
Net credit sales

Debtors Turnover Ratio 
Average receieable
Net credit sales = Credit Sales - Sales Return
Opening Debtors & B / R  Clo sin g Debtor & B / R

Average Re ceivables 
2
The ratio measures how rapidly receivables are collected. A high ratio is indicative of shorter time lag
between credit sales and cash collection. A low ratio shows that debts are not being collected rapidly.
(iii) Average Collection Period: This ratio specify that in how much days collection is made from
debtors. thus:
Average receivable
Average collection period   No. of months or days in a year
Net credit sales
or
Month (or days ) in a year
Debtors Turnover
This ratio is measurement of efficiency of debt collection department of a firm. It refers to quality
measurement of debtors, because this ratio depicts the collection effeciency of the firm.
(iv) Creditors Turnover Ratio:
Net credit purchases

Creditors Turnover 
Average payables
Opening and clo sin g & B / P

Average Payables 
2
Net credit Purchases = Total credit purchases - Purchases Return

A low ratio reflects liberal credit terms granted by suppliers, while a high ratio shows that accounts are to
be settled rapidly. A firm can reduce its requirement of current assets by relying on suppliers credit.
(v) Creditors Payment Period:
Average Payables
Creditors payment Period   No. of months / Days in a year
Net credit Purchases
This ratio shows that in how much days amount is paid to suppliers.
(vi) Total Assets Turnover Ratio:
Cost of goods sold

Total Assets Turnover Ratio 
Total Assets
Total Assets = Net fixed Assets + Current Assets + Intangible Assets (if there is any realisable value) but
excluding fictitous assets.
(vii) Fixed Assets Turnover Ratio:
Cost of goods sold

Fixed Assets Turnover Ratio 
Net Fixed Assets
This ratio specify the efficiency and profit earning capacity of the firm.
(viii) Current Assets Turnover Ratio:
Cost of goods sold

Current Assets Turnover Ratio 
Current Assets
It reflects the efficiency & capacity of working capital.

(ix) Capital Turnover Ratio:
Cost of goods sold

Capital Turnover Ratio 
Capital employed
Capital employed = Fixed Assets + Current Assets - Current Liabilities (excluding fictitous assets and
non-trading assets)
Efficiency and effectiveness of business operations are judged by this ratio. It is a better measurement of
use of capital employed.
(x) Working Capital Turnover Ratio:
Cost of goods sold

Working Capital Turnover Ratio 
Net working Capital
It is used to assess the efficient use of working capital in making sales. A high ratio indicates over trading
and a low ratio indicate under trading.
Note: In above ratios always cost of goods sold is taken but if it is not available then “sales” may be
used. If opening balance are not given then only closing balance will be taken for calculation. In the
absence of specific information all sales/purchases is treated as credit, purchase return and sales returns
are also treated as return from credit.)
Activity C:
1. A low stock turnover ratio indicates:
Illustration 2 : From the following balance sheet, calculate turnover ratios :
Liabilities Rs. Assets Rs.

Share Capital 80000 Fixed Assets 150000
Profit and Loss Account 80000 Debtors 60000
15% Mortgage loan 70000 Bills receivables 20000
Creditors 50000 Stock 40000
Bills Payable 20000 Cash at Bank 20000
Priliminary expenses 10000
300000 300000
Sales during the year amounted to Rs. 60000 which yielded a gross profit of 20%. Receivables at the
beginning Rs. 70000 and payables at the end Rs. 60000, Opening stock Rs. 30000.
Solution :
Cost of goods sold = Rs. 160000 - 32000 = 128000
Capital employed = Rs. 150000 + 60000 + 20000 + 40000 + 20000 - (50000 + 20000) = 220000
Average stock = (30000 + 40000) / 2 = Rs. 35000
Cost of goods sold 128000

(i) Stock Turnover R atio    3.66 times
Average stock 35000
Net credit sales 160000

(ii) Debtors Turnover R atio    2.133 times
Average Receivabl es 75000
Opening Debtors & B/R  Closing Debtors & B/R

Average Receuvable 
2
(60000  20000)  70000
Average Receuvable   Rs. 75000
2
Net credit purchases 138000

(iii ) Creditors Turnover Ratio    2.12 times
Average payables 65000
(50000  20000)  60000
Average Payables   65000
2
Cost of goods sold =Opening stock + Purchases – Closing stock

128000 = 30000+Purchases-40000
Purchases =Rs. 138000

(iv ) Total Assets Turnover Ratio    0.4413 : 1
Total Assets 290000
(v ) Capital Turnover Ratio    0.58 : 1
Capital employed 220000
(vi ) Working Capital Turnover Ratio    1.82 : 1
Working Capital 70000
Working Capita = Current Assets – Current Liabilities = (60000+20000+40000+20000) –

(50000+20000) = Rs. 70000

(vi ) Fixed Assets Turnover Ratio    0.853 : 1
Fixed Assets 150000
4.9 Analysis of Profitability (Based on Sales, Capital)

Profitability refers to the ability to earn profit. Profitability depends on quantum of sales and use of
finincial reasources. It can be calculated on these two bases :
(a) Profitability Ratios Based on Sales:
Gross Pr ofit
(i ) Gross Pr ofit Ratio  100
Net Sales
The higher the ratio, the greater will be the margin and lower the ratio the profit is declining in comparsion to
sales,
Operating Cost
(ii ) Operating Ratio  100
Net Sales
Operating costs = Cost of goods sold + operating expenses

It indicates the opernational efficiency and profit earning capacity of the firm.
Operating Pr ofi
(iii ) Operating Pr ofit Ratio  100
Net Sales
Operating Profit = Gross Profit - Operating expenses or 100-operating ratio

It indicates operating efficiency of the firm.
(iv) Expenses Ratios:
Material consumed
(a ) Material consumed Ratio  100
Net Sales
Finance exp enses
( b) Finance exp enses Ratio  100
Net Sales
(c ) Manufactur ing / Ad min istration / Selling exp enses Ratio 
Manufactur ing / Ad min istration / Selling exp enses Ratio
100
Net Sales
It reveals the managerial efficiency by comparing these ratios over a period of time.
Net Pr ofit ( After tax ) or ( before tax )

(v) Net Pr ofit Ratio  100
Net Sales
It reveals overall profitability and efficiency of the business. A high ratio means adequate return to the
owners and firms capacity to stand in a competitive market. If the ratio is calculated on before tax profit
it measure the managerial efficiency and if it is calculated by taking after tax then it is used for comparing
two firms or for the owner’s purpose.
(B) Profitability Ratio Based on Capital: Efficiency of an enterprises can be judged by capital
employed also because some times conclusions drawn on the basis of net profit to sales may be
misleading. Such important ratios are:
(a) Return on capital Employed (ROCE) (Return on Investment)
Net Profit before tax

ROCE   100
Capital employed
(or) Assets Trunover  Profit Margin
Sales Net Profit
(or)   100
Total Assets Sales
(or) Assets Trunover X Profit Margin
Capital Employed means :
Gross Capital Employed = Fixed and current Assets (excluding fictitous Assets and intangible assets if it
has no realisable value)
Net Capital Employed = Total Assets (excluding fictious assets and intangible assets which has no value)
- current liabilities.
Average Capital Employed = Opening and Closing Capital employed
Opening and Closing Capital employed
Average Capital Employed 
2
(or) Capital employed at the end - 1/2 of Current years profit

It is barometer of the overall performance of the enterprise. It is a measure of the earning power of the
net assets of the business. It is beneficial for inter firm and intra-firm comparison.
This ratio is expressed in detail by du-pont analysis as follows.
DU-PONT CHART
PROFIT
CAPITAL EMPLOYED
Profit Margin Assets Turnover
Net Profit / Sales Sales / Capital Employed
Sales (-) Operating expenses Fixed Assets (+) Working Capital
Cost of good sold (+) Selling, Adm. and other expenses Current Assets (-) Current Liabilities
By this management can identify the areas which affect the profit.
Net Profit tax and interst
(b) Return on Net Worth   100
Net worth
Net worth or shareholders fund or owners equity or Proprieters funds =
E. S Capital + P.S. Capital + Securities Premium + reserves and surplus (after adjusting fictitous assets
and losses)
This ratio reveals that amount of earnings for each rupee that the shareholders have invested in the
company. It is useful for inter-firm and intra-firm comparison.
Net Profit tax  Preference Dividend
(c) Return on Equity Shareholde rs funds   100
Equity shareholde rs funds
The ratio provides adequate test to evaluate whether a company has earned satisfactory return for its
equity holders or not. Investor can compare the normal rate of return in market with this rate to reach on
investment decision.
Net Profit after tax
(d) Return on total Assets   10
Total Assets excluding fictitous assets
Illustration: 3 From the following balance sheet calculate N.P. Ratio, ROCE, Return on equity
shareholders fund.

4000 Equity share Capital of Rs. 100 each 400000 Net Fixed Assets 700000
10% P.S. Capital 100000 Current Assets 230000
Reserves 50000 Preliminary Expenses 20000
Current years profit (tax rate 50%) 150000
12% Debentures 100000
950000 950000
Sales 15,00,000
Solution:
Net Profit 150000

Net Profit Ratio   100   100  10%
Sales 1500000
Net Profit Ratio 300000
ROCE   100   100  32.26%
Capital employed 9300000
Net Profit tax =Net Profit after tax+Tax = 150000+150000 = Rs. 30000
Capital employed (Total) = Fixed Assets + Current Assets = 700000+230000 = Rs. 930000
Net Profit after tax  Pr eference Dividend

Return on Equity Shareholde rs Funds   100
Equity shareholde r funds
150000 - 10000
 100  23.33%
60000
4.10 Analysis of Longterm Solvency

These ratios are called as leverage or capital structure or debt management ratios. All these are expressed
as follows:
External Equities or Total Debts

(1) Debt Equity Ratio 
Internal equities or Net worth or total Equity
External equities = short terms and longterm loans
Internal Equities = Shareholders funds
A high ratio shows that the claims of creditors are greater than those of owners hence lesser safety.
Whereas, a low ratio provides sufficient margin to creditors due to higher stake of owners. This ratio
should be balanced.
Proprietory funds
(2) Proprietory Ratio 
Total Assets
It reveals the general financial strength of the business. A higher ratio indicates sound financial position.
Total Debt
(3) Solvency Ratio 
Total Assets excluding fictitous assets
If total assets are more than external liabilities, the firm is treated as solvent.
Net Fixed Assets

(4) Fixed Assets Ratio 
Capital Employed
It indicates whether there is proper adjustment between longterm funds and fixed use of capital.
Variable cost bearing capital

(5) Capital Gearing Ratio 
Fixed cost bearing capital
Variable cost bearing capital = Equity holders funds

Fixed cost bearing capital = Debentures + long term loans+Preference Shares
A higher ratio reveals that lesser fixed financial charges thus more surplus available to shareholders.
Whereas, lower ratio indicate over burden of financial charges, and it is the situation of high gearing.
Net Profit before interest and tax

(6) Interest Coverage Ratio or Service Ratio 
Fixed Interest charge
It is very significant for loan providers. A high ratio indicates sufficient interest paying capacity of the firm to
the long term loan providers. Low ratio indicates that the firm is using excessive debt. By this ratio investor
can forecast the financial risk through comparing this ratio from standard ratio of the same business.
Illustration : 4 From the following balance sheet calculate :
Debt-Equity Ratio, Proprietory Ratio, Solvency Ratio, Capital Gearing Ratio and Interest Coverage Ratio.

7000 Equity Shares of Rs. 10 each 70000 Net Fixed Assets 200000
2000 Preference Shares of Rs. 10 each 20000 Stock 30000
Reserves and surplus 80000 Debtors 30000
8% Debentures 100000 Cash at Bank 30000
290000 290000
Reserves and surplus includes current year net profit after tax (50%) and interest Rs. 40000.
Solution:
Total Debts 100000  20000

Debt Equity Ratio    0706 : 1
Total Equity 170000
Proprietory funds 170000
Proprietory Ratio    0.586 : 1
Total Assets 290000
Total Debts 120000
Solvency Ratio    0.414 : 1
Total Assets 290000
Variable cost bearing capital 70000  80000
Capital Gearing Ratio    1.25 : 1
Fixed cost bearing capital 20000  100000
Net Profit before interest and tax
Interest Coverage Ratio 
Fixed interest Charges
40000  40000 88000
   11 times
8000 8000
4.11 Analysis of Investment

These ratios are known as “Market value Ratio” which are the following :
Profit after tax  Preference dividend

(1) Earning Per Share (EPS) 
Number of Equity Shares
Through this ratio profitabilitiy of the firm can be measured from the shareholders point of view. The higher
ratio indicate better performance and greater would be the market price of a company’s share. It is beneficial
for inter-firm and intra - firm comparison for the investors point of view.
Market Pr ice Per Share ( MPS)

(2) Pr ice  Earning Ratio  ( P / E Ratio ) 
Earning Per Share ( EPS)
It indicates the market opinion of the earning capacity. The comparision of P/E Ratio with another similar
firms can specify whether the share is overvalued or under valued.
Activity D:
1. EPS of X Ltd. is Rs. 20 and MPS Rs. 200. EPS of Similar firm Y Ltd. Rs. 30 and MPS Rs.
240. The shares of X Ltd. are under valued or overvalued and Why?
Dividend Paid to Equity Shareholde rs

(3) Dividend Per Share ( DPS) 
No. of Equity Shares outs tan din
It represents to what extent the profit has been received by the shareholders.
DPS
(4) Dividend yield Ratio   100
MPS
It represents to what extent the profits has been received by the shareholders.
Activity F:
1. Face value of a share Rs. 10, whereas market value per share Rs. 200. Dividend distributed @
100% what is dividend yield ratio.
Dividend Per Share

(5) Dividend Payout Ratio ( D / P Ratio )   100
Earning Per Share
Or
Equity Dividend
Dividend Payout Ratio ( D / P Ratio )   100
Pr ofit after tax  PS dividend
It shows that how much earning is distributed and how much is retained as ploughing back of profits. This
ratio is also useful for inter as-well-as intra firm comparison.
Equity Share Capital  Re serves & Surplus

(6) Book Value per Share 
Total number of equity shares
It is a reflection of past profits and dividend policy of the company.

Illustration 5 : 10% 1000 Preference shares of Rs. 100 each, 100000 Equity shares of Rs. 10 each
Additional informations : Profit after tax (50%) Rs. 250000
DPS Rs. 2 per share, MPS Rs. 40.
Calculate EPS, P/E ratio, Dividend yield ratio and Dividend Payout ratio.
Solution :
Net Pr ofit after tax  P.S. Dividend 250000  10000

(1) EPS  EPS   Rs. 2.4
No. of Equity Shares 10000
MPS 40
(2) P / E Ratio    16.67 : 1
EPS 2.4
DPS 2
(3) Dividend yield Ratio   100   100  5%
MPS 40
DPS 2
(4) Dividend payment Ratio   100   100  83.33
EPS 2.4
4.12 Preparation of Financial Statements from Ratios

Calculated ratios and some absolute figures are given while remaining figures are absent for preparing
Trading and Profit and Loss Account. In such cases unknown item are calculated and Trading and Profit
and Loss Account may be prepared. Some of the examples are here:
Illustration 6 : Complete the Balance Sheet in the form given below, using following information:
Solution:
Rs.
Sales 7200000
Total Assets Turnover 3
Fixed Assets Turnover 5
Current Assets Turnover 7.5
Debtors Turnover 15
Total Assets/Net Worth 2.5
Debt-Equity 1.00
Inventory Turnover 20
Sales 7200000
(1) Total Assets Turnover   3  Rs. 24 Lakh.
Total Assets Total Assets
Sales 7200000
(2) Fixed Assets Turnover  5  Rs.14.40 Lakh.
Fixed Assets Fixed Assets
Sales 7200000
(3) Current Assets Turnover   7. 5   Rs. 9.60 Lakh.
Current Assets Current Assets
Sales 7200000
(4) Inventorie s Turnover   20   Rs. 48 Lakh.
Inventorie s Inventorie s
Sales 7200000
(5) Debtors Turnover   15   Rs. 4.8 Lakh.
Debtors Debtors
Total Assets 2. 5
(6) Total Assets / Net Worth   2.5   Rs. 9.6 Lakh.
Net Worth Net Worth
Debt Debt
(7) Debt Equity  1  Rs. 9.6 Lakh.
Equity 9.6
(8) Cash at Bank = Current Assets – Inventories – Debtors.

9.60 – 3.60 = 4.8 = Rs. 1.2 Lakh.
(9) Current Liabilities = Total Assets – Net Worth – Debt
Rs. 24 Lakh – 9.6 Lakh = Rs. 4.80 Lakh

Net Worth Fixed Assets
Debt Current Assets
Current Liabilities Inventories
Debtors
Cash and Bank
Net Worth 9.6 Fixed Assets 14.90
Debt 9.6 Current Assets
Current Liabilities 4.8 Inventories 3.60
Debtors 4.80
Cash and Bank 1.20
24 24
4.13 Summary
 Ratio analysis is a systematic use of ratio to interpret the financial statement so that the strengths and
weaknesses of a firm can judge.
 Ratio make the related infomation comparable. A single figure itself has no meaning.
 Liquidity ratio measure the ability of a firm to meat its short terms obligations and reflects its short
term financial strength
 Longterm solvency is reflected in its ability to assure the long term creditors with regerd to periodic
payment of interest and the repayment of loan on maturity. Such ratios reflects the safety margin to
the long term creditors.
 Activity ratios enable the firm to know how effeciently these assets are employed by it. These ratios
indicate the speed with which assets are being converted or turned over into sales.
 Profitability ratios enable the firm to know overall managerial efficiency of the firm. It is calculated
on the basis of sales and on the basis of capital.
 Du-pont analysis is a barometer of the overall performance of the enterprise. It is a measure of the
earning power of net assets of the business.
 Ratio analysis in view of its several limitations should be considered only as a tool for analysis rather
than as an end in itself. The reliability is based on quality of data used. Though ratio analysis is an
important tool for analysis and intrepretation of financial statements.

1. What are the advantages of ratio analysis ?
2. What procedure would you adopt to study the liquidity of a business firm.
3. As an investor how would you analysis the financial position of a company.
4. Explain the limitations of financial ratios.
5. “A single ratio has no meaning but group of ratios or comparision over a period or comparison or
between similar firm has an utility.” Explain this statement.
6. Calculate Current and Quick ratio from the following :
(Ans: C.R. 3.22 : 1 Quick Ratio = 3 : 1)
7. Calculate inventory turnover ratio, receivables collection period and average payment period from
the following:
Rs. Rs.
Net Debtors 12000 Creditors 12000
Inventory 8000 G.P. on Sales 20%
Bills Payable 4000 No. of days in a year 360
Purchases 30000
Sales 60000
8. Calculate EPS, P/E ratio, DPS, Dividend payout ratio and Dividend yield ratio.
Profit after tax Rs. 14.40 Lakh
Tax rate 50%
Proposed Dividend 20%
10% P.S. Capital 50000 shares of Rs. 10 each
E.S. Capital 17500 shares of Rs. 100 each
Reserve at the beginning of the year : Rs. 14 Lakh
Current market price of Equity Shares : Rs. 125
(Ans. EPS = Rs. 79.42, P/E Ratio = ( Rs. 15.74 DPS = Rs. 20)
9. From the following information, complete the balance sheet given below :
Total Debt to net worth 0.5 to 1
Turnover of total Assets (based on sales) 2
Gross Profit 30%
Average collection period (based on 360 days in a year) 40 Days
Inventory Turnover Ratio (based on cost of goods sold) 3 times
Acid-Test ratio 0.75 to 1

Capital 200000 Fixed Assets
Reserve and surplus 300000 Stock
Creditors Debtors
Cash
(Ans. Creditors Rs. 250000, Debtors Rs. 166667, Stock Rs. 350000, Cash Rs. 20833, Fixed
Assets Rs. 212500)
10. A Ltd. has a current ratio 4.5 : 1 and liquid ratio 3 : 1 If its stock is Rs. 72000. Calculate its total
current assets and current liabilities.
(Ans. Current Assets Rs. 216000, Current Liabilities Rs. 48000)
11. Rs. 200000 is net sales of a firm. If stock turnover ratio is 4 times. calculate the stock at the end of
the year. If stock at the end is 1.5 times of that in the beginning
(Ans : Stock at the end Rs. 60000)

- Higgin R.C.: Analysis for financial management (Irwin, Megraw-Hill, Boston) 2000
- Khan M.Y. : Financial management, Text, Problems and cases (Tata Mcgraw-Hill Publishing company
Ltd., New Delhi) 2007a
- Agrawal M.R. : Financial Management (Garima Publications, Jaipur) 2012
- Maheshwari S.N. : Management Accountancy (Sultan chand and sons, New Delhi) 2010
Unit - 5 : Funds Flow Statement
Structure of Unit:
5.0 Objectives
5.1 Introduction
5.2 Meaning of Fund Funds Flow Statement
5.3 Objectives of Fund Flow Statement
5.4 Sources and Uses of Fund
5.5 Difference Between Fund Flow Statement and Other Financial Statements
5.6 Techniques of Preparing Fund Flow Statement
5.7 Importance of Fund Flow Statement
5.8 Limitation of Fund Flow Statement
5.9 Summary
5.0 Objectives
After completing this lesson, you will able to:
 Understand the meaning of Fund Flow Statement

 Know the difference between fund flow statement and other financial statement
 Know the purpose of preparing fund flow statement
 Prepare fund flow statement
 Identified the sources and uses of fund
 Describe the importance and limitation of fund flow statement
5.1 Introduction
The main financial statements of business are Balance Sheet and Profit and Loss Account. These financial
statements show the financial passions as on a particular date and the profit or loss of the particular period.
But these statements do not provide the information about the availability of fund, the sources of fund and
where the funds were utilized during the particular period. It is necessary to management to know about the
availability of fund, sources of fund and uses of fund for the future planning and decision making. Therefore,
a fund flow statement is prepared. Fund flow statement provides the information about availability, sources
and uses of fund.
In India, the institute of Charted Accounts has issued Accounting Standard-3 for preparing the statement on
the basis of working capital called ‘Statement of Change in Financial Position’. But in March, 1997, the
institute of Charted Accounts has issued Accounting Standard-3 (Revised), which is on cash basis and
discard the working capital definition of fund. Now, in India it is not compulsory to prepare fund flow
statement by Indian companies.
5.2 Meaning of Fund Funds Flow Statement

The fund flow statement reveals the information about the sources and uses of fund during the particular
financial period. But here the question arises, what is the meaning of fund and flow of fund?
5.2.1 Meaning of Fund
The concept of fund is used in different sense. In border sense the term fund refers to economic value
expressed in money measurement. While in a narrow sense fund means only cash and is equivalent. But the
most acceptable means of fund is taken net working capital. Net working capital means difference between
current assets and current liabilities. In other words, if current assets of company are more than current
liability of business, it is called net working capital.
5.2.2 Meaning of Flow of Fund
Flow of fund means movement of fund. I take the example of air; we can feel its movement or flow of air.
Same thing is happen with fund, due to the activity of business fund is transfer from one asset to another
assets. If fixed assets are converted into current asset or fixed liability is converted into current liabilities,
these are the flow of fund. But if current assets are changed with current assets or current assets are
changed into current liabilities, then, there is no flow of fund because there is no change working capital.
Suppose, we get tJhe money from debtor, this is not flow of fund because, working capital is not changed.
Both items of current assets and when current assets change into current assets, there will not be change in
working capital.
The list of current and non-current items is as follows:
Non-Current Liabilities Non-Current Assets
Share Capital Fixed Assets
Reserve and surplus Intangible Assets
Debentures Investments
Long term loans Fictitious Assets
Provisions for depreciation Profit & Loss Account
*Provision for Taxation
*Proposed Dividend
Curre nt Liabilities Curre nt Assets
Creditors Stock
Bills Payables Debtors
Bank Overdraft Bills Receivables
Outstanding Expenses Cash & Bank
Unearned Income Prepaid Expenses
Accrued Income
* Provision for Taxation and Proposed Dividend are also treated as current liabilities.
Flow of Fund = Fixed asset changes into current asset or current asset changes into fixed assets; or
Fixed liability changes into current liability or current liability changes into fixed liability.
5.2.3 Definition / Meaning of Fund Flow Statement
Fund flow statement is a statement which shows the inflow and out flow of funds between two dates of
balance sheet. So, it is known as the statement of changes in financial position. We all know that balance
sheet shows our financial position and inflow and outflow of fund affects it. So, in company level business,
it is very necessary to prepare fund flow statement to know what the sources are and what are applications
of fund between two dates of balance sheet? Generally, it is prepare after getting two year balance sheet.
According to Accounting Standard Board of ICAI, “A statement which summaries for the period covered
by it, the changes in financial position including the sources from which the funds were obtained by the
enterprised and the specific use to which the fund were applied.”
According to Robert N. Anthony, “The fund flow statement describes the sources from which additional
funds were derived and the uses to which these funds were put.”
According to Foulke R. A., “A statement of sources and application of funds is a technical device designed
to analyse the changes in the financial conditions of business enterprise between two dates.”
Thus fund flow statement is a statement which shows where funds come from and in what way they were
used and the causes of changes in working capital. In other words it is a statement which shows the changes,
inflow or outflow or the movement of fund.
Fund flow statements are known with different names
 Statement of source and uses of funds
 summary of financial operations
 Movement of working capital statement
 Fund received and distributed statement
 Fund generated and expended statement.
5.3 Objectives of Fund Flow Statement

Generally the fund flow statement provides the information about the different sources and application of
fund during the particular period. The main objectives of fund flow statement are:
a) The basic object of preparing the statement is to have a rich into the financial operations of the
concern. It analyses how the funds were obtained and used in the past.
b) One important object of the statement is that it evaluates the firm’ financing capacity. The analysis of
sources of funds reveals how the firm’s financed its development projects in the past i.e., from
internal sources or from external sources. It also reveals the rate of growth of the firm.
c) To provide the information about the important items like fixed assets, long term loans, capital etc.,
relating to sources and applications of fund.
d) To provide the information about the difference sources of fund, i.e., how much fund is being
collected from the issuing shares or debenture, how much from long term or short term loans, how
much from disposal of fixed assets and how much from operational activities?
e) To help to understand the changes in assets and asset sources which are not readily evident in the
income statement or financial statement.
f) To inform as to how the loans to the business have been used.
g) To point out the financial strengths and weaknesses of the business.
5.4 Sources and Uses of Fund

5.4.1 Sources of Fund
Sources of fund are indicated by increase in liability and decrease in assets. The main sources of funds are:
1. Fund from operation activities
2. Issue of shares capital
3. Issue of debentures
4. Raising of long term loans
5. Receipts from partly paid shares , called up
6. Amount received from sales of non current or fixed assets
7. Non trading receipts such as dividend received
8. Sale of investments ( Long term )
9. Decrease in working capital (as per schedule of changes in working capital)
5.4.2 Applications or Uses of Funds
Applications of fund are indicated by decrease in liability and increase in assets. The main uses of funds are:
1. Funds lost in operations ( Balance negative in second step )
2. Redemption of preference share capital
3. Redemption of debentures
4. Repayment of long term loans
5. Purchase of long term loans
6. Purchase of long term investments
7. Non trading payments
8. Payment of tax
9. Payment of dividends
10. Increase in working capital (as per schedule of changes in working capital)
5.5 Difference Between Fund Flow Statement and Other Financial Statements
5.5.1 Difference Between Fund Flow Statement and Profit & Loss Account
1. Fund Flow Statement shows the change in sources and applications of fund between two dates
while Profit & loss account shows the results of operations of one organization during the related
period.
2. In Fund Flow Statement funds raised are matched with funds applied disregarding the distinction of
capital and revenue concept while in Profit & Loss Account expenses are matched against income
and capital & revenue concept are predominant.
3. Profit & Loss Account facilitates preparation of the fund flow statement while fund flow statement
does not help in preparation of the Profit & Loss Account.
5.5.2 Difference Between Fund Flow Statement and Balance Sheet
1. Fund Flow Statement shows the changes in working capital between two dates while Balance
Sheet shows the financial position of a business on a particular date.
2. Fund Flow Statement incorporates items casing change in working capital while Balance Sheet
incorporates the balance of real and personal accounts.
3. Fund Flow Statement is basically an analytical tool and therefore, it is very good for decision
making while Balance Sheet is not an analytical tool and it is simply a summary of assets and
liabilities on a particular date.
4. Fund Flow Statement is prepared for the use of internal management; hence its publication is
obligatory while Balance Sheet is prepared for the use of external parties of the business, hence its
publication is mandatory.
5.6 Techniques of Preparing Fund Flow Statement

The fund flow statement is prepared on the basis of treating net working capital as fund. Such statement
shows the causes of changes in working capital during two accounting periods. For preparing fund flow
statement on the basis of working capital mainly following two statements are prepared:
a) Statement or Schedule of Changes in Working Capital
For making of fund flow statement, it is necessary to make statement of changes of working capital. Because
net increase in working capital is use of fund and net decrease in working capital is source of fund. Making
of statement of changes working capital is very easy and simple. We take two balance sheets, one is current
year balance sheet and other is previous year balance sheet. Then we separate current assets and current
liabilities. While ascertaining the increasing or decreasing in individual item of current assets and current
liabilities and its effect on working capital, the following rules should be taken into account:
a) If current year current assets are more than previous year current assets, it means increase in
working capital.
b) If current year current assets are less than previous year current assets, it means decrease in working
capital.
c) If current year current liabilities are more than previous year current liabilities, it means decrease in
working capital.
d) If current year current liabilities are less than previous year current liabilities, it means increase in
working capital.
Statement or schedule of changes in working capital is prepared as follows:
Statement or schedule of changes in working capital

Previous Curre nt Working Capital
Particular
Year Year Increase Decrease
A. CURRENT ASSETS:
Stock --- ---
Debtors --- ---
Bills Receivables --- ---
Cash & Bank --- ---
Prepaid Expenses --- ---
Accrued Income --- ---
Other Current Assets --- ---
TOTAL (A) === ===
B. CURRENT LIABILITIES:
Creditors --- ---
Bills Payables --- ---
Bank Overdraft --- ---
Outstanding Expenses --- ---
Unearned Income --- ---
Provision for Tax* --- ---
Proposed Dividend* --- ---
Other Current Liabilities --- ---
TOTAL (B) === ===
Working Capital (A-B)
Increase / Decrease in Working Capital
Explanation:
(a) Any addition information given about current assets of current account will not be considered,
while preparing such statement.
(b) *If provision for taxation or proposed divided are treated as current assets than they should be
included in this statement.
Illustration 1: Following are summarized Balance Sheets of A Ltd. as on 31st December, 2010 and 2011.
You are required to prepare a statement showing changes in working capital for the year ended 31st
December, 2011:
Liabilities 2010 2011 Assets 2010 2011

Share Capital 4,00,000 5,00,000 Cash 60,000 94,000
Creditors 1,40,000 90,000 Debtors 2,40,000 2,30,000
Retained earnings 20,000 46,000 Stock 1,60,000 1,80,000
Land 1,00,000 1,32,000
5,60,000 6,36,000 5,60,000 6,36,000
Solution:
Statement showing changes in working capital
for the year ended 31st December, 2011
Increase in Decrease
Particulars 2010 2011
W.C. in W.C.
A. Curre nt Assets
Cash 60,000 94,000 34,000
Debtors 2,40,000 2,30,000 10,000
Stock 1,60,000 1,80,000 20,000
4,60,000 5,04,000
B. Curre nt Liabilities
Creditors 1,40,000 90,000 50,000
Working Capital (A-B) 3,20,000 4,14,000
Net increase in Working Capital 94,000 94,000
4,14,000 4,14,000 1,04,000 1,04,000
5.6.2 Fund Flow Statement
Fund flow statement focuses on the reasons of changes in working capital. When fund flow statement is
preparing, only non-current assets and non-current liabilities are considered. Fund flow statement shows
the various sources and uses of fund. Such statement is prepared in the following two formats:
(i) Statement form

(ii) Accounting form
(i) Statement form: Under this statement application of funds are deducted from the sources of
funds. Difference between sources of fund and uses of fund shows increase or decrease in working
capital. This statement is prepared as follows:
Fund Flow Statement
For the year ending 31st March, ….
Particular Amount
A. Sources of Fund:
Fund from operation (if any)
Issue of Shares
Issue of Debenture
Rising of long term loans
Sale of fixed assets
Sale of investment
Non-trading receipts (divided or interest on investment etc.)
Total (A)
B. Application / Uses of Fund:
Loss from operation (if any)
Redemption of Preference Shares
Redemption of Debenture
Repayment of long term loans
Purchase of fixed assets
Purchase of investment
Tax Paid
Dividend Paid
Non-trading payment (If any)
Total (B)
Increase / (Decrease) of Working Capital
(ii) Accounting form:

Fund Flow Statement
For the year ending 31st March, ….
Sources of Fund Application / Uses of Fund
Fund from operation (if any) Loss from operation (if any)
Issue of Shares Redemption of Pref. Shares
Issue of Debenture Redemption of Debenture
Rising of long term loans Repayment of long term loans
Sale of fixed assets Purchase of fixed assets
Sale of investment Purchase of investment
Non-trading receipts (divided or Tax Paid
interest on investment etc.) Dividend Paid
Decrease in Working Capital Non-trading payment ( If any)
(Bal. figure if any) Increase in Working Capital
(Bal. figure if any)
5.6.2.3 Calculation of Fund / Loss from Operation
The main source of fund is profitable operation. Fund from operation is not necessarily equal to net profit.
Hence, the items of income statement which do not involve working capital should be adjusted to the net
profit. The fund from operation is calculated as follows:
Net income (Loss) of the year XXXX
Add: Non-fund and Non-operating Expenses/Losses:
Depreciation on fixed assets ++++
Goodwill (or patents) written off ++++
Preliminary expenses written off ++++
Discount on issue of shares/debentures written off ++++
Loss on sale of fixed assets or long term investments ++++
Transfer to reserves ++++
Provision for taxation ++++
Proposed dividend ++++
Less: Non-fund and Non-operating Incomes/Gains:
Profit on sale of fixed assets/long-term investments ----
Interest or dividend received ----
Retransfer of excess provision ----
Fund (Loss) from operation ===
Fund (Loss) from operation can also be calculated by preparing adjusted Profit & Loss
Account:
Adjusted Profit & Loss A/c
Particulars Rs. Particulars Rs.
To Non-fund and Non-operating items By Balance b/d (Opening Balance)
already debited to P&L a/c: By Non-fund and Non-operating
-Depreciation on fixed assets Incomes/Gains:
-Goodwill (or patents) written off -Profit on sale of fixed assets / long-
-Preliminary expenses written off term investments
-Discount on issue of shares/debentures -Interest or dividend received
written off -Retransfer of excess provision
-Loss on sale of fixed assets or long By Funds from operations (Balancing
term investments Figure if any)
-Transfer to reserves
-Provision for taxation
-Proposed dividend
To Balance c/d (Closing Balance)
To Loss from operations (Balancing
Figure if any)
Illustration 2:
Following are the Balance Sheets of X Ltd. as on 31st December, 2010 and 2011. You are required to
prepare a Funds Statement for the year ended 31st December, 2001.

Share Capital 1,00,000 1,25,000 Goodwill - 2,500
General Reserve 25,000 30,000 Buildings 1,00,000 95,000
P&L A/c 15,250 15,300 Plant 75,000 84,500
Bank Loan 35,000 67,600 Stock 50,000 37,000
(Long-term) Debtors 40,000 32,100
Creditors 75,000 - Bank - 4,000
Provision for Tax 15,000 17,500 Cash 250 300
Additional Information: 2,65,250 2,55,400 2,65,250 2,55,400
(i) Dividend of Rs. 11,500 was paid.
(ii) Depreciation written off on plant Rs.7,000 and on buildings Rs.5,000.
(iii) Provision for tax was made during the year Rs. 16,500.
Solution:
Funds Flow State ment

For the year ending 31st December, 2011
Sources Rs. Application Rs.
Funds from operations 45,050 Purchase of Plant 16,500
Issue of Shares 25,000 Income tax paid 14,000
Hank Loan 32,600 Dividend paid 11,500
Goodwill paid 2,500
Net increase in Working Capital
(Bal. figure) 58,150
1,02,650 1,02,650
Working Notes:
Calculation of Funds from Ope rations:
Particular Detail Amount
Balance of P&L a/c (2010) 15,300
Add: Non-fund and non-operating items which have already
debited to P&L a/c:
-General reserve 5,000
-Provision for tax 16,500
-Dividends paid 11,500
-Depreciation:
On Buildings 5,000
On Plant 7,000 45,000
60,300
Less: Balance of P&L a/c (2011) 15,250
Funds from Operations 45,050
Share Capital A/c

Particulars Rs. Particulars Rs
To Balance c/d 1,25,000 By Balance b/d 1,00,000
By Bank a/c 25,000
1,25,000 1,25,000
General Reserve A/c

To Balance c/d 30,000 By Balance b/d 25,000
By P&L a/c 5,000
30,000 30,000
Provision for Taxation A/c
To Bank a/c 14,000 By Balance b/d 15,000
To Balance c/d 17,500 By P&L a/c 16,500
31,500 31,500
Bank Loan A/c

By Bank a/c 2,600
67,600 67,600
Land and Building A/c

To Balance c/d 1,00,000 By Depreciation a/c 5,000
By Balance c/d 95,000
1,00,000 1,00,000
Plant A/c
To Balance c/d 75,000 By Depreciation a/c 7,000
To Bank 16,500 By Balance c/d 84,500
91,500 91,500
Goodwill A/c
To Bank 2,500 By Balance c/d 2,500
2,500 2,500
Illustration 3: From the following Balance Sheets of ABC Ltd. on 31st Dec. 2010 and 2011, you are
required to prepare:
(i) A Schedule of changes in working capital,
(ii) A Funds Flow Statement.

Share Capital 2,00,000 2,00,000 Goodwill 24,000 24,000
General Reserve 28,000 36,000 Buildings 80,000 72,000
P&L A/c 32,000 26,000 Plant 74,000 72,000
Creditors 16,000 10,800 Investments 20,000 22,000
Bills payable 2,400 1,600 Stock 60,000 46,800,
Provision for Tax 32,000 36,000 Bills Receivable 4,000 6,400
Prov. for doubt. debts 800 1,200 Cash & Bank 13,200 30,400
Debtors 36,000 3 8,000
3,11,200 3,11,600 3,11,200 3,11,600
Additional Information:
(i) Depreciation provided on plant was Rs.8,000 and on Buildings Rs.8,000

(ii) Provision for taxation made during the year Rs.38,000
(iii) Interim dividend paid during the year Rs. 16,000.
Solution:
Statement showing Changes in Working Capital
Increase in Decrease
W.C. in W.C.
Current Assets
Cash & Bank Balances 13,200 30,400 17200
Debtors 36,000 38,000 2,000
Bills Receivable 4,000 6,400 2,400
Stock 60,000 46,800 13,200
1,13,200 1,21,600
Curre nt Liabilities
Provision for doubtful debts 800 1,200 400
Bills Payable 2,400 1,600 800
Creditors 16,000 10,800 5,200
19,200 13,600
Working Capital (CA - CL) 94,000 1,08,000
Increase in Working Capital 14,000 14,000
1,08,000 1,08,000 27,600 27,600
Funds Flow State ment

Funds from operations 72,000 Purchase of Plant 6,000
Tax paid 34,000
Purchase of investments 2,000
Interim dividend paid 16,000
Increase in Working Capital 14,000
72,000 72,000
Working Notes:
To Bank a/c (Bal. Fig.) 34,000 By Balance b/d 32,000
To Balance c/d 36,000 By P&L a/c 38,000
70,000 70,000
Plant A/c
To Balance b/d 74,000 By Depreciation 8,000
To Bank a/c (Purchase) 6,000 By Balance c/d 72,000
(Bal. Fig.)
80,000 80,000
Buildings A/c
To Balance b/d 80,000 By Depreciation a/c 8,000
By Balance c/d 72,000
80,000 80,000
Investments A/c
To Balance b/d 20,000 By Balance c/d 22,000
To Bank a/c (Purchase) 2,000
(Bal. Fig.)
22,000 22,000

To Non- fund and Non-operating By Balance b/d 32,000
items already debited to P&L a/c: By Funds from operations 72,000
(Balancing Figure)
-Transfer to General Reserve 8,000
-Provision for Tax 38,000
-Depreciation on Plant 8,000
-Depreciation on Buildings 8,000
-Interim dividend 16,000
To Balance c/d 26,000
1,04,000 1,04,000
General Reserve A/c

By P&L a/c (Bal. Fig.) 8,000
36,000 36,000
Illustration 4: From the following Balance Sheet of X Ltd., as on 31st December, 2000 and 31st December
2001, you are required to prepare a funds | flow statement.
(Rs.)
Share Capital 4,00,000 5,00,000 Land and Buildings 4,00,000 4,80,000
General Reserve 80,000 1,40,000 Machinery 3,60,000 2,60,000
P&L A/c 64,000 78,000 Stock 2,00,000 2,52,000
Bank Loan 3,20,000 80,000 Debtors 1,60,000 1,28,000
Creditors 3,00,000 2,60,000 Cash at Bank 1,04,000 18,000
Provision for
Taxation 60,000 80,000
12,24,000 11,38,000 12,24,000 11,38,000
Additional Information :
(i) During the year ended 31st December 2011 dividend of Rs.84,000 was paid.
(ii) Assets of another company were purchased for a consideration of Rs. 1,00,000 payable by the
issue of shares. The assets included Land and Buildings of Rs.50,000 and stock of Rs.50,000.
(iii) Depreciation written off on machinery is Rs.24,000 and on Land and Buildings is Rs.45,000.
(iv) Income-tax paid during the year was Rs.70,000.
(v) Additions to Buildings were for Rs.75,000.
Solution:
Statement showing Changes in Working Capital

Increase in Decrease in
W.C. W.C.
Current Assets
Cash at Bank 1,04,000 18,000 86,000
Debtors 1,60,000 1,28,000 32,000
Stock 2,00,000 2,52,000 52,000
4,64,000 3,98,000
Current Liabilities
Creditors 3,00,000 2,60,000 40,000
Working Capital 1,64,000 1,38,000
Decrease in working capital 26,000 26,000
1,64,000 1,64,000 1,18,000 1,18,000
Funds Flow State ment for the year ending 31st Dec. 2011
Issue of Shares 50,000 Purchase Land & Buildings 75,000
Sale of Machinery 76,000 Bank Loan paid 2,40,000
Funds from operations 3,17,000 Dividend paid 84,000
Decrease in Working Capital 26,000 Income-tax paid 70,000
4,69,000 4,69,000
Working Notes:
To Machinery 24,000 By Opening Balance 64,000
To Land & Buildings 45,000 By Funds from Operations 3,17,000
To Provision for tax 90,000
To General Reserve 60,000
To Dividends paid 84,000
To Closing balance 78,000
3,81,000 3,81,000

To Cash 70,000 By Balance b/d 60,000
To Balance b/d 80,000 By Adj. P&L a/c 90,000
1,50,000 1,50,000
Machine ry A/c
To Balance b/d 3,60,000 By Adj. P&L a/c 24,000
By Sale of Machinery 76,000
By Balance c/d 2,60,000
3,60,000 3,60,000
Land and Buildings A/c
To Balance b/d 4,00,000 By Adj. P&L a/c 45,000
To Share Capital 50,000 By Balance c/d 4,80,000
To Cash 75,000
5,25,000 5,25,000
General Reserve A/c

To Balance c/d 1,40,000 By Balance b/d 80,000
By Adj. P&L a/c 60,000
1,40,000 1,40,000
5.7 Importance of Fund Flow Statement

The fund flow statement provides the information regarding changes in working capital of an organization
for a particular period. Therefore, we say that the importances of fund flow are as follows:
a) Funds flow statement reveals the net result of operations done by the company during the year.
b) In addition to the balance sheet, it serves as an additional reference for many interested parties like
creditors, suppliers, government etc. to look into financial position of the company.
c) It shows how the funds were raised from various sources and also how those funds were put to use
in the business, therefore it is a great tool for management when it wants to know about where and
from funds were raised and also how those funds got utilized into the business.
d) It reveals the causes for the changes in liabilities and assets between the two balance sheet dates
therefore providing a detailed analysis of the balance sheet of the company.
e) Funds flow statement helps the management in deciding its future course of plans and also it acts as
a control tool for the management.
f) Helps in the evaluation of alternative finance and investments plan;
g) Investors are able to measure as to how the company has utilized the funds supplied by them and its
financial strengths with the aid of funds statements.
h) Helps the management of companies to forecast in advance the requirements of additional capital
and plan its capital issue accordingly.
i) Help in the planning process of a company
j) Helps in analysis of financial operations.
k) Helps in formulation of realistic dividend policy.
l) Helps in proper allocation of resources.
m) Helps in appraising the use of working capital.
n) It helps knowing the overall creditworthiness of a firm.

5.8 Limitation of Fund Flow Statement
The funds flow statement has a number of uses, however it has certain limitations also which are as
follows:
a) It should be remembered that a funds flow statement is not a substitute of an income statement or
a balance sheet. It provides only some additional information as regards changes in working
capital.
b) It can not reveal continuous changes.
c) It is not an original statement but simply, arrangement of data given in the financial statements.
d) It is essential historic in nature and projected funds flow statement cannot be prepared
e) Changes in cash are more important and relevant for financial management than the working
capital.
f) It does not include non-fund transitions.
g) It does not disclose changes in management policy regarding investment in current assets and
shorter financing.
5.9 Summary
In this unit we have tried to develop the idea of flow of funds within the organization. Starting with the funds
requirement for an organisation, we have tried to trace the sources and uses of funds. We tried to study the
important sources of funds, namely, the operations, sale of fixed assets, long-term borrowings and issue of
new capital. Similarly, important uses of funds were traced to acquisition of fixed assets, payment of dividends,
repayment of loans and capital. The whole exercise reveals the areas in which funds are deployed and the
sources from which they are obtained. Finally, we have learned how to go about doing the funds flow
analysis with the help of published accounting information.

1. What is a Fund Flow Statement? Explain the importance and limitations of fund flow statement.
2. Explain the term ‘Fund’ and ‘Flow’ in respect of fund flow statement. Describe the various sources
and uses of funds.
3. How fund flow statement is prepared? Explain the various methods of preparing it.
4. Explain the meaning of fund flow statement. What are its main objectives?
5. Explain the difference between:
a) Fund flow statement and Profit & Loss Account
b) Fund flow statement and Balance Sheet
c) Fund flow statement and Schedule change in working capital
6. From the following Balance Sheets of ABC Ltd. as on 31st December, 2010 and 2011. You are
required to prepare a statement showing changes in working capital:
Share Capital 5,00,000 6,00,000 Fixed Assets 7,50,000 10,00,000
Reserve & Surplus 2,00,000 4,00,000 Investment 1,00,000 3,00,000
Loans 3,00,000 5,00,000 Stock 2,00,000 2,20,000
Creditors 1,50,000 2,00,000 Debtors 1,00,000 80,000
Bills Payable 1,00,000 70,000 Cash 30,000 70,000
Bills Receivable 70,000 1,00,000
12,50,000 17,70,000 12,50,000 17,70,000
7. From the following Balance Sheet, you are required to prepare a schedule of changes in working
capital and a Fund Flow Statement:
Balance Sheet As on 31st March

Share Capital 10,000 15,000 Machinery 7,000 15,000
P & L a/c 4,000 6,000 Furniture 3,000 5,000
Provision for Tax 2,000 3,000 Debtors 3,000 3,500
Proposed Dividend 1,000 2,500 Stock 8,000 6,000
Creditors 4,000 6,000 cash 2,000 5,000
Outstanding Exp. 2,000 2,000
23,000 34,500 23,000 34,500
8. From the following Balance Sheet and other information of M/s. Ridhi & Sidhi Limited as at March
2011 and 2012, you are required to prepare:
a) A statement showing changes in working capital
b) A Fund Flow Statement
Balance Sheet of M/s. Ridhi& Sidhi Limited
As on 31st March
Share Capital 2,00,000 2,40,000 Machineries 2,00,000 2,50,000
Retained Earnings 1,25,000 1,60,000 Less: Accumulated
Depreciation (60,000) (80,000)
Debenture 1,50,000 90,000 1,40,000 1,70,000
Trade Creditors 30,000 40,000 Land 1,00,000 80,000
Trade Debtors 75,000 1,00,000
Inventory 1,40,000 1,20,000
Cash Balances 50,000 60,000
5,05,000 5,30,000 5,05,000 5,30,000
a) Cash dividends of Rs.25,000 has been paid during the year.
b) An old machine costing Rs. 10,000 has been sold for Rs. 7,000. The written down value of
the machine was Rs. 5,500
9. From the following information, prepare a fund flow statement and a schedule of changes in working
capital:
Balance Sheet as on 31st December

Equity Share Capital 10,00,000 11,00,000 Goodwill 50,000 40,000
General Reserve 2,00,000 2,00,000 Land & Building 4,20,000 6,60,000
Plant &
Profit & Loss a/c 1,10,000 1,90,000 6,00,000 8,00,000
Machinery
Debenture 5,00,000 3,00,000 Closing Stock 2,50,000 2,10,000
Creditors 50,000 40,000 Debtors 3,00,000 2,40,000
Bills Payable 30,000 24,000 Cash 3,00,000 24,000
Provision for doubtful Preliminary
20,000 30,000 30,000 20,000
debts Expenses
Provision for tax 40,000 1,10,000
19,50,000 19,94,000 19,50,000 19,94,000
Additional information:
a) During the year 2011 a part of machinery costing Rs. 7,500 (accumulated depreciation thereon
being Rs. 2,500) was sold for Rs. 3,000.
b) Dividend of Rs. 1,00,000 was paid during the year ended 31st December, 2011.
c) Income tax of Rs. 50,000 was paid during the year 2008.
d) Depreciation for the year 2011 was provided as follows:
Land & Building Rs. 10,000 and Plant &Machinery Rs. 50,000
10. From the following Balance Sheet and additional information, prepare fund flow statement:

Share capital 60,000 67,500 Fixed assets 30,000 42,000
Creditors 15,000 22,500 Stock 15,000 10,500
P & L a/c 22,500 34,500 Debtors 45,000 67,500
Outstanding exp. 4,500 7,500 Cash 7,500 9,000
Bills Payable 3,000 1,500 Prepaid expenses 4,500 3,000
Deferred expenses 3,000 1,500
1,05,000 1,33,500 1,05,000 1,33,500
An old machine has been sold for Rs. 6,000. The written down value of the machine was Rs.
4,500. Dividend Rs. 6,000 has been paid during the year and Rs. 3,000 depreciation has been
charged.

- Khan, Jain (2009), Management Accounting, Tata McGraw Hill, 2009, New Delhi
- Gupta K. Shasho, Sharma R.K., (2009), Kalyaani Publication, 2009, Hyderabad
- Rustagi R.P., (2011), Taxmann Publication (P) Ltd., 2011, New Delhi
- Agarwal, Shah, Mendhirtta, Sharma and Tailor (2009), Cost and Management Accounting, Malik
& Company, 2009, Jaipur
- Agarwal M. R. (2011), Management Accounting, Garima Publication, 2011, Jaipur
- Agarwal & Agarwal (2010), Management Accounting, RBD Publication, 2010, Jaipur
Unit - 6 : Cash Flow Statement
Structure of Unit:
6.0 Objectives
6.1 Introduction
6.2 Meaning of Cash Flow Statement
6.3 Objectives of Cash Flow Statement
6.4 Importance of Cash Flow Statement
6.5 Limitation of Cash Flow Statement
6.6 Difference Between Funds Flow Statement Vs. Cash Flow Statement
6.7 Classification of Cash Flow
6.8 Techniques of Preparing Cash Flow Statement
6.9 Summary
6.0 Objectives
After completing this lesson, you will able to:
 Recall the meaning of Cash Flow Statement
 Know the purpose of preparing Cash flow statement
 Prepare Cash flow statement
 Identified the various activities which generate cash
 Describe the importance and limitation of Cash flow statement
 Know the difference between fund flow statement and other financial statement
6.1 Introduction
Company final accounts include Profit and loss account and balance sheet. Profit and loss account present
net profit or loss of specified period and Balance sheet show financial possession of the company. But they
are not present cash inflow or outflow, which effect by the decision based on final account. Cash flow
statement provides information about the cash receipt and payment of the company for specified period.
Cash flow statement is required by Accounting Standard 3 (revised) issued by the Institute of Chartered
Accounts of India in March 1997. Accounting Standard 3 is mandatory in nature in respect of accounting
periods commencing on or after 1.04.2001 for an enterprises whose equity or debt securities are listed on
a recognised stock exchange in India and enterprises that are in the process of issuing equity or debt
securities that will be listed on a recognised stock exchange in India as evidence by the board of director’s
resolution in this regard. And all other commercial, industrial and business reporting enterprises, whose
turnover for the accounting period exceed Rs. 50 corer.
6.2 Meaning of Cash Flow Statement

Cash flow statement is a statement of inflow or outflow of cash or cash equivalent of the company in the
specified period. In other words, cash flow statement present the reason of changes in cash passion in two
Balance Sheet date.
Cash flow includes inflow or outflow of cash or cash equivalent. It’s means, the movement of cash into the
company and out of the company. Hear ‘cash’ include cash in hand and cash at bank and ‘cash equivalent’
include short term investment that are quickly converted into cash. Information about inflow of cash or
sources of cash and outflow of cash or application of cash are required for cash flow statement. According
to Accounting Standard 3, cash flow statement is classified into the following three categories of cash inflow
or outflow:
 Cash flow from operating activities.
 Cash flow from investing activities.
 Cash flow from financial activities.
6.3 Objectives of Cash Flow Statement

Information about the cash flows of an enterprise is useful in providing users of financial statements with a
basis to assess the ability of the enterprise to generate cash and cash equivalents and the needs of the
enterprise to utilise those cash flows. The economic decisions that are taken by users require an evaluation
of the ability of an enterprise to generate cash and cash equivalents and the timing and certainty of their
generation. The Statement deals with the provision of information about the historical changes in cash and
cash equivalents of an enterprise by means of a cash flow statement which classifies cash flows during the
period from operating, Investing and financing activities. The cash flow statement reflects a firm’sliquidity or
solvency. The main objects of cash flow statement are:
a) To provide information on a firms liquidity and solvency to change cash flow in future circumstances
b) To provide additional information for evaluating changes in assets, liabilities and equity
c) To improve the comparability of different firms’ operating performance by eliminating the effects of
different accounting methods
d) To indicate the amount, timing and probability of future cash flows
6.4 Importance of Cash Flow Statement

The cash flow statement provides information regarding inflows and outflows of cash of an organization for
a particular period. Therefore, we say that the following are the importance of cash flow statement:
a) Cash flow statement helps to identify the sources from where cash inflows have arisen and where in
the cash was utilized within a particular period.
b) Cash flow statement is significant to management for proper cash planning and maintaining a proper
matching between cash inflows and outflows
c) Cash flow statement shows efficiency of a firm in generating cash inflows from its regular operations
d) Cash flow statement reports the amount of cash used during the period in various long-term investing
activities, such as purchase of fixed assets
e) Cash flow statement reports the amount of cash received during the period through various financing
activities, such as issue of shares, debentures and raising long-term loan
f) Cash flow statement helps for appraisal of various capital investment programmes to determine
their profitability and viability
g) Cash flow statement helps the investors to judge whether the company is financially sound or not.
6.5 Limitation of Cash Flow Statement
Despite a number of uses, Cash Flow Statement suffers from the following limitations:
a) Ignore Accounting Concept of Accrual Basis: As CFS is based on cash basis of accounting, it
ignores the basic accounting concept of accrual basis
b) Ignores Non-cash Transactions: CFS ignores the non-cash transactions. In other words, it does not
consider those transactions which do not affect the cash e.g., issue of shares against the purchase of
fixed assets, conversion of debentures into equity shares, etc
c) Not Suitable for Judging the profitability: CFS is not suitable for judging the profitability of a firm as
non-cash charges are ignored while calculating cash flows from operating activities
d) Based on Secondary Data: CFS is based on secondary data. It merely rearranges the primary data
already appearing in other statements i.e., Balance Sheet and Income Statement
e) Short-term analysis: CFS is a technique of short-term financial analysis. It does not help much in
knowing the long-term financial position
f) Not based on full information: CFS does not present true picture of the liquidity of a firm. Liquidity
does not depend upon ‘cash’ alone. Liquidity, also affected by the assets which can be easily
converted into cash. Exclusion of these assets obstruct the true reporting of the ability of the firm to
meet its liabilities
g) By itself, it cannot provide a complete analysis of the financial position of the firm.
h) It can be interpreted only when it is in confirmation with other financial statements and other analytical
tools like ratio analysis.
6.6 Difference Between Funds Flow Statement Vs. Cash Flow Statement
Funds flow and cash flow statements both are used in analysis of business transactions particular period.
But there are some differences between these two statements which are given below:
a) Funds flow statements is based on the accrual accounting system but in case of cash flow statements
only those transactions are taken into consideration which affecting the cash or cash equivalents
only.
b) Funds flow statement analysis the sources and application of funds of long-term nature and the net
increase or decrease in long-term funds will be reflected on the working capital of the firm. The cash
flow statement will only consider the increase or decrease in current assets and current’ liabilities in
calculating the cash flow of funds from operations.
c) Funds Flow analysis is more useful for long range financial planning while cash flow analysis is more
useful for identifying and correcting die current liquidity problems of the firm.
d) Funds flow statement analysis is a broader concept, it takes into account both long-term and short-
term funds into account in analysis. But cash flow statement deals with the one of the current assets
on balance sheet assets side only.
e) Funds flow statement tallies the funds generated from various sources with various uses to which
they are put. Cash flow statements start with the opening balance of cash and reach to the closing
balance of cash by proceeding through sources and uses.
6.7 Classification of Cash Flow
Cash flow includes inflow or outflow of cash or cash equivalent. It means the movement of cash into the
company and out of the company. Cash flows can be classified into the following three categories:
Cash Flow from Operating Activities: Operation activities include those activities from which business
income are generated and these are not investing or financing activities. Operation activities are result of the
net profit or loss of the organisation. For example cash receipts from sales of goods and rendering of
services, royalties, fees, commission and other receiving. And cash payment to supplier of goods and
provider of services, to employees and to other in behalf of employees and for revenue expenses.
Operating activities include the production, sales and delivery of the company’s product as well as
collecting payment from its customers. This could include purchasing raw materials, building inventory,
advertising and shipping the product etc.
Cash flows from operating activities generally result from the transactions and other events that enter into
the determination of net profit or loss. Examples of cash flows from operating activities are:
a) Cash receipts from the sale of goods and the rendering of services;
b) Cash receipts from royalties, fees, commissions and other revenue;
c) Cash payments to suppliers for goods and services;
d) Cash payments to and on behalf of employees;
e) Cash receipts and cash payments of an insurance enterprise for premiums and claims, annuities and
other policy benefits;
f) Cash payments or refunds of income taxes unless they can be specifically identified with financing
and investing activities; and
g) Cash receipts and payments relating to futures contracts, forward contracts, option contracts and
swap contracts when the contracts are held for dealing or trading purposes.
Cash Flow from Investing Activities: The separate disclosure of cash flows arising from investing
activities is important because the cash flows represent the extent to which expenditures have been made
for resources intended to generate future income and cash flows. Examples of cash flows arising from
investing activities are:
a) Cash payments to acquire fixed assets (including intangibles);
b) Cash receipts from disposal of fixed assets (including intangibles);
c) Cash payments to acquire investments in shares, warrants or debt instruments of other enterprises;
d) Cash payments to disposal of investments in shares, warrants or debt instruments of other enterprises;
e) Cash advances and loans made to third parties;
f) Cash receipts from the repayment of advances and loans made to third parties;
Cash Flow from Financial Activities: The separate disclosure of cash flows arising from financing
activities is important because it is useful in predicting claims on future cash flows by providers of funds
(both capital and borrowings) to the enterprise. Examples of cash flows arising from financing activities are:
a) Cash receipts from issuing shares;
b) Cash proceeds from issuing debentures, loans, notes, bonds, and other short or long-term borrowings;
and
c) Cash payment on redemption of preference shares or debentures;
d) Cash repayments of amounts borrowed.
6.8 Techniques of Preparing Cash Flow Statement
The financial statements of the business are prepared on accrual basis of accounting, therefore in order to
calculate the cash flow, some adjustment are made for non cash expenses and incomes. There are two
methods for determine the cash flow: (i) direct method and (ii) indirect method.
The direct method of preparing a cash flow statement results in a more easily understood report. The
indirect method is almost universally used, because AS requires a supplementary report similar to the indirect
method if a company chooses to use the direct method.
6.8.1 Direct Method
The direct method for creating a cash flow statement reports major classes of gross cash receipts and
payments. Under Accounting Standard dividends received may be reported under operating activities or
under investing activities. If taxes paid are directly linked to operating activities, they are reported under
operating activities; if the taxes are directly linked to investing activities or financing activities, they are
reported under investing or financing activities.
Cash Flow Statement (Direct Method)

Detail Amount
Particular
(Rs.) (Rs.)
Cash flows from operating activities
Cash receipts from customers ++++
Other operating receipts ++++
Cash paid to suppliers ----
Cash paid for operating expenses ----
Income taxes paid ----
Net cash flows from operating activities ====
Cash flows from investing activities
Purchases of fixed assets ----
Purchases of Investments ----
Proceeds from the sale of Fixed Assets ++++
Proceeds from the sale of Investments ++++
Cash receipts as Dividends / Interest on investments ++++
Net cash flows from investing activities ====
Cash flows from financing activities
Receipts from issue of shares ++++
Receipts from issue of Debenture ++++
Payment on redemption of preference shares ----
Payment on redemption of debenture ----
Payment of dividend or interest ----
Net cash flows used in financing activities ====
Net increase in cash and cash equivalents ====
Cash and cash equivalents, beginning of year ++++
Cash and cash equivalents, end of year ====
Illustration 1: From the following Balance Sheet and income statement of ABC Ltd. as at March 2011
and 2012, you are required to prepare cash flow statement using direct method:
Balance Sheet
Share Capital 5,76,000 7,10,400 Land & Building 76,800 1,53,600
Profit & Loss a/c 2,42,880 2,62,000 Machinery 5,76,000 9,21,600
Creditors 3,84,000 3,74,400 Cash 96,000 1,15,200
Outstanding Debtors 2,68,800 2,97,600
38,400 76,800
Expenses
Provision for Tax 19,200 21,200 Stocks 4,22,400 1,53,600
Acc. Dep. on Advance 12,480 14,400
Building &
Machinery 1,92,000 2,11,200
14,52,480 16,56,000 14,52,480 16,56,000
Income State ment

For the year ended 31st March, 2012
Particular Detail Amount
Net Sales 40,32,000
Less: Cost of goods sold 31,68,000
Depreciation 96,000
Salaries and wages 3,84,000
Operating expenses 1,28,000
Provision for tax 1,40,800 39,16,800
Net operating profit 1,15,200
Add: Non operating incomes:
Profit on sale of machinery 19,200
Profit for the year 1,34,400
Profit & Loss a/c as on 31st March, 2011 2,42,880
3,77,280
Dividend declared and paid 1,15,280
Profit & Loss a/c as on 31st March, 2012 2,62,000
Additional Information: Cost of machinery sold Rs. 1,15,200
Solution:
Cash Flow Stateme nt
For the year ended 31st March, 2012
Detail Amount
Particular
(Rs.) (Rs.)
A. Cash Flow from Operation Activities:
Cash receipt from customers 40,03,200
Cash paid to suppliers (29,08,800)
Cash paid for operating expenses (4,75,520)
6,18,880
Less: Tax Paid (1,38,800) 4,80,080
B. Cash Flow from Investment Activities:
Purchase of Land (76,800)
Purchase of Machinery (4,60,800)
Sale of Machinery 57,600 (4,80,000)
C. Cash Flow from Financial Activities:
Issue of share capital 1,34,400
Dividend paid (1,15,280) 19,120
Net increase in cash 19,200
Add: Cash balance at the beginning 96,000
Cash balance at the beginning 1,15,200
Working Note:
Cash receipt from custome rs
Particular Amount
Sales 40,32,000
Add: Debtors at the beginning 2,68,800
Less: Debtors at the end (2,97,600)
Cash receipt from custome rs 40,03,200
Cash paid to suppliers

Particular Amount
Cost of goods sold 31,68,000
Add: Creditors at the beginning 3,84,000
Stocks at the end 1,53,600
Less: Creditors at the end (3,74,400)
Stocks at the beginning (4,22,400)
Cash paid to suppliers 29,08,800
Cash paid for ope rating expenses

Particular Amount
Salaries and wages 3,84,000
Operating expenses 1,28,000
Add: Outstanding Expenses at the beginning 38,400
Advance at the end 14,400
Less: Outstanding Expenses at the end (76,800)
Advance at the beginning (12,480)
Cash paid for ope rating expenses 4,75,520
Provision for Tax a/c
Particular Rs. Particular Rs.
To Bank a/c (bal. figure) 1,38,800 By Balance b/d 19,200
To Balance c/d 21,200 By Profit & Loss a/c 1,40,800
1,60,000 1,60,000
Land & Building a/c

To Balance b/d 76,800 To Balance c/d 1,53,600
To Bank a/c (bal. figure) 76,800
1,53,600 1,53,600
Machine ry a/c
To Balance B/d 5,76,000 By Acc. Depreciation a/c 76,800
To Profit & Loss a/c (Profit on By Bank a/c 57,600
sale of machinery) 19,200
To Bank a/c (bal. figure) 4,60,800 To Balance c/d 9,21,600
10,56,000 10,56,000
Accumulated Depreciation a/c

To Machinery a/c 76,800 To Balance b/d 1,92,000
To Balance c/d 2,11,200 To Profit & Loss a/c 96,000
2,88,000 2,88,000
6.8.2 Indirect Method
The indirect method uses net-income as a starting point, makes adjustments for all transactions for non-cash
items, then adjusts for all cash-based transactions. An increase in an asset account is subtracted from net
income, and an increase in a liability account is added back to net income. This method converts accrual-
basis net income (loss) into cash flow by using a series of additions and deductions.
The following rules are used to make adjustments for changes in current assets and liabilities, operating
items not providing or using cash and non operating items:
a) Decrease in non cash current assets are added to net income
b) Increase in non cash current asset are subtracted from net income
c) Increase in current liabilities are added to net income
d) Decrease in current liabilities are subtracted from net income
e) Expenses with no cash outflows are added back to net income
f) Revenues with no cash inflows are subtracted from net income (depreciation expense is the only
operating item that has no effect on cash flows in the period)
g) Non operating losses are added back to net income
h) Non operating gains are subtracted from net income
Cas h Flo w S tate me nt (Indire ct M ethod)
D etail A mo unt
Pa rtic ula r
(Rs.) (Rs .)
Cash flo ws fro m o pera ting activitie s
Net inco me o f the year XXXX
Add : N o n-fund and no n-operating Expenses/Losse s:
Depreciatio n o n fixed asse ts ++++
Goodwill (or pate nts) written o ff ++++
Preliminary e xpe nses written o ff ++++
Disco unt o n issue o f s hares/debentures written o ff ++++
Loss o n sale o f fixed a ssets or lo ng term investments ++++
Transfer to reserves ++++
Provisio n for taxatio n ++++
Proposed d ivid end ++++
Less: N on F und and No n operating Inco mes/Gains :
Pro fit o n sale o f fixed asse ts/lo ng-term investme nts - ---
Interest or d ivide nd received - ---
Fund/Loss fro m operatio n ====
Add : Decrease in C urrent Assets ++++
Add : Increase in Current Liab ilities ++++
Less: Increase in Current Ass ets - ---
Less: Decrease in C urrent Liab ilities - ---
====
Less: Tax Paid - ---
Net cash flo w fro m o pera ting activ ities ====
Cash flo ws fro m investing a ctiv ities
Purchases o f fixed assets - ---
Purchases o f Investme nts - ---
Proceeds fro m the sale o f F ixed Assets ++++
Proceeds fro m the sale o f Inves tments ++++
Cash rece ip ts as D ivide nds / Interest o n investments ++++
Net cash flo ws fro m inve sting activities ====
Cash flo ws fro m fina ncing activities
Receip ts fro m issue o f shares ++++
Illustration 2: From the following Balance Sheet and other information of M/s. Ridhi & Sidhi Limited as at
March 2011 and 2012, you are required to prepare cash flow statement following the indirect method:
Balance Sheet of M/s. Ridhi& Sidhi Limited
As on 31st March
Share Capital 2,00,000 2,40,000 Plant and 2,00,000 2,50,000
Machineries
Retained Earnings 1,25,000 1,60,000 Less: Accumulated (60,000) (80,000)
Depreciation
Debenture 1,50,000 90,000 1,40,000 1,70,000
Trade Creditors 30,000 40,000 Land 1,00,000 80,000
Trade Debtors 75,000 1,00,000
Inventory 1,40,000 1,20,000
Cash Balances 50,000 60,000
Additional Information: 5,05,000 5,30,000 5,05,000 5,30,000
a) Cash dividends of Rs.25,000 has been paid during the year.
b) An old machine costing Rs. 10,000 has been sold for Rs. 7,000. The written down value of the
machine was Rs. 5,500
Solution:
Cash Flow Stateme nt
Detail Amount
Particular
(Rs.) (Rs.)
A. Cash Flow From Operating Activities:
Net Profit (Increase in retained earnings) 35,000
Add: Depreciation 24,500
Proposed Dividend 25,000
Less: Profit on sale of Plant and Machinery (1,500)
Fund from operation 84,500
Add: Net Decrease in Inventory 20,000
Net Increase in Creditors 10,000
Less: Net Increase in Debtors (25,000) 88,000
B. Cash Flow From Investing Activities:
Sales of Plant and Machinery 7,000
Sales of Land 20,000
Purchase of Plant and Machinery (60,000) (33,000)
C. Cash Flow From Financing Activities:
Issue of Share Capital 40,000
Redemption of Debentures (60,000)
Dividends Paid (25,000) (45,000)
Net increase in cash (A+B+C) 10,000
Cash Balance at the Beginning of the Period 50,000
Cash Balance at the End of the Period 60,000
Working Note:
Plant and Machinery A/c
Particular Amount Particular Amount
To Balance b/d 2,00,000 By Bank a/c 7,000
To P & L a/c (Profit on sale) 1,500 By Acc. Depreciation a/c 4,500
To Bank a/c (Purchase) By Balance c/d 2,50,000
(Balancing figure) 60,000
2,61,500 2,61,500
Accumulated Depreciation A/c
Particular Amount Particular Amount
To Plant and Machinery a/c 4,500 By Balance b/d 60,000
To Balance c/d 80,000 By P&L a/c (Balancing
figure) 24,500
84,500 84,500
Illustration 3: Use the following data to construct a statement of cash flows using the direct and indirect
methods:
Balance Sheet (As on 31st December)
Liability 2011 2010 Assets 2011 2010
Share Capital 88,000 84,000 Fixed assets 316,000 270,000
Retained earnings 59,000 60,500 Accumulated
Depreciation (45,000) (30,000)
Debenture 173,000 160,000 2,71,000 2,40,000
Accounts payable 18,000 16,000 Accounts receivable 25,000 32,500
Wages payable 4,000 7,000 Cash 4,000 14,000
Prepaid insurance 5,000 7,000
Inventory 37,000 34,000
342,000 327,500 342,000 327,500
Income State ment

Particular Amount (Rs.)
Sales 200,000
Cost of goods sold (123,000)
Depreciation expense (15,000)
Insurance expense (11,000)
Wage Expense (50,000)
Net Income 1,000
a) During 2000 declared and paid dividends of Rs.2,500
b) During 2000, ABC paid Rs.46,000 in cash to acquire new fixed assets.
c) The accounts payable was used only for inventory.
Solutio n:
Cash Flo w S tate me nt (Dire ct M e thod)
De tail A mo unt
Pa rtic ula r
(R s.) (Rs.)
A. Cash Flo w fro m O pe ratio ns:
Cash re ce ived fro m c usto mers 207,500
Cash Pa id to S upp lier (124,000)
Cash pa id for insura nc e (9,000)
Cash pa id for wa ges (53,000) 21,500
B. Cash Flo w fro m Inve stme nts:
Cash pa id for fixed assets (46,000) (46,000)
C. Cash flo w fro m financing activitie s:
Cash d ivide nd pa yments (2,500)
Proceeds fro m issue o f Debe nture 13,000
Proceeds fro m issue o f S ha re Cap ita l 4,000 14,500
Net Cash F lo w (10,000)
Be ginning Cash Ba la nce 14,000
End ing Cash Ba la nce 4,000
Cash Flow Stateme nt (Indirect Method)
Detail Amount
Particular
(Rs.) (Rs.)
A. Cash Flow from Operations:
Net Income 1,000
Add: Depreciation 15,000
Fund from Operation (16,000)
Add: Decrease in Accounts receivable 7,500
Decrease in Prepaid insurance 2,000
Increase in Account Payable 2,000
Less: Increase in Inventory (3,000)
Decrease in Wages Payable (3,000) 21,500
B. Cash Flow from Investments:
Cash paid for fixed assets (46,000) (46,000)
C. Cash flow from financing activities:
Cash dividend payments (2,500)
Proceeds from issue of Debenture 13,000
Proceeds from issue of Share Capital 4,000 14,500
Net Cash Flow (10,000)
Beginning Cash Balance 14,000
Ending Cash Balance 4,000
Working Note:
a) Cash received from customers:
Sales of the year 2,00,000
Add: Accounts receivable at the beginning of the year (2010) 32,500
Less: Accounts receivable at the end of the year(2011) (25,000)
Cash received from customers 2,07,500
b) Cash paid for inventory
Cost of goods sold 1,23,000
Add: Inventory at the end of the year (2011) 37,000
Less: Inventory at the beginning of the year(2010) (34,000)
Purchase of the year 1,26,000
Add: Accounts payable at the beginning of the year (2010) 16,000
Less: Accounts payable at the end of the year(2011) (18,000)
Cash Paid to Supplier1,24,000
c) Cash paid for insurance
Insurance as per income statement 11,000
Add: Prepaid insurance at the end of the year(2011) 5,000
Less: Prepaid insurance at the beginning of the year (2010) (7,000)
Cash paid for insurance 9,000
d) Cash paid for wages
Wages as per income statement 50,000
Add: Outstanding Wages at the beginning of the year (2010) 7,000
Less: Outstanding Wages at the end of the year(2011) (4,000)
Cash paid for Wages 53,000
6.9 Summary
In this unit we have tried to develop the idea of flow of cash within the organization. We have tried to find out
the cash generate form operation activities or cash generate form investment activities or cash generate form
financial activities. We tried to study the importance of cash and cash flow statement. We learnt how to go
about doing the cash flow analysis with the help of accounting information and finally presenting cash flows
in the form of a “cash flow statement”. We also learnt, distinguishing between cash and fund as also cash
flow statement and funds flow statement.

1. What do you understand by Cash Flow Statement? Explain its advantages and limitations.
2. What is Cash Flow Statement? How it is prepared? Explain the classification of cash flows.
3. What is Cash Flow Statement? Differentiate between cash flow statement and fund flow statement.
4. From the following information you are required to prepare a Cash Flow Statement of Shanti
Stores Ltd for the year ended 31" December, 2001 using the direct method:
B alance S he e ts
Lia bi li tie s 2010 2011 A s se ts 2010 2011

S hare C ap ita l 70,000 70,000 P la nt M ac hiner y 50,000 91,000
S ecur ed Loa ns - -- 40,000 Inve ntor y 15,000 40,000
C red itor s 14,000 39,000 D ebtor s 5,000 20,000
Ta x pa yab le 1,000 3,000 C ash 20,000 7,000
P &L A/c 7,000 10,000 P repa id G e nera l E xp.
2,000 4,000
92,000 1,62,000 92,000 1,62,000
P rof it & Los s A/c fo r t he ye ar e n de d 31" D e ce m be r, 2001
P articul ars R s. P art iculars R s.

To O pening I nve ntor y 15,000 B y sa les 1,00,000
To P urc has es 98,000 B y C los ing inve ntor y 40,000
To G ross P ro fit c/d 27,000
1,40,000 1,40,000
To G e nera l E xpe nses 11,000 B y G ross P ro fit b/d 27,000
To D ep rec iatio n 8,000
To Ta xes 4,000
To N et P ro fit c /d 4,000
27,000 27,000
To D ivide nd 1,000 B y Ba la nce b /d 7,000
To B a la nce c /d 10,000 B y N et P ro fit b /d 4,000
11,000 11,000
5. From the following Balance Sheet and additional information, prepare cash flow statement using
the indirect method:

Share capital 60,000 67,500 Fixed assets 30,000 42,000
Creditors 15,000 22,500 Stock 15,000 10,500
P & L a/c 22,500 34,500 Debtors 45,000 67,500
Outstanding exp. 4,500 7,500 Cash 7,500 9,000
Income received in Prepaid expenses 3,000 1,500
advance 3,000 1,500 4,500 3,000
1,05,000 1,33,500 1,05,000 1,33,500
An old machine has been sold for Rs. 6,000. The written down value of the machine was Rs.
4,500. Dividend Rs. 6,000 has been paid during the year and Rs. 3,000 depreciation has been
charged.
6. From the following Balance Sheets of XYZ Ltd. you are required to prepare cash flow statement
using the indirect method:

Equity Share Capital 3,00,000 4,00,000 Goodwill 1,15,000 90,000
8% Preference Share Land and
Capital 1,50,000 1,00,000 Buildings 2,00,000 1,70,000
General Reserve 40,000 70,000 Plant 80,000 2,00,000
Profit & Loss Account 30,000 48,000 Debtors 1,60,000 2,00,000
Proposed Dividend 42.000 50,000 Stock 77,000 1,09,000
Creditors 55,000 83,000 Bills Receivable 20,000 30,000
Bill Payable 20,000 16,000 Cash in Hand 15,000 10,000
Provision for Taxation 40,000 50,000 Cash at Bank 10,000 8,000
6,77,000 8,17,000 6,77,000 8,17,000
a) Depreciation of Rs. 10,000 and Rs. 20,000 have been charged on Plant and Land and Building
respectively in 2011.
b) An interim dividend of Rs. 20,000 has been paid in 2011.
c) Rs. 35,000 Income-tax was paid during the year 2011.
7. The following are the balance Sheets of X Ltd. For the year ending 31st December 2000 and 2001

Share Capital 2,00,000 3,00,000 Fixed Assets 1,60,000 2,00,000
Profit and Loss Account 1,20,000 1,60,000 Add: Additions 40,000 60,000
Sundry creditors 60,000 50,000 Less: Depreciation 18,000 24,000
Provision for taxation 40,000 50,000 1,82,000 2,36,000
Proposed Dividend 20,000 30,000 Investments 8,000 16,000
Stock 1,60,000 2,18,000
Debtors 60,000 80,000
Cash 30,000 40,000
4,40,000 5,90,000 4,40,000 5,90,000
a) Taxes Rs. 44,000 and dividend Rs. 24,000 were paid during the year 2001
b) The net profit for the year 2001 before depreciation Rs. 1,34,000
You are required to prepare cash flow statement.
8. From the following Balance Sheets of ABC Ltd. on 31st Dec. 2010 and 2011, you are required to
prepare cash flow statement using the indirect method:

Share Capital 2,00,000 2,00,000 Goodwill 24,000 24,000
General Reserve 28,000 36,000 Buildings 80,000 72,000
P&L A/c 32,000 26,000 Plant 74,000 72,000
Creditors 16,000 10,800 Investments 20,000 22,000
Bills payable 2,400 1,600 Stock 60,000 46,800,
Provision for Tax 32,000 36,000 Bills Receivable 4,000 6,400
Prov. for doubt. debts 800 1,200 Cash & Bank 13,200 30,400
Debtors 36,000 3 8,000
3,11,200 3,11,600 3,11,200 3,11,600
(i) Depreciation provided on plant was Rs.8,000 and on Buildings Rs.8,000
(ii) Provision for taxation made during the year Rs.38,000
(iii) Interim dividend paid during the year Rs. 16,000.
9. From the following Balance Sheet of X Ltd., as on 31st December, 2010 and 31st December 2011,
you are required to prepare a funds | flow statement.
(Rs.)
Share Capital 4,00,000 5,00,000 Land and Buildings 4,00,000 4,80,000
P&L A/c 1,44,000 2,18,000 Machinery 3,60,000 2,60,000
Bank Loan 3,20,000 80,000 Stock 2,00,000 2,52,000
Creditors 3,00,000 2,60,000 Debtors 1,60,000 1,28,000
Provision for
Cash at Bank 1,04,000 18,000
Taxation 60,000 80,000
12,24,000 11,38,000 12,24,000 11,38,000
Additional Information :
(i) During the year ended 31st December 2011 dividend of Rs.84,000 was paid.
(ii) Depreciation written off on machinery is Rs.24,000 and on Land and Buildings is Rs.45,000.
(iii) Income-tax paid during the year was Rs.70,000.
(iv) Additions to Buildings were for Rs.75,000.

- Khan, Jain (2009), Management Accounting, Tata McGraw Hill, 2009, New Delhi
- Gupta K. Shasho, Sharma R.K., (2009), Kalyaani Publication, 2009, Hyderabad
- Rustagi R.P., (2011), Taxmann Publication (P) Ltd., 2011, New Delhi
- Agarwal, Shah, Mendhirtta, Sharma and Tailor (2009), Cost and Management Accounting, Malik
& Company, 2009, Jaipur
- Agarwal M. R. (2011), Management Accounting, Garima Publication, 2011, Jaipur
- Agarwal & Agarwal (2010), Management Accounting, RBD Publication, 2010, Jaipur
Unit - 7 : Management of Working Capital
Structure of Unit:
7.0 Objectives
7.1 Introduction
7.2 Concept of Working Capital
7.3 Types of Working Capital
7.4 Determinants of Working Capital
7.5 Advantages of Adequate Working Capital
7.6 Disadvantages from Redundant or Excess Working Capital
7.7 Estimation of Working Capital Requirements
 Percentage of Sales Method
 Regression Analysis Method
 Operating Cycle Method
 Forecasting Net Current Assets Method
 Projected Balance Sheet Method
7.8 Summary
7.0 Objectives
After completing this unit you will be able to:
 to understand concept of Working Capital
 to know the types of Working Capital
 to understand determinants of Working Capital
 to point out advantages and disadvantages due to adequate and excessive Working Capital
 to learn the methods of estimation of Working Capital requirements
7.1 Introduction
Working Capital is the part of the firms capital which is required for financing short term or current assets
such as stock, receivables, marketable securities and cash. Money invested in these current assets keep
revolving with relative rapidity and are being constantly converted into cash. This cash flows rotat again in
exchange of other such assets. Working Capital is also called as “short term capital”. “Liquid Capital”,
“Ciculating or revolving capital”, The Working Capital management refers to management of the working
capital or to be more precise the management of current assets and current liabilities. The goal of working
capital management is to manage the firms’ current assets and current liabilities in such a way that a satisfac-
tory level of working capital is maintained. This is so because, if the firm cannot maintain a satisfactory level
of working capital, it is likely to become insolvent and may even be forced into bankruptcy. Each of the
short term sources of financing must be continuously managed to ensure that they are obtained and used in
the best possible way. The current assets should be large enough to cover its current liabilities in order to
ensure a reasonable margin of safety.
7.2 Concept of Working Capital
There is no uninomous decision with the definition of working capital. The word working with reference to
capital refers to circulation of capital from one form to another during day-to-day operations of business.
The word capital refers to the monetary values of all assets of the business. There is lot of difference of
opinions among accountants, enterpreneurs and economists. There are two concepts of working capital:
Gross Working Capital : It referred to as working capital, means the total current assets.
Net working capital : It can be defined in two ways (i) the most common definition of net working capital
is the difference between current assets and current liabilities, and (ii) alternate definition of Net working
capital is that portion of current assets which is financed with long term funds.
Net working capital as a measure of liquidity, is not very useful for comparing the performance of different
firms, but it is quite useful for internal control. The goal of working capital management is to manage the
current assets and liabilities in such a way that an acceptable level of net working capital is maintained.
Another concept is “operating concept.” The duration or time required to complete the sequence of events
right from purchase of raw materials/goods for cash to the realisation of sales in cash is called the operating
cycle or working capital cycle.
Operating Cycle
Credit Sales
Debtors and Bills Receivables Sales
Cash Finished
goods
Raw Working-in
Materials Progress
The net duration of operating cycle is calculated by adding the number of days involved in the different
stages of operation. This concept is more appropriate than others. According to this concept, the neces-
sary liquid funds required by a firm for production, administration and selling can be determined
for the whole year. If cash working capital requirements are known in advance, then non-cash current
assets may be better managed. Now it is an important tool in projecting working capital requirements of an
enterprise.
Activity A:
1. What is operating cycle Concept :
7.3 Types of Working Capital
(A) On the Basis Balance Sheet :

(i) Gross working Capital (ii) Net working capital
It is discussed earlier in 7.2
(B) On the Basis of Time :
(i) Permanent working capital
(ii) Variable (Temporary) working capital
(a) seasonal working capital
(b) specific working capital
Permanent Working Capital : It means that minimum amount which is parmanently blocked in the busi-
ness and that cannot be converted into cash in the normal course of business. This amount is definitely
required throughout the year on a continuous basis for maintaining the circulation of current assets. Tondon
committee has identified this capital as core current assets. As the business grows the requirement of per-
manent working capital also increased due to increase in current assets. This portion of working capital is
financed through longterm sources.
Variable Working Capital : The amount which is above the permanent level of working capital is called as
temporary working capital. Such requirement of this part of working capital financed from shortterm funds,
whenever needed. It is classified further : (A) seasonal working capital : Some of the industries like
refrigertors and coolers may need extra fund to carry on production and to accumulate stock before the sale
operations. It is of short term nature, it has to be financed from short term sources like bank loan etc. (B)
Specific working Capital : Such capital is required to meet unforseen contingencies like slumps and
others. It is arranged to meet special exigencies.
Activity B:
1. Defind Gross Working Capital :
7.4 Determinants of Working Capital

In order to determine the proper amount of working capital of a firm, the following factors should be
considered carefully :
1. Seasonal nature of the firm
2. Firm’s credit policy
3. Size of Business
4. Nature of business
5. Rate of growth of business
6. Business cycle
7. Duration of operating cycle
8. Change in terms of purchase and sales.
The amount of working capital required depends upon a large number of other factors like political stability,
means of transport, co-ordination of activities, rate of industrial development, speed of circulation of work-
ing capital, profit margin etc. The above determinants should be considered, because no certain criterian to
determine the amount of working capital needs that may be applied to all firms.
7.5 Advantages of Adequate Working Capital
Inadequate working Capital is harmful for a business organisation. It is a source of energy to a business. The
profitability of a business also depends upon planning of adequate working capital. Following are the ad-
vantages to a business enterprise if adequate working capital is available with the firm.
1. Adequate working capital enables a firm to pay its suppliers immediately.
2. Adequate working capital creates an environment of confidence, high morale, confidence and in-
creases overall efficiency of the business.
3. Adequate working capital increases the productivity and efficiency of fixed assets in the business.
Adequacy of working capital aftects the use of fixed assets.
4. Due to adequate working capital a firm can pay its debt in time and also its collection from debtors
is relatively in time. Hence it increases goodwill of the firm because adequate working capital pro-
vides better security.
5. Despite of sufficient profits, if a firm has unadequate working capital, then it cannot distribute ap-
propriate and enough dividentd. Hence, if there is adequate working capital a firm can distribute
sufficient profits and it can bring satisfaction amoung shareholders.
6. Due to a better credit worthiness, a firm can easily fetch shortterm loans and advances from banks
for completing its seasonal and short period needs.
Activity C:
1. Adequate Working Capital enable the firm and create an environment of
7.6 Disadvantages from Redundant or Excess Working Capital

Excess working capital refers to idle funds which do not earnany profit for the firm. If there is idle funds with
a firm following disadvantages are :
1. If management is not utilising its current resources than it indicate inefficient management.
2. Excess working capital means, there is a defective credit policy and collection policy.
3. There may be more change of holding excess inventory, if there is excess working capital such
situation results upon companies profitability and efficiency in using its resources.
4. Excess working capital results, the low rate of return, and it will causing dissatisfaction among
shareholders.
5. Due to idle funds the efficacy of firm to earn profits is effected, hence due to more interest liability,
it reduces the amount of profits.
Hence, if can be concluded that excess working capital reduces return on investment while adequate work-
ing capital increase the firms profitability as-well-as goodwill.
7.7 Estimation of Working Capital Requirements

There are following methods for estimation of working capital :
1. Percantage of Sales Method: Relationship between sales and working capital is calculated over the
year, if it is found stable then it is taken as a base for determining working capital. In this method, percentage
of each item of working capital is determined. On the basis of this relationship value of each component of
working capital is calculated and then these estimated amount is sum up for final result. We can learn it from
following example.
Illustration 1 : Suppose sales for the year 2011-2012 Rs. 20 Lakh, and anticipated sales for the year
2012-2013 Rs. 30 Lakh The Balance Sheet of the company as on 31st March 2012 is as follows :

Capital 300000 Fixed Assets 350000
Reserves & Surplus 200000 Stock 100000
Creditors 100000 Receivables 100000
Cash in hand and at Bank 500000
6000000 6000000
Calculate estimated working capital requirement for 2012-2013 adding 10% per annum for contingecies.
Solution :
Actual % of Sales Estimates for

2011-12 2011-12 2012-13
Rs. Rs.
Sales 20,00,000 100 30,00,000
(A) Current Assets
Stock 1,00,000 5% 1,50,000
Receivables 1,00,000 5% 1,50,000
Cash in hand and At Bank 50,000 2.5% 75,000
2,50,000 3,75,000
(B) Current Liabilities
Sundry Creditors
1,00,000 5% 1,50,000
1,00,000 1,50,000
(C) Net Working Capital (A-B)
Add: 10% for contingencies 2,25,000
22,500
247500
2. Regression Analysis Method: It is a statistical technique in which working capital requirements is

calculated by using least square method. The relationship between sales and working capital is expressed
by the following equation :
y = a + bx
x = Sales (Independent variable)
y = Working Capital (Dependent variable)
a = Intercept
b = Slop of the time
We can learn it from following example :
Illustation 2 : The sales and working Capital for a period of seven years are given below : (Rs. in crores)
Year Sales (Rs.) Working Capital (Rs.)
2005-06 100 35
2006-07 120 39
2007-08 130 50
2008-09 150 58
2009-10 180 65
2010-11 210 80
2011-12 240 85
Estimate the working capital requirement by using regression analysis for the year 2012-13, if anticipated
sales is Rs. 275 crores.
Solution :
Year Sales Working XY X2
(x) Capital
(y)
2005-06 100 35 3500 10000
2006-07 120 39 4680 14400
2007-08 130 50 6500 16900
2008-09 150 58 8700 22500
2009-10 180 65 11700 32400
2010-11 210 80 16800 44100
2011-12 240 85 20400 57600
1130 412 72280 197900
y = a+bx
xy = na+b£x
exy = a£x + b£x2
412 = 7a + 1130 b (i)
72280 = 1130a + 197900 b (ii)
Multiplying (i) equation by 1130 & second by 7
465560 = 7910 a + 1276900 b
505960 = 7910 a + 1385300 b
(-) (-) (-)
(-) 40400 = -108400 b
b= .3727
Finding the value of a by multiplying value of b in equation (i)
412 = 7a + 421.14
-7a = 9.1439
9.1439
a =
7
a = (-) 1.3062
Hence y = a + bx
y = -1.3062 + 0.3727x
y = -1.3062 + 0.3727 x 275
or = -1.30692 + 102.4925
or = 101.4563
y = Working Capital = Ans. Rs. 101.4563 crores
When sales in Rs. 275 crores the workign capital Rs. 101.4563 crores.
3. Operating Cycle Method : In This Method
following steps are for computation of working capital
1. Calculation of Operating Expenses :
Value of Raw Material Consumed
Op. Stock of Raw Material -
(+) Purchases -
-
(+) Closing stock of Raw Material - -
-
Direct Wages
Prime Cost
-
-
Add : Manufacturing overhead
Add : Op. stock of work in progress -

-
Less : Closing stock of working Progress -

Cost of Production -
-
Add : Administrative Overhead
Add : Op. Stock of finished goods

-
Less : Closing stock of finished goods
-
Cost of Goods sold -
Add : Selling & Distribution expenses -

-
Total operating expenses
Note : 1 Depreciation, non cash items and mortisation of intangible assets should not included. Similarly
capital expenses and appropriation of profits and tax payments should not included.
2. Calculation of Operating Cycle Period : Total number of days involved in the different stages of
operation as materials storage period, conversion period, finished goods storage period, debtors collection
period and creditors payments period. It is a total period involved in different stages of operations, which
may be calculated as follows :
Operating Cycle Period : Material storage period + conversion period + finished goods storage period +
debtors collection period - creditors payment period. The calculation of each are as follows:
(a) Material Storage Period : It is the period for which raw material will remain in stores before
they are issued for production. It is calculated by following formula :
(Opening stock  Closing stock)/2

Material Storatge Period 
Material consumed for the year/365
Note : Raw material consumed = Op. stock of raw material + Purchases - closing stock of raw
material
(b) Conversion Period (Work-in-Progress Period) : The time which is taken in converting the
raw material into finisheed goods. It is calculated by following formula :
(opening WIP  Closing WIP)/2

Conversion Period 
Total Production Cost/365
Total production cost = value of R.M. consumed + Direct Wages+ Manufacturing expenses (ex-
cluding depreciation) + Op. stock of WIP - closing stock of WIP
(c) Finished Goods Storage Period : It is the period for which goods have to remain in the go-
down before sale taken place. It is calculated as follows :
(Opening stock  Closing Stock)/2

Finished Goods Storage Period 
Total cost of goods sold/365
Note : Total cost of goods sold : Cost of Production (excluding depreciation) + opening stock of
finished goods - closing stock of finished goods. It does not include adm. expenses and selling and
distribution expenses.
(d) Debtors Collection Period :It is the time lag in payments by debtors. It is calculated as
follows:
(Opening Debtors & B/R  Closing Debtors & B/R /2)
Total credit sales/365
(e) Creditors Payment Period : It is the length of credit period available from trade creditors. It
is calculated as follows :
(Opening Creditors & B/R  Closing Creditors & B/R /2)
Total credit purchases/ 365
Note :
(1) In the absence of any information, total purchases and total sales be treated as credit.
(2) There is no hard and fast rule and for taking 365 days as number of days in a year,
However, sometimes even 360 days may be considered.
(3) If, opening values of stock, debtors or creditors are not available then closing bal
ances of these items should be taken.
3. Number of Operating Cycles : The number of operating cycles in a year are determined by the
following formula :
365 / 360
No. Operating cycle 
Operating cycle period
4. Calculation of amount of Working Capital : The amount of actual Working Capital required is calcu-
lated by dividing the total operating expenses for the period by the number of operating cycles in that
period. It is expressed as follows : Operating Expenses
Working Capital 
No. Operating cycle
Alternatively working capital may be calculated as follows :

Operating cycle period
Working capital  Cash Balance required  X Estimated cost of goods sold
365/360
Activity D:
1. Operating cycle period is equal to : ----------------------------------------------------------
5. Provision for Contingencies : The above calculation of working capital is based on estimates hence it
may not be more accurate, Therefore, a provision for contingencies as required 5% or 10% may be added
while ascertaining the final amount of estimated working capital.
Through, the following illustration above calculation can be understandable :
Illustration 3 : From the following information calculate the working capital requirement under operating
cycle method taking 5% reserve for contignencies : Rs.
Opening Stock : Raw Material : 9000

Work-in-progress 9000
Finished goods 4000
Purchases (credit) 36000
wages & manufacturing Exp. 15000
Admistrative expenses (excluding Dep.) 12000
Selling and distribution expenses 13000
Sales (credit) 105000
Closing Stock
Raw Materials 10000
Finished goods 4500
Opening Receivables 6000
Closing Receivables 10000
Opening payables 5000
Closing Payables 10000
Calculation of operating cycle Period
(Opening stock  closing stock of Raw Mater ials)/2

(A) Raw material storage period 
Raw Mater ials Consumed/3 65
Raw Materials consumed = Opening stock of R.M. + Purchases - Closing stock of Raw Materials
Rs. 9000 + 36000 - 10000 = Rs. 35000
(9000  10000) / 2 9500

   99 days
35000 / 365 95.89
(Opening stock  closing stock of WIP)/2
(B) Conversion period  
Total Production Cost/365
(9000  9500) / 2 9750

   99 days
49000 / 365 135.6164
Production cost : Rs.
Material consumed (as above) 35000
Add: Wages & Manufacturing Exp. 15000
Add: Opening Stock of WIP 9000
59000
Less: Closing Stock of WIP 9500
49500
(Opening Stock  Closing Stock of Finished goods)/2

(C) Finished goods storage Period 
Cost of goods sold/365
(4000  4500) / 2 4250

   32 days
49000 / 365 134.246
Cost of goods sold : Rs.
Production cost (as above) 49500
Add: Opening Stock of Finished goods 4000
Less: Closing Stock of Finished goods 4500
49000
(Opening Receivabl es  Closing Receivabl es)/2

(D) Debtors Collection Period 
Sales/365
(6000  10000) / 2 8000

   28 days
105000 / 365 287.67
(Opening payables  Closing payables)/ 2

(E) Creditors Payment Period 
Purchases /365
(5000  10000) / 2 7500

   76 days
36000 / 365 98.63
(F) Net operating cycle Period = A+B+C+D-E
99+72+32+28-76 = 155 Days
(G) Computation of working Capital required =
365
(i) No. of operating cycle per year 
Net operating cycle period
365
  2.3548
155
(ii) Total operating expenses. Rs.
Cost of goods sold (as above) 49000
Add: Adm. expenses 12000
Add: Selling & distribution expenses 13000
74000
Total operating exp enses

(iii )Working Capital required 
No. of operating cycles in a year
74000
  Rs. 31425
2.3548
(iv) Working Capital required
Rs. 31425
+ 5% Reserve for Rs. 1571
Contingencies Rs. 32996
4. Forecasting Net Current Assets Method : It’s a method which is also recommended by Tondon
Committee for computing working capital requirements. In this method of forecasting first of all, estimate of
stock of raw materials, estimated value of work-in-process, estimated value of stock of finished goods,
amount receivable from debtors and others and estimate minimum cash balance required to Meet-day-to-
day payments required. Then also estimate outstanding payment for material, wages, and other adm. ex-
penses. Now, difference between forecasted amount of current assets and current liabilities gives net work-
ing capital requirements of the firm. A flat percentage may be added in this amount of provision for contin-
gencies.
A specimen of calculating working Capital requirements in given below :
Statement Showing Estimated Working Capital Requirements
Rs.
Amount
(A) Current Assets : -

(i) Stock of Raw Materials (for....... months consumption)
(ii) Work-in-process (for.........months)
(A) Raw-materials
(B) Direct wages - -
(C) Overheads -
(iii) Stock of finished goods (for......... months)
(A) Raw Materials
(B) Direct Wages -
(C) Overheads
(iv) Receivables (for........ month’s sales)
(A) Raw Materials
(B) Direct wages -
(C) Overheads -
(v) Payment in advance (if any) -
(vi) Cash - balance required -
(vii) others (if any)
(B) Current Liabilities :
(i) Creditors (for....... months purchase of Raw Material)
(ii) Lag in payment of expenses (outstanding Exp...... months) -
(iii) others (if any) -
Net working Capital (A-B) -
Add : Provision for contingencies -
Working Capital required
Notes :
1. While preparing above statement there are two approaches : (A) Total approach : In this method all
cost including depreciation and profit margin are included (B) Cash cost approach : under this
approach depreciation is excluded from cost of production. The profit margin is also not consid-
ered while calculating investment in receivables, i.e. debtors are valued at cash cost of sales, which
includes adm., selling and distribution expenses.
2. Investment in work-in-process is calculated on the assumption that material is input in the beginning
of the process, where labour and overhead should be introduced for half the process time, hence on
the assumption that wages and overhead should be evenly spread during the production.
3. Students are advised to write specific assumption which student used while solving the problem.
4. Normally, debtors, are calculated on cash cost basis.
We can learn this method from the following example:
Illustration 4 : X Ltd. plans to sell 60000 units next year. The expected cost of goods sold is as follows:
Rs. Per unit
Raw Material 100
Manufacturing expenses (including wages) 30
Selling, Administration Expenses 25
Selling Price 200
The duration of various stages of the operating cycle is expected to be as follows :
Raw Material 2 Months
Work-in-progress 1 Months
Fiished goods 1 Months
Debtors 1 Months
Assuming sales are evenlyspread over throughout the year, wages and overhead are evenly incurred. It is
also assumed that a minimum Rs. 50000 cash balance is desired. The company enjoys a credit of 1/2 month
on its purchases. Workout net working capital requirement for next year.
Solution :
Statement of Working Capital requirements
Rs.
Amount
(A) Current Assets : 1000000

(i) Raw Materials (2 months)
(5000 X 100 X 2)
(ii) WIP (1 month) 575000
Raw Material (5000 X 100 X 1) 500000
Manufacturing Expenses (5000 X 30 X 1/2) 75000
(iii) Finished goods (1 month) 650000
Raw Material (5000 X 100 X 1) 500000
Manufacturing Expenses (5000 X 30 X 1) 150000 775000
(iv) Debtors (1 Month) 50000
(5000 X 155 X 1)
(v) Cash balance
(A) 3050000
(B) Current Liabilities
Creditors (1/2 months)
(5000 X 100 X 1/2) 250000
Net Working Capital required. 2800000
Working notes :
1. It is assumed that all sales and purchases are on credit.
2. Debtors are calculated on the basis of cash cost of sales.
5. Projected Balance Sheet Method: In this method, estimates of different assets (excluding cash) and
liabilities are made, with taking into consideration the transcations in the ensuing period. After that, a “Pro-
jected Balance Sheet is prepared on the basis of these forecasts. If the total of assets side is more than the
total of liabilities side, then it indicates the deficiency of working capital which is to be collected by the
management either taking bank loan or from other sources. On the contrary, if total of liabilities side is more
then total of assets side than it represents cash balance available to the firm. Such surplus cash may invest
outside the business or as management plans for it.
This method is not a popular method and calculations made through this method are not more scientific.
7.8 Summary
 Working Capital is that part of the total Assets of the business that changes from one form to
another form in the ordinary course of business operations.
 Gross working capital means the sum of the current assets of the business.
 Net working capital is the difference between current assets and current liabilities of the business.
 The time required to complete the sequence of business events starting from cash raw material
work-in-process finished goods debtors cash is called as operating cycle or working capital cycle.
 As per Balance-Sheet concept Working Capital is classified as Gross Working Capital and Net
Working Capital.
 Inadequate working capital as-well-as excessive working capital is disastrous for the business.
 A Corporation can preserve its image with meeting all the expenses and liabilities promptly and take
care for emergency needs, if its hold adequate working capital.
 Return on investment will reduce if a Corporation have excessive or redundant working capital.
 There are so many factors which should be considered for determination of working capital.
 Most popular method for estimating Working Capital requirement is forecasting Net Current
Assets Method

1. Explain the concept of working capital.
2. What are the types of working capital ? Explain it
3. What are the determinants of working capital ?
4. “Profitability of the business also depends upon working capital”. Explain the statement.
5. “Excessive working capital is harmful for the business”. Explain the statement.
6. From the following information, calculate the estimated working capital by using regression
analysis method.
Year Sales Working Capital
2005-06 55 20
2006-07 75 30
2007-08 100 40
2008-09 130 50
2009-10 170 60
7. Compute operating cycle period from the following informations, taking 365 days in a year.
Rs.
Average Stocks :
Raw Materials 30000
Finished goods 25000
Total production cost (excluding depreciation Rs. 10000) 960000
Raw Material consumption 400000
Average debtors 45000
Total Cost of sales (excluding depreciation Rs. 10000) 1100000
Sales 1600000
Average period allowed by Suppliers : 15 days
8. You are required to calculate estimated working capital from the following information:
1. Level of activity 5000 units
2. Elements of cost
Raw Materials Rs. 8 per Unit
Direct wages Rs. 2 per Unit
Overheads (excluding dep.) Rs. 6 per Unit
Selling price Rs. 20 per Unit
3. Raw materials are in stock on an average one month.
4. Credit allowed by creditors is one month.
5. Materials are in process, on an average half a month.
6. Credit allowed to debtors is 3 months.
7. Lag in payment of wages in one week.
8. Assume 52 weeks in a year and 4 weeks in a month.
9. Expected bank balance required to Rs. 7000.
10. It is assumed that the production is carried on evenly during the year, wages and
overheads accrue similarly.
9. Calculate working capital requirements by using operating cycle method:
Stocks: Opening Clo sing
Rs . Rs.
Raw Material 2000 0 26 000
Work-in -p roces s 1200 0 16 000
2000 0
Finished go od s 24 000
Purchases (all credit) 140 000
Cost of goo ds s old 200 000
Sales (all Cred it) 240 000
Debto rs 40 000
16 000
Cred ito rs
Assume 3 60 d ays in a year.

- Khan, Jain : Management Accountancy
- S.N. Maheshwari : Management Accountancy
- Saxena, Vasistha : Management Accountancy
- Agrawal, Agrawal : Management Accountancy
Unit - 8 : Management of Inventories
Structure of Unit:
8.0 Objectives
8.1 Introduction
8.2 Meaning of Inventory and Inventory Management
8.3 Objectives of Inventory Management
8.4 Benefits of Holding Inventory
8.5 Factors Affecting Level of Inventory
8.6 Risk and Costs Associated With Holding Inventory
8.7 Techniques of Inventory Management
8.8 Summary
8.9 Keywords
8.0 Objectives
After Studying this unit you should be able to:
 Understand the concept of inventory management.
 List out various objectives for holding inventories.
 Identify the factors affecting investment level in inventory.
 Pin point risk and cost associated with holding inventory.
 Explain re-ordering, physical verification systems of inventory management.
 Determine stock levels, reorder point and economic order quantity.
 Use selective inventory management techniques like ABC,VED etc.
8.1 Introduction
The role of capital is crucial in this increased pace of industrialization. The capital raised by a firm is invested
in fixed assets and current assets for carrying on its activities. Inventory constitutes the largest portion of
current assets. As such, inventories are a vital element in the efforts of the firm to achieve desired goals.
The concept of inventory management has been one of the many analytical aspects of management. It
involves optimization of resources available for holding stock of various materials. Excessive inventory
leads to unnecessarily blockage of funds, resulting decreased profit. On the other hand, lack of inventory
not only impairs the profitability but also results in interruption in production and causes inefficiencies. Often
one is inclined to agree with the observation that "when you need money, look at your inventories, before
you look at your banker.' Even, if there is no shortage of funds in a business the financial manager has to
participate actively in the formulation of inventory policies with a view to speeding inventory turnover ratio
and maximising return on investment.
8.2 Meaning of Inventory and Inventory Management

Inventories are resources of any kind having an economic value.
S.E. Bolten defines it as "The term 'Inventory' refers to the stockpile of the product, a firm is offering for sale
and the components that make up the product."
The Accounting Research and Terminology Bulletin defines the term inventory as "The aggregate of those
items of tangible personal property which;
(a) are held for sale in the ordinary course of business,
(b)are in the process of production for such sales or
(c) are to be currently consumed in the production of goods or services to be available for sale."
ICMA defines it as "The function of ensuring that sufficient goods are retained in stock to meet allrequirements
without carrying unnecessarily large stocks."
The following items are included in inventory:
1. Raw Materials:- These are goods that have not yet been committed to production in a manufacturing
firm i.e. stored for use in future production.
2. Works-in-Progress:- This category includes those materials that have been committed to the
production process but have not been completed at the end of a financial year. Thus, these are
neither raw materials nor finished goods.
3. Finished Goods:- These are completed products awaiting sale. For a trading concern inventory
always means finished goods, while for a manufacturing firm they are the final output of the production
process.
4. Consumables and Stores:- Loose tools, cotton, lubricant, oil, grease etc. which are required for
running and maintenance of plant and machineries are called consumables and stores. Though these
are not held for sale, but have significant importance.
The problems of managing inventories in manufacturing enterprises are relatively complex.
Inventory Management:- The area of inventory management covers the following individual phases:
determining the size of inventory to be carried and lot sizes for new orders, establishing timing schedules and
procedures, ascertaining safety levels, providing proper storage facilities, co-ordinating inventory policies
with sales and production, arranging the procurement and disbursement of materials, record keeping, assigning
responsibilities for carrying out the inventory control functions and providing necessary reports for supervising
the overall activity. Within these individual phases acquisition, Unit/physical control i.e. material handling
and production related decision are made by persons within purchasing and production departments. The
financial executive is only one of the persons in top management who is concerned with the levels and
fluctuations of investment in inventories. He is concerned with any aspect of inventory management that is
controllable from the stand point of reducing inventory costs and risks. This is also called value control.
As per Gordon B. Carson, "Inventory control refers to the process by which the investment in materials and
parts carried in stock are regulated within pre-determined limits set in accordance with the inventory policy
established by the management".
Thus, inventory management refers to a system which ensures the supply of required quantity and quality of
inventory at the required time and at the same time prevents unnecessary investment in inventories.
8.3 Objectives of Inventory Management

Reducing inventories without impairing operating efficiency frees working capital that can be effectively
employed elsewhere. The aim of a sound inventory management system is to secure the best balance
between "too much and too little." Too much inventory carries financial burden and too little reacts adversely
on continuity of productions and competitive dynamics. The real problem is not the reduction of the size of
the inventory as a whole but to secure a scientifically determined balance between several items that make
up the inventory. Thus, Inventory management should strike a balance between excess inventory and too
little inventory. The primary objects of inventory management are-
I. to minimize wastage and losses of material in course of purchase, storage, handling and uses,
II. to achieve maximum economy in purchasing and inventory holding,
III.to make minimum investment in working capital by forecasting the demand and production in advance,
IV.to ensure uninterrupted flow of materials of the right quality for continuous production,
V. to provide better service to customers by maintaining an adequate inventory level.
8.4 Benefits of Holding Inventory

Primarily, inventory is held for transaction purposes. Today's inventory is tomorrow's consumption. An
enterprise cannot ensure uninterrupted production unless it maintains adequate inventory of raw materials.
By holding inventories the firm is able to separate the processes of purchasing, producing and selling. By
doing the separation of these functions, the firm realizes a number of specific benefits:-
1. Avoid Losses of Sale:- Inadequate inventory may disturb the production function and resulting
the firm may not be in a position to deliver the goods within the scheduled time to its customers and
it may lose customer forever. The ability of the firm to give quick service and to provide prompt
delivery is closely tied to the proper management of inventory.
2. Gaining Quantity Discounts:- If a firm is willing to maintain large inventory in selected product
lines, it may be able to make bulk purchases of goods at heavy discount. Suppliers frequently offer
a greatly reduced price if the firm orders double or triple of its normal order. By paying less for its
goods, the firm can increase profits, as long as the costs of maintaining the inventories are less than
the amount of the discount.
3. Continuity in Production:- Inadequate inventory may cause production interruption and
inefficiencies . It is very difficult to procure raw material whenever it is needed. If the firm has
scheduled a long run and begins production, only due to shortage of a vital raw material, the production
may be halted at considerable cost to the firm. So it is necessary to maintain an adequate level of
inventory to continue the production process without any interruption.
4. Low Ordering Cost:- Every time a firm places an order it incurs certain costs. The variable cost
associated with individual orders can be reduced if the firm places a few large rather than numerous
small orders.
5. To Meet Contingencies:- Inventory is also held as a precaution or as a contingency for increase
in lead time or consumption rate. This increase may be due to suppliers strike, labour strike,
transporters strike, short supplies or bulk orders etc.
6. Optimum Utilization of Resources:- In a manufacturing concern production planning can be
done with an object to have optimum utilization of resources namely men, machines and materials.
This objective can be achieved only if we hold sufficient inventory.
8.5 Factors Affecting Level of Inventory

As stated above, a firm should maintain its inventory at reasonable level. There are different factors, which
determine the level of inventory, the important among them are as follows.
1. Nature of the Product:- The nature of the product greatly affect the quantity of inventory, like in
case of perishable and fashion goods. It is not feasible to store large quantity. If the firm deals in
such type of products for which raw material is available only in a particular season, then the
organisation has to invest a huge fund in the season.
2. Nature of Business:- If the business deals with luxury and consumer products, then it may maintain
lower level of inventory. But if it deals with industrial goods it has to maintain a higher level of
inventory.
3. Terms of Purchase:- If supplier provides heavy discount and liberal credit facilities on bulk purchase,
then firm may maintain high level of inventory. Similarly, if supply conditions are favourable, no
disturbance in supply chain then inventory level can be low, but in adverse condition or uncertainty,
firm should main high level of inventory.
4. State of Economy:- In case of booming economy, firm will maintain high level of inventory to grab
the high chances of emerging large orders and vice-versa.
5. Inventory Turnover Rate:- When the turnover rate is high, investment in inventories tends to be
low and vice-versa.
6. Value of the Product:- In case of high value product, firm cannot afford to have large inventory. In
case of low value products, firm can keep large quantities in stock.
7. Attitude of Management:- Conservative management does not bother much in forecasting, demand
and consider it safer to carry large stocks, while energetic or dynamic manager decides this by using
advanced techniques of forecasting.
8. Other Factors:- Many other factors like market structure, fluctuations in price level, availability of
funds, government policies, period of operating cycle etc. also affect the level of inventories.
8.6 Risk and Costs Associated With Holding Inventory

When a firm holds goods for future sale, it exposes itself to a number of risks and costs. Inventories
constitute a large percentage of the total cost. Inventory management is one of balancing tactics of various
costs so that the total cost can be minimized. These costs are as follows;
1. Material Cost:- These are the cost of purchasing the goods plus transportation and handling
charges. This may be calculated by adding the purchase price, the delivery charges and the sales tax
charged by the supplier (if any).
2. Cost of Ordering:- It is the cost of placing an order and securing the supplies. The ordering cost
is of variable nature and increases in proportion to the number of orders placed but has negative
relation with level of inventory. It includes the following;
 Preparation of purchase order.
 Documentation processing costs.
 Costs of receiving goods(Inspection and handling).
 Quality analysis expenses.
 Transport costs.
 Addition costs of frequent or small quantity order, rejecting faulty goods.
 Follow up costs.
 Where goods are manufactured internally, the set up and tooling costs associated with each production
run, which is also known as 'set up cost'.
3. Cost of Holding or Carrying Inventory:- These are the expenses of storing goods. Once the
goods have been accepted, they become part of the firm's inventories. It comes around 30% of the
total inventory cost in most of the industrial undertakings. Cost of carrying stocks includes the
following:
 Storage costs (rent, lighting, heating, refrigeration, air conditioning etc.)
 Stores staffing, equipment maintenance and running costs.
 Material handling costs.
 Capital cost and opportunity cost.
 Accounting, audit, stock taking or perpetual inventory costs.
 Product risk costs (deterioration and obsolescence)
 Insurance and security costs.
 Pilferage, damage and theft cost.
4. Under Stocking Costs:- It is the penalty incurred to the concern on account of the inability to meet
the demand in time. It includes the following:
 Loss of goodwill.
 Loss of profit due to reduction in sales.
 Machine and man hours lost due to unavailability of materials.
 Loss of future sales because customers go elsewhere.
 Compensation payable on account of non- fulfilment of orders.
 Extra costs associated with urgent purchases.
5. Over Stocking Costs:- In situations where disproportionate amount of funds are invested in
inventories, excessive borrowing or financing would be required. It increases interest expenses and
reduces profits. It also involves increase in associated costs like opportunity, obsolescence, loss
due to decline in prices etc.
The costs of ordering opposes the cost of carrying while the under stocking costs opposes overstocking
costs. If these costs operate in the same direction, there will be no inventory problem. The under stocking
and overstocking costs, help an industrial unit to determine the service level that has to be maintained for the
inventory. The costs of ordering and the cost of carrying enable us to optimize on the number of orders and
the quantity of inventory to be ordered.
8.7 Techniques of Inventory Management

Designing a sound inventory management system is a large pre-requisite for balancing operations. Reducing
inventories without impairing operating efficiency frees working capital that can be effectively employed
elsewhere. Various techniques applied for inventory management are as follows:
1. Reordering systems
(a) Two bins system
(b) Order cycling system
(c) Min max system
2. Physical verification systems
(a) Continuous stock taking
(b) Periodic stock taking
3. Accounting systems
(a) Perpetual inventory system
(b) Establishment of system of budgets
4. Inventories control ratios
(a) Input output ratio
(b) Inventory turnover ratio
5. Setting of various stock levels
6. Economic order quantity
7. Selective inventory control techniques
1. Reordering Systems
(a) Two Bin System: Bin means the drawer, almirah or other place of keeping the goods. Under
two bin system, each item of material is stored in two bins and material is continuously issued from
one bin until the stock of materials is emptied in that bin. Then material from the second bin is started
using and action will be taken to replenish the materials in the first bin. The material in the second bin
will be sufficient enough until the fresh delivery is received. The major advantage of this system is
that stock can be kept at a lower level because of the ability to re-order whenever stock fall to a
low level, rather than waiting for the next re-order date.
(b) Order Cycling System: In case of this system the review of materials in hand is undertaken
periodically. If the review discloses that stock of a particular material will last before the next review
date keeping in view of its consumption rate, an order for replenishment of that material is made
immediately. The review period differs from material to material. Critical items of stock have a
shorter review period; on the other hand less critical stock items will have a larger interval. This
technique is also called as periodic order system.
(c) Min Max System: According to this plan, for every material two levels are fixed (i) minimum
level and (ii) the maximum level. The minimum level functions as the re-order point. As soon as the
stock of material comes down to minimum level a new order is placed for quantity which will bring
it to the maximum level. This method is one of the oldest methods of materials control. It is very
simple to operate and easy to understand.
2. Physical Verification Systems
(a) Continuous Stock Taking: Under this system, physical stock verification is made for each
item of stock on continuous basis. It is physical checking of the stock records with actual stock on
continuous basis. It is a method of verification of physical stock on a continuous basis instead of at
the end of the accounting period. It is a verification conducted round the year, thus covering each
item of store twice or thrice. Valuable items are checked more frequently than the stocks with lesser
value.
CIMA defines "Continuous stock taking is the process of counting and valuing selected items at
different times on a rotating basis."
The main benefits of this technique are that day to day work is not disturbed, discrepancies, irregularities
or changes are detected at early stage. Thus it acts as an effective deterrent to malpractices.
Continuous stock taking is not, however without disadvantages. It imposes regular strain on the
stores staff and unless carried out very carefully, may lead to misplacement of materials.
(b) Periodic Stock Taking:- Under this system the stock levels are reviewed at fixed intervals e.g.,
at the end of every month or three months. All the items of stocks in the store are reviewed periodically.
CIMA defines periodic stock taking as "a process where by all stock items are physically counted and then
valued". The aim of periodic stock taking is to find out the physical quantities of materials of all types are
physically counted at a given date.
3. Accounting Systems:
(a) Perpetual Inventory System: Basically it is a method of accounting for inventory. Under this
system inventory records are maintained in such a way that it can show the balance of the stock
after each receipt and issue. Bin cards and stores ledger are used under this system.
CIMA defines perpetual inventory system as "the recording as they occur of receipts, issues and the
resulting balances of individual items of stock in either quantity or quantity and value".
The main benefit of this system is that every time we have updated record of inventory and the
checking and verification is done at any time without disturbing the normal function.
It is worthwhile to mention the difference between perpetual inventory system and physical verification
system. Under the perpetual inventory system only balances are updated on concurrent basis while
in the physical verification system the inventory is physically verified and checked with the actual
balances drawn from the stores ledger.
(b) Establishment of Systems Of Budgets: To control investment in the inventories, it is necessary
to know in advance about the inventories requirement during a specific period usually a year. Under
this technique estimates are prepared regarding the requirement of various material and on the basis
of these estimate budget is prepared. Such a budget will discourage the unnecessary investment in
inventories.
4. Inventory Control Ratios: Inventory control ratios also play a vital role in controlling the inventory.
The ratios work as a comparison tool. The various ratios are as given below:
(a) Input Output Ratio:- This ratio indicates the relation between the quantity of material used in
the production and the quantity of final output. This acts as a performance indicator of a particular
production centre.
Input Units
Input output ratio = x 100
Output Units
(b) Inventory Turnover Ratio: This ratio indicates the movement of average stock holding of
each item of material in relation to its consumption during the accounting period
Cost of materials consumed

Inventory Turnover ratio =
Costs of average stock held during the period
Days during the period

Inventory Turnover ratio (in days) =
Inventory turnover ratio
Stock turnover figures may reveal the following types of stocks:
I. Fast Moving Stock: These are materials which are in great demand. An attempt should be
made to keep these materials in stock at all the times.
II. Slow Moving Stock: These are materials which have a low turnover ratio. Thus inventory of
such materials should be maintained at very low level.
III. Dormant Stock: Materials which have no demand are classified as dormant stocks. The
purchase officer, the store-keeper, the production controller and cost accountant should sit together
to decide whether to retain these materials because of good chance of future demand or to decide
whether demand or to cut losses by scrapping the materials while they may have some market
value.
IV. Obsolete Stock: These are materials which are no longer in demand because a better substitute
has been found. These materials should either be scrapped or discarded.
Other ratio like inventory as a percentage of current assets, total assets are also useful.
5. Setting of Various Stock Levels: Various stock levels are fixed for effective management of
inventories. These levels serve as indices for initiating action on time so that the quantity of each item
of inventory is controlled.
" Re-Order Level:- Re-order level is the level of stock availability when a new order should be
raised. The stores department will initiate the purchase of material when the stock of material reaches at this
point. This level is fixed between the minimum and maximum stock levels. The re-order level can be determined
by applying the following formula:
Re-Order level= (Maximum consumption rate x Maximum re-order period)
Or
Re-order level= (Lead time x Usage rate per day) + Safety stock
While deciding this level (i) the rate of consumption of the material, and (ii) the time required in receiving the
supply are kept in mind. Re- order level is the determined so much above the minimum stock level that by
the time new stock is received, if the material is consumed at the normal rate, actual stock in the store may
not go below the minimum stock level.
 Minimum Stock Level: Minimum stock level is the lower limit below which the stock of any stock item
should not normally be allowed to fall. This level is also called safety stock or buffer stock level. The main
object of establishing this level is to protect against stock- out of a particular stock item. The following two
points are kept in view while determining the minimum stock level:
(a) Time Required for Receiving Fresh Stock: After order for purchase of some item is placed
it takes some time in receiving the goods. If this time is more, the minimum stock level should be
kept more; and if the time taken is less, minimum stock level will also be kept low.
(b) Rate of Consumption of the Material: If a material is consumed in large quantity per day, its
minimum stock level has to be kept higher. If the consumption per day is in small quantity, its
minimum stock level is kept low.
Minimum stock level is computed by using following formula:
Minimum stock level = Re-order level - (Normal consumption rate x Normal re-order period)
Or
Minimum stock level = Usage rate per day x Days of safety
 Maximum Stock Level:- Maximum stock level represents the upper limit beyond which the quantity
of any item is not normally allowed to rise to ensure that unnecessary working capital is not blocked
in stock items. The maximum level of stock is fixed after due consideration of the storage costs of
holding excessive stock, cost of insurance, cost of obsolescence, risk of deterioration, cost of
capital, time required in receiving fresh stock and average rate of consumption. It represents the
total of safety stock level and economic order quantity. It is computed by the following formula:
Maximum stock level = (Re-order level + Re-order quantity) - (Minimum consumption rate x
Minimum re-order period)
Or
Maximum stock level = Economic order quantity + Safety stock
 Average Stock Level:- Average stock level is obtained by adding the minimum and maximum
stock levels and diving the sum by two.
Average stock level = (Minimum stock level + Maximum stock level)/2
Or
Average stock level = Minimum stock level +1/2 Re-order quantity
 Danger Level:- Danger level of stock is fixed below the minimum stock level and if stock reaches
below this level, urgent action for replenishment of stock should be taken to prevent stock out
position.
Danger Stock level= Minimum rate of consumption x Minimum re-order period.
Illustration 1: In a factory components A and B are used weekly as follows:
Normal Usage 50 units
Maximum Usage 75 units
Minimum Usage 25 units
Re-order Quantity A= 300 units
B= 500 units
Re- order Period A= 4 to 6 weeks
B= 2 to 4 weeks
Calculate for each component:
(i) Re-order Level
(ii) Maximum Stock Level
(iii) Minimum Stock Level
Solution: Calculation of various stock levels
(1) Re- Order Level = ( Max. Usage x Max. re-order period)
Component A = (6 x 75) = 450 units
Component B = (4 x 75) = 300 units
(2) Maximum Stock Level = (Re-order level + Re-order quantity) - (Minimum
consumption rate x Minimum re-order period)
Component A = (450+300) - (25 x 4)= 650 units
Component B = (300+500) - (25 x 2) =750 units
(3) Minimum Stock Level = Re-order level - ( Normal Usage x Normal re-order period)
Component A = 450 - (50 x 5) = 200 units
Component B = 300 - (50 x 3) = 150 units
6. Economic Order Quantity:- The economic order quantity refers to the order size that will result is
the lowest total of order and carrying costs for an item of inventory. If a firm places unnecessary
orders, it will incur unneeded ordering cost. If it places too few orders, it must maintain large stocks
of goods and will have excessive carrying cost. So it is clear that there is negative co-relation
between ordering cost and carrying cost. By calculating an economic order quantity, the firm identifies
the number of units to order that results in the lowest total of these two costs.
Assumption of economic order quantity:
 The rate of demand is known and sales occur at a constant rate.
 Lead time is constant and known.
 Stock holding costs not changes with time factor and are known.
 There is no price discount.
 Lead time is constant and known.
 Ordering costs are in proportion to number of orders.
 The replenishment is made instantaneously.
Economic order quantity can be determined by
(i) Algebraic method
(ii) Graphic method
(1) Algebraic Method:- Economic order quantity can be computed by using the following formula:
EOQ = √ 2AB/ CS
Here, EOQ = Economic order quantity
A= Annual consumption
B = Buying or ordering cost per order
C = Cost per unit
S = Storage or inventory carrying cost
Illustration 2: The annual usage of a refrigerator manufacturing company is 1,60,000 units of a certain
component. The order placing cost is Rs. 100 per order and the cost of carrying one unit for a year is 10%
of the cost per unit which is Rs. 80. Calculate the economic order quantity.
Solution:
EOQ = √ 2AB/ CS
= √2 x 1,60,000 x 100 /10% of Rs. 80
= 2,000 units
Illustration 3: From the following information find out economic order quantity-
1. Annual usage = 3,200 units
2. Price per unit : Rs. 30
3. Cost of placing an order : Rs. 100
4. Cost of working capital : 10 % per annum
5. Cost of rent, insurance, tax etc. per unit per annum: Re. 1
Solution:
EOQ = √2AB/CS
= √2 x 3,200 x 100 /4
= 400 units
Note:- Inventory carrying cost = Cost of rent, insurance etc.+ Interest
= 1+30*10%
= 1+3 = Rs. 4 per unit
(2) Graphic Method: The EOQ can also be calculated by graphic method. While using this method
various costs related to inventory like stock holding cost, ordering cost and total cost are plotted on Y axis,
while order size is plotted on X axis. The point at which total cost is minimum is EOQ. Total cost is minimum
at that point where the line of ordering cost intersects the line of carrying cost. The graphical presentation of
the behaviour of ordering cost and carrying cost can be illustrated as follows:
EOQ with Quantity Discount:- A particularly unrealistic assumption with the basic EOQ calculation is that
the price per item remains constant. Usually some form of discount can be obtained by ordering large
quantities. When a quantity discount is offered, three things can happen:-
(i) Reduction in the yearly acquisition cost of the item.
(ii) Increase in the cost of holding inventory as now a larger average inventory will have to be carried.
(iii) Decrease in ordering cost as now less orders will have to be initiated.
If the increase in carrying cost is less than, the savings due to ordering cost and quantity discount offered, the
order of large quantity ( more than EOQ) should be given.
Illustration 4: For one of the A class item the purchase manager spents Rs. 500 in procuring 1,000 units in
a single lot in a year and thereby avails a discount of 5% on the price of Rs. 10 per unit. No discount will be
given for any other order quantity. Inventory carrying charges work out to 40%. If he follows EOQ policy
what would be the gain or loss to the organisation?
Solution:
(a) = √2AB/CS
= √2 x 1,000 x 500 /4
= 500 units
Note:- No. of orders per year = 1,000/500 = 2 orders
(b) If 5% discount is availed
No. of orders = 1 order
product price = 10 - 5% of 10 = Rs. 9.5
Inventory carrying cost = 9.5 x 40/100
= Rs. 3.80
W ithout di scount Wi th 5 % discount
E OQ un its 50 0 1,00 0
O rd ering cost 2 x 500 = 1,00 0 1 x 500 = 5 00
carrying cost 0 (50 0/2) x 4 = 1,0 00 (1,00 0/2) x 3.8 = 1, 900
M aterial Purchase cost 1, 000 x 10 = 1 0,000 1,00 0 x 9 .5 = 9,5 00
T ot al co st 12 ,000 11,9 00
Suggestion: - If he follows EOQ, organization will bear a loss of Rs. 100 (12,000 - 11,900), so 5%
discount were be beneficial for the organisation.
7. Selective Inventory Control Techniques:- Effective inventory management requires understanding
and knowledge of the inventories and to gain this understanding some analysis and classification ofinventory
is required. Main selective inventory control techniques are as follow:
(a) ABC analysis: ABC analysis is a basic analytical management tool which enables top
management to place the effort where the result will be greatest. This is a rational approach for
determining the degree of control that should be exercised on each item of inventory. The technique
tries to analyse the distribution of any characteristics by stock value of importance in order to
determine its priority. This is also known as ' Always Better Control' techniques. Under this technique
the items in inventory are classified in three categories:
 Category A: In this category such items are selected which are comparatively costly and are
substantial in the cost structure. Number of such items is very small, but these items represent the
major portion of the total value of materials. Items selected in this group are very sensitive in nature.
 Category B: In this category those items of material are included which are less important and
less costly as compared to those included in group 'A'. Capital needed for purchase of these items
is neither too large nor too small.
 Category C: Items of the material in the store which have very low cost are included in this
category. Number of such items is large, but these represent a very small fraction of the total cost of
material. As the purchase of these items requires only a small capital, such items are purchased in
large quantity at a time.
Obviously, 'A' class items should be subject to strict management control under either continuous review or
periodic review with short review cycles. Constant attention is paid by purchases and stores management
i.e. no or very low safety stock is maintained, centralised and frequent purchase system is followed, rigorous
value analysis is done, efforts for minimisation of wastage are done etc. 'C' class items require little attention
and can be relegated down the line for periodic review. Control over 'B' class items should be somewhere
in between.
Clas sificati on of Invento ry
Category % of % of Co ntro l Requ ired Su perv isio n
item s v al ue
A 10% t o 5 0% to Strict con trol s ystem Top manag ement
15% 7 0%
B 25% 2 5% to Co ntinuou s watch o ver Midd le man agem ent
to 30% 3 0% invent ory
C 60% t o 1 0% to General co ntrol Lower management
65% 1 5%
The graphic presentation of ABC classification is as follows;
Note: The number ( percentage) are just indicative and actual break up can vary from situation to situation.
In inventory management, this technique has been applied in those areas which need selective control, such
as criticality of items, obsolete stocks, purchasing orders, receipts of materials, inspection, store keeping
and verification of bills. This approach helps the material manager to exercise selective control and focus his
attention only on a few items when he is confronted with lakhs of stores items. Many organisations those
adopted this technique have claimed that ABC analysis has helped in reducing the clerical costs and resulted
in better planning and improved inventory turnover.
Limitations: Though, ABC analysis is a powerful scientific and systematic approach in the direction of cost
reduction and saving time as it helps to control items with a selective approach. Some items though negligible
in monetary value, may be vital for smooth functioning of plant and constant attention is needed. For example
diesel, oil is categorised in class 'C' items in most of the manufacturing firms, will become the most high value
item during power crises. So, the results of ABC analysis have to be periodically reviewed and updated.
(b) VED Classification: This type of classification divides items into three categories in the decending
order of their criticality. Here 'V' stands for Vital items and their stock analysis requires more
attention, because out of stock situation will result in stoppage of production for example, needle
for the machine. Thus, 'V' items must be stored adequately to ensure smooth operation of the plant.
'E' means Essential items. Such items are considered essential for efficient running but without these
items the system would not fail but production capacity will be affected. Example, lubricant oil for
machine. Care must be taken to see that they are always in stock. 'D' stands for Desirable items
which do not affect the production immediately but availability of such items will lead to more
efficiency and less fatigue.
This technique is mainly used in the storage of spare parts and more suitable method for automobile
industries.
(c) FSND Classification: FSND classification divides the items into four categories according to
their material turnover ratio:
(i) F = Fast moving items. Stocks of such items are consumed in a short span of time.
(ii) N = Normal moving items. Normally such items are exhausted over a period of a year or so.
(iii) S = Slow moving items. Though moves slowly but it is still expected to be used up.
(iv) D = Dead items. The material which is dormant and obsolete covered under this category.
Stock of fast moving items must be observed continuously and replenishment orders be placed in
time to avoid stock out situations. The reorder level and quantities of slow moving items should be
based on estimate of future demand to minimize the risks of surplus stock. For dead items, efforts
must be made to find alternative uses. Otherwise, it must be disposed of.
(d) Just In Time (JIT) Approach: Under this technique, the material is purchased only when it is
required. The basic principle of this philosophy is to produce at each manufacturing stage, only the
necessary products at the necessary time in the necessary quantity to hold the successive in
manufacturing stages together. Thus efforts are made to maintain the stock at zero level. This technique
is also called as 'Zero Inventory Production System' or 'Material As Needed System'. The purpose
behind the technique is to eliminate waste not only the conventional form of waste such as scrap,
rework and equipment down time but also excess lead time over production and poor space
utilization.
(e) Value Analysis: This technique was developed by Lawrence D. Miles, to obtain optimum benefit
from materials. Value analysis investigation of material is usually carried out every year in order to-
(i) Minimize consumption.
(ii) Maximize the utilization.
(iii) Substitute indigenous materials for imported ones without sacrificing quality or
performance.
(iv) Substitute it with cheaper material. Value analysis aims at assessing the value of an items
and then enhancing it systematically.
(f) Other Techniques-
(i) HML Classification: To control purchases the material is classified into High, Medium
and Low value items depending on the unit price of material.
(ii) SDE Analysis: Materials can be classified according to their availability at the time of
procurement in Scarce, Difficult and Easy to obtain category. Lead time analysis and special
purchasing strategies can be used for scarcely available items.
(iii) Statistical Techniques: Operation Research (OR), Linear Programming (LP),
Programme Evaluation Review Technique (PERT) can be used by the manager for the
purpose of planning and control of inventory.
(iv) Application of Computers: The scope of application of computers in inventory
management is really immense. With the basic issues and receipts, documents billing, inventory
planning, material budgeting, inventory valuation, fixation of inventory levels can be efficiently
computerized. Moreover, if the manual and mechanized system has been properly designed,
the implementation of a computerized system will not pose any problem.
8.8 Summary
Inventory represents the major portion of the total current assets in most of the concerns. Every business
concern maintains some level of inventory, therefore it is important to manage and control the inventory for
smooth functioning of business. The basic problem of inventory management is to strike a balance between
the operating efficiency and the cost of investment and other costs associated with large inventories.
The greater the efficiency with which the firm manages its inventory, the lower the required investment in
inventory. The financial officer should pay attention to the following aspects of inventory management (a)
Action taken against imbalances of raw material and work in progress inventory that may limit the utility of
stocks of that item which is in shortest supply. (b) Production schedules as far as possible, should be firmly
adhered to for reducing inventory of raw materials and in progress goods. Any change should get early
notification. (c) Continuous efforts should be made to shorten the production cycle. (d) There should be
reasonable procurement lead time assumptions and safety stock levels. (e) There should be an efficient
system to dispose of goods that are unusable or obsolete for production. (f) Special pricing policy may be
required to move extremely slow moving finished items. Various techniques like two bin system, setting of
reorder point, fixation of stock levels, determination of economic order quantity, selective inventory
management techniques (ABC, VED, SDE, FSND etc.) can be used to maintain optimum level and control
of inventory. Thus inventory management helps to reduce inventory without any adverse effect on production
and sale.
8.9 Key Words

 Inventory Management: The function of ensuring that sufficient goods are retained for smooth
functioning of the business operations.
 Ordering Cost: The cost which is associated with the purchasing or ordering of material.
 Carrying Cost: The cost incurred for handling/ holding the material in stores.
 Lead Time: This is the time gap between placing of an order and the time of actual supply.
 Minimum Stock Level: The lowest figure of inventory balance, which must be maintained, so that
there is no stoppage of production.
 Maximum Stock Level: That quantity of material above which the stock of any item should not
generally be allowed to go.
 Re-order Level: It is the level at which fresh order should be placed for replenishment of stock.
 ABC Analysis: The system which exercises discriminating control over different items of stores
classified on the basis of the investment involved.
 Economic Order Quantity: The size of the order for the total of both ordering and carrying cost
is minimum is known as economic order quantity.
 Two Bin System: If items in one bin exhausts new order is placed and till the mean time quantity
from the other bin is used.

1. What is inventory management?
2. The major objective of inventory management is 'to minimise cash outlays for inventories'. Explain
how this can be achieved.
3. Write short notes on :-
(a) ABC analysis
(b) Just in time approach
(c) Double bin system
(d) Perpetual inventory system
4. What do you mean by 'Economic order quantity'? How is it determined?
5. How would you determine the optiomal order size when quantity discounts are available? Illustrate
your answer with a suitable example?
6. Discuss the selective inventory management techniques.
7. Explain the formulas of determination of minimum and maximum stock levels. What factors are
taken into account in fixing these limits?
8. Explain the concept of 'ABC analysis' as a technique of inventory control.
9. The average annual consumption of a material is 18,250 units at a price of Rs. 36.50 per units. The
cost of placing an order is Rs. 50 and the storage cost is 20% on average inventory. How much
quantity is to be purchased at a time.
Ans. 500 units
10. A company manufactures a special product which requires a component 'A'. The following detail is
available-
(i) Annual demand = 8000 units
(ii) Cost per unit = Rs. 400
(iii) Carrying cost = 20%
(iv) Cost of placing an order = Rs. 200 per order.
The company has been offered a quantity discount of 4% on the purchase of 'A' provided the order
size is 4000 components at a time.
You are required to
(a) Calculate the economic order quantity.
(b) Advise whether the company should avail quantity discount.
Ans . ( EOQ = 200 units; Not to accept the quantity discount)
11. The following information is supplied to you in respect of an item of stores.
Minimum usage = 50 units
Maximum usage = 150 units
Reorder quantity = 600 units
Reorder period = 4 to 6 weeks
You are required to ascertain.
(i) Reorder level
(ii) Minimum stock level
(iii) Maximum stock level
(iv) Average stock level
Ans. (Reorder level = 900 units; Minimum stock level = 400 units; Maximum stock level = 1300
units; Average stock Level = 850 units)

- Chandra, Prasanna - Financial Management : Theory and Practice, Tata Mcgraw Hills, New Delhi.
- Mehta, D. R. - Working Capital Management, Printice Hall, New Delhi.
- Agarwal, M. R. - Management Accounting; National Publishing House, Jaipur.
- Hampton, John J. - Financial Decision Making Concepts, Problems and Cases, Printice Hall, New
Delhi.
- Kuchhal, S. C. - Financial Management - An analytical and conceptual approach. Chaitanya,
Allahabad.
- Khan, Jain - Principals of Financial Management, Tata Mcgraw Hills, New Delhi
- Pandey, I. M. - Financial Management, Vikas, New Delhi.
- Chandra, Bose D. - Fundamentals of Financial Management, PHI Learning Pvt. Ltd., New Delhi.
Unit - 9 : Management of Cash and Marketable Securities
Structure of Unit:
9.0 Objectives
9.1 Introduction
9.2 Meaning of Cash
9.3 Motives of Holding Cash
9.4 Meaning and Objectives of Cash Management
9.5 Factors Affecting the Cash Requirement
9.6 Functions of Cash Management
9.6.1 Cash Planning and Control
9.6.2 Management of Cash inflows and Outflows
9.6.3 Determination of Optimum Level of Cash
9.6.4 Optimum investment of Surplus Cash
9.7 Cash Management Models
9.7.1 Baumol’s Model
9.7.2 Miller-Orr Model
9.8 Investment in Marketable Securities
9.9 Summary
9.10 Key Words
9.0 Objectives
The main objectives to study this unit are:
 To explain the reasons of holding cash.
 To describe the meaning and objectives of cash management.
 To explain the factors which affect the cash requirement.
 To discuss the techniques of cash planning and control.
 To focus on the management of cash collection and disbursement.
 To highlight the need for investing surplus cash in marketable securities.
 To understand cash management models to determine the optimum cash balance.
9.1 Introduction
Since cash is the medium of exchange, it is the most important component of working capital. Cash is the
basic input required to keep the organisation running on a continuous basis and the ultimate output expected
to be realised by selling goods and services. It can be compared to the blood in the human body which gives
life and strength to the body. Similarly, Cash keeps the organisation as a vital entity. The firm should keep
sufficient cash, neither more nor less. Cash shortage will disrupt the firm’s manufacturing operations while
excessive cash remaining idle will increase the cost without contributing anything towards the profitability of
the organisation and since cash is the most sensitive and fraud prone asset, there will be high chances of
embezzlement. Therefore, for smooth functioning and for higher profitability effective cash management is of
paramount importance. Apart from the fact that it is the most liquid current asset, it is the commondenominator
to which all current assets get converted eventually. This underlines the significance of cash management.
9.2 Meaning of Cash
Cash in the money which a firm can disburse immediately without any restriction. In cash management, the
term cash is used in both narrow and broad senses. In narrow sense, it includes coins, currency, cheques,
drafts held by the firm and demand deposits in its bank accounts.
In broader sense, it also covers near cash assets, i.e. marketable securities and time deposits in banks and
other financial institution. The word ‘cash management’ is, generally used for cash and near cash assets i.e.
for both type of assets.
Cash has the following characteristics : -
1. Cash itself does not produce goods or services. Interest can be earned by depositing or lending it
but it does not earn any profit like other assets. So it is called an unproductive asset. Shortage of
cash is likely to harm the operations of a firm.
2. Every business needs to show a minimum cash to carry its business activities. If busines does not
show sufficient cash balance, it will not be able to pay its creditors on time. This may be called
critical level of cash.
3. Cash is a medium of exchange and plays an important role as most of the transactions involve flow
of cash funds.
4. Deploying extra funds always involves opportunity cost. Therefore, excess cash should be invested
in a profitable way to yield something in the form of interest and dividend rather than remaining idle.
9.3 Motives of Holding Cash

Although cash does not earn any substantial return for the business on its own, a firm holds cash byvirtue of
the following motives : -
a) Transaction Motives:Transaction motive is the most important reason for which cash balance is
maintained by a firm. This motive refers to the holding of cash for meeting the day-to-day transactions
of business. Firms hold cash to make the necessary payments for the goods and services they
require i.e. purchase of raw material, hiring of labour, repair and maintenance of fixed assets etc.
Similarly, there is a regular inflow of cash in the form of interest, dividend, cash sales, collection from
debtors etc.
The need to hold cash arises because cash receipts and cash payments do not coincide perfectly.
Sometimes cash receipts (inflows) exceed cash payments (outflows) or vice versa. So, the firm
should maintain adequate cash balance to meet its obligations when outflows exceed inflows,
otherwise firm will loose it’s reputation in the market. When cash is retained by a firm, it is said to
have been held for transaction motive. Thus, transaction motive refers to holding of cash to meet
anticipated obligations whose timings do not perfectly synchronise with cash receipts.
b) Precautionary Motives: The second motive of holding cash is to make the business to cope with
unforeseen contingencies. It provides a cushion or buffer to withstand some unexpected emergency.
“The cash balance held in reserve for random and unforeseen fluctuations in cash flow are called as
Precautionary Motive”.
Unexpected cash needs at short notices may arise as a result of:
a) uncontrollable situations like floods, droughts, fire, accidents, strike, lockouts etc.,
b) presentation of bill for settlement earlier than expected,
c) slow recovery of tradebills,
d) sheer rise in material and labour cost;
e) cancellation of some orders for goods on account of poor quality and
f) some penalty is imposed under some court orders.
The quantum of precautionary cash will depend upon the predictibility of cash inflows. Micheal
firth say’s, “the more uncertain the cash flows are, the greater the precautionary balances that have
to kept.” If a firm can borrow at short notice to pay the unforeseen obligations, it will need to
maintain a relatively small balance and vice-versa. Some times, a portion of such cash balance may
also be held in marketable securities to earn some return.
c) Speculative Motive: Speculative motive refers to the holding of cash to take advantage of
unexpected opportunities which may emerge suddenly. Sometimes firms hold cash balances above
the precautionary level of cash balance to ; (a) take advantage of speculative investment opportunities
(b) exploit discounts for prompt payment, (c) improve credit rating, (d) make purchases at reduced
price by paying immediate cash (e) delay the purchase in anticipation of decline in price.
while the precautionary motive is defensive in nature, the speculative motive represents positive and
aggressive approach.
“The speculative motive is the desire of the firm to take advantage of opportunities which present
themselves at unexpected moments or which are typically outside the normal course of business”.
In addition to above some firms have cash balance for compensation motive discussed as below.
d) Compensation Motive: Another motive to hold cash balance is to compensate banks for providing
certain free services like clearance of cheques, transfer of funds etc. and loans. Usually clients are
required to maintain a minimum balance in there accounts, which cannot be utilized by the firm for
transaction motives. The banks themselves can use the amount to earn a return. Such balances are
compensating balances.
e) Statutory Motive: This motive is applicable particularly in case of banking industry, where as per
the provisions of sec. 42 (1) of Reserve Bank of India Act 1935 and as per the provisions of sec.
18 of Banking Regulation Act 1949, all the commercial banks are required to maintain some minimum
amount of cash with themselves, with their branches and in a current account with RBI. If a bank
fails to meet the minimum cash reserve requirements, it will be levied with civil and criminal penalties.
9.4 Meaning and Objectives of Cash Management

Cash flows are inseparable parts of the business operations of firms. While inadequacy of cash disturbs the
functional schedule and payment which can cause the firms failure, excess of cash means blockage of funds,
which lowers the profitability of firm. Cash Management is a technique to plan and control of cash in such a
way that sufficient cash is always available to meet the obligations of the firms and excess balances, if any,
may invested to enhance profitability.
A cash management scheme therefore, is a delicate balance between the twin objectives of liquidity and
costs.
Objectives of Cash Management: The main objective of cash management is to trade-off liquidity and
profitability in order to maximise the firms value. The larger the cash balance, the greater the degree of
liquidity, the lesser will be profit earning capacity of the firm. Similarly, the lesser the cash balance and the
degree of liquidity, the more will be the profit earning capacity. So every firm needs optimum level of cash.
The basic objectives of cash management are : -
i to meet the cash disbursement needs as per the payment schedule,
ii) to minimize the cash balance.
iii) effective control of cash.
These are conflicting and mutual contradictory and the task of cash management is to reconcile them.
i) Meeting the Cash disbursement Needs: In the normal course of business firms need cash to
invest in inventory, pay to short term lenders and to make payment for operating expenses. If these
payment are not meet on time, the business operations may be disturbed.
Thus it is needless to say that all the business activities would remain stand still if proper payment
schedule is not maintained. The primary objectives of cash management is to ensure the meeting of
cash outflows or disbursements as and when required.
ii) Minimising Funds Locked Up as Cash Balances: Another objectives of cash management is to
minimise the amount locked up as cash balance because whatever cash balance is maintained, the
firm looses interest income on that balance. Therefore, investment in idle cash balance must be
reduced to minimum.
iii) Effective Control of Cash: Usually, the financial manager is confronted with two conflicting views.
On one hand, although the higher cash balance ensures proper payment which will prevent the firm
from bankruptcy or insolvency, will make good relations with suppliers, firms can bargain for discount,
but it also implies that large funds will remain idle as cash is a non earning asset and the firm will have
to forgo profits. On the other hand, if a firm keeps its cash balance at low level, it cannot meet its
payment schedule. The aim of cash management should be to try to have an optimum level of cash
by taking into account the above facts.
9.5 Factors Affecting the Cash Requirement

A firm must have so much of cash balance, that daily requirements and unexpected demands can be met
out. The factors affecting cash requirements and their effect on cash management are as follows:
1. Credit Position of the Firm: Firms with good and sound credit standing and goodwill need not to
maintain separate cash for unforeseen situations, as cash is available to such firms whenever needed.
They can get liberal credit facilities to purchase necessary material. On the contrary, firms with bad
credit position shall have to maintain high level of cash balance.
2. Relation With Banks: If firm has good relation with banks, it can get the facility of cash credit and
bank overdraft resulting less requirement of maintaining cash balance.
3. Terms of Purchase and Sale: Terms of purchase and sale also affect the level of cash balance. If
a firm has facilities to buy material on credit terms but sells its products on cash, it can operate its
business affairs with a little cash balance. On the other hand, if the firm makes purchases on cash
basis but sells its products to customers on credit terms, larger cash balance will have to be maintained.
4. Nature of Demand of Goods: If there is a steady demand of product in the market i.e. products
of day to day requirement (necessary items) and the product is sold for cash or for short credit
period, firm will need low level of cash. On the contrary, firm’s engaged in the production of luxury
items have to maintain high level of cash.
5. Inventory Policy: If high level of inventory is maintained by the firm, large amount is required for
this, while if a firm follows just in time inventory system, it need not to maintain large cash funds.
6. Production Process: Longer the production process, higher the requirement of cash balance but if
production process is short, the need of maintaining cash balance will be low.
7. Collection Period of Receivables: If, in a firm, speed of collection of accounts receivable is
quick, the cash will be available at all time, bad debts will be lower and, the firm is not required to
carry large cash balance. However, if collection period is large, high balance will have to be maintained.
8. Management Policy: Cash balance held by a firm also depends upon management policies and
attitude towards the liquidity preference, risk bearing capacity, sales and purchases policy, quantity
of investment and inventory etc. If the owners and managers of the firm want strict plans of cash
management, it can work with lower cash balance otherwise high balance will be required.
9. Matching of Cash Inflows and Outflows: The extent of non synchronization between cash inflow
and outflow determines the requirement of cash . Higher the degree of variance between cash
collection and disbursement, higher will be the requirement of cash and vice versa.
9.6 Functions of Cash Management

Management of cash is an important function of the finance manager. He should formulate strategies for the
following areas : -
9.6.1 Cash planning and Control
Cash planning is a process of predicting cash inflows and cash outflows of the firm so as to determine
surplus or shortage of cash. At times, a firm can have idle cash with it if its cash inflows are more than its
outflows. Such excess can be anticipated and properly invested if cash planning is resorted to. Similarly,
cash poor position can be corrected if the cash needs are planned in advance. Thus, cash planning is a
technique to plan and control the use of cash. This may be done on daily, weekly or monthly basis depending
upon the size of the firm and policies of management. Cash budget is the most significant tool for cash
planning and control.
a) Cash Budget: A firm should hold adequate cash balances but should avoid excessive balances.
The firms has therefore to assess its need for cash properly. “A cash budget is a statement showing
anticipated cash inflow, outflow and net cash balance for a future period of time”.
Cash budget is an important device to forecast the predictable discrepencies between cash inflows
and outflows over a projected time period. It is a summary statement which shows the estimated
cash inflows and cash outflows over the firms planning horizon. The time period for which cash
budget can be prepared depends upon the following points : -
i) Impact of seasonal variations on cash flows;
ii) Degree and pattern of fluctuations in cash flows, and
iii) Preciseness in prediction of cash flows.
A Cash Budget has the following benefits:
 It coordinates the timings of cash needs. It identifies the period(s) when there might either be a
shortage of cash or remain an abnormally large balance.
 It also helps to pinpoint period(s) when there is likely to be excess cash to take advantage like cash
discounts on its accounts payable, capital expenditure decision etc.
 Lastly it helps to plan/arrange adequately needed funds (avoiding excess/shortage of cash) on
favorable terms.
There are three methods to prepare the cash budget:
 Receipt and Payment Method.
 Adjusted Profit and Loss Account Method, and
 Projected Balance Sheet Method.

For short term (monthly, weekly, quarterly) cash budget, receipt and payment method is used while
for long term cash budget other methods can be used.
Methodology of preparing cash budget is explained in detail in the chapter - ‘Finacial Forecasting’.
With advance planning through cash budget firms get adequate time to take the necessary action for
borrowing and lending of cash on the terms which are most advantageous to the firm.
b) Cash Flow Analysis: A simple definition of a cash flow statement is - ‘a statement which discloses
the causes of changes in cash position between the two periods’.
As per ICWAI, “Cash flow statement is a statement setting out the flow of cash under different
heads of sources and their utilizations to determine the requirements of cash during the given period
and to prepare for its adequate provisions”. Thus along with changes in the cash position the cash
flow statement also outlines the reasons for such inflows or outflows of cash which in turn helps to
analyze the functioning of the business. Cash flow analysis is based on historical data while cash
budget is a technique for future estimation.
c) Ratio Analysis: Ratios like cash turnover ratio, cash flow coverage ratio, cash payment ratio are
also important techniques of cash planning and control.
9.6.2 Management of Cash Inflows and Outflows
After knowing the cash position with the help of cash budget, the management should work out the basic
strategies to be employed to manage its cash flows. So that there does not exist a significant deviation
between projected cash flows and actual cash flows. In the words of Van Horne, “Optimising cash availability
involves accelerating collections as much as possible and delaying payments as long as is realistically possible”.
The methods used for accelerating the collections and decelerating disbursements are as follows -
(A) Accelerating Cash Collections: In order to accelerate cash inflows, the collection from customers
should be prompt. The finance manager has to devise action not only to fraudelent diversion of cash
but also to speed up collection of cash.
A firm can conserve cash and reduce its requirements for cash balances if it can speed up its cash
collections by issuing invoices quickly or by reducing the time lag between a customer pays bill and
the cheque is collected and funds become available for the firm’s use i.e. first of all customers should
be encouraged to make the payments as early as possible and secondly efforts should be made to
quickly process and collect the cheques and drafts deposited by the customers. There are basically
three tyeps of floats that create the difference : -
(i) Mail Float: The time gap between the postage of cheques / drafts by the debtors and the
receipt of the same in the firm is called mail or postal float.
(ii) Processing Float: Time taken in processing the cheque within the firm before they are deposited
in the bank due to lethargy of employees is termed as processing float.
(iii) Collection Float: The time difference between the cheque is deposited into the bank and its
actual realisation is called collection float.
Decentralised collection systems known as concentration banking and lock box systems can help
us to speed up collection of cash and in reducing the time involved in these floats considerably.
(a) Concentration Banking: A large firm operating over wide geographical areas can speed
up its collection by following a decentralised collection procedure. In concentration banking
the company establishes a number of strategic collection centres in different regions instead of
a single collection centre at the head office. Payments received by the different collection centres
are deposited with their respective local banks which in turn transfer all surplus funds to the
concentration bank of head office. The concentration bank with which the company has its
major bank account is generally located at the headquarters. Concentration banking is one
important and popular way of reducing the size of the float as it helps in -
i) Reduction of Mailing Time: Under the system of concentration banking, as the collection
centres themselves collect cheques from the customers and immediately deposit them in
local bank account, the mailing time is reduced. If collection centres are allowed to send
bills to the customers of their respective areas, the time required for mailing is less than the
bills are mailed from the head office.
ii) Reduction of Time Required to Collect Cheques: As the cheques deposited in the
local bank accounts are usually drawn on banks in that area, the average collection period
also comes down.
iii) Expediting Collection of Cash: The system of concentration banking also helps in
quicker collection of cash as it reduces the size of deposit float.
Thus, in case of business organisations having large number of branches located at different
places all over the country, this system helps a lot in the quick collection of money. Under this
method, the firm will have to bear additional costs for establishing collection centres in different
areas. Therefore, the criterion for adopting this system of concentration banking is that saving
or benefits from this should exceed the cost of using this system. Generally, this system may be
beneficial for firms having large business and scattered customers.
(b) Lock - Box System: Lock-box system is another step in expediting collection of cash.
Lock-Box is a post office box maintained by a firm’s bank that is used as a receiving point for
customer remittance. Collection centre and its actual depositing in the local bank account.
Under lock-box system, the firm hires a post-office box and instructs its customers to mail their
remittances to the box. The firm’s local bank is given the authority to pick up the remittances
directly from the lock box. The bank collects from the box several times a day. It deposits the
cheques, clears them locally and credits the cash in the firm’s account. Local banks are given
standing instructions to transfer funds to the Head Office when they exceed a particular limit.
The local bank sends a deposit slip together with the list of payments and other enclosures to
the firm for proof, record and information after crediting the respective account of the firm.
The selection of the cities for lock-boxes depends upon the geographic coverage of business
area; number of customers in a particular area; frequency of receiving remittances from customers
and the cost of renting out and using post boxes. Lock box system in a sense, is like concentration
banking since the collection is decentralised. The only significant difference between the two is
that, under concentration banking system the customers send the cheques to the collection
centres, while under lock-box system, they send them to post-office box.
In a way, the lock box arrangement is an improvement over the concentration banking system
because one step in the collection process is eliminated with the use of lock box. This system
saves (i) processing time within the firm before depositing a cheque in the bank and (ii) the
cheques received in the lock box are not delivered by the post office or the firm itself to the
bank, rather, the bank itself picks them up saves this mailing time.
The following are the advantages of lock-box system : -
(i) It helps to eliminate the time lag between the receipt of cheques by a firm and their
deposit into the bank.
(ii) The system reduces the overhead expenses as the firm is free from botheration of receiving,
processing, endorsing and depositing remitted cheques.
Although, the use of lock-box system accelerates the collection of receivables, the set up of this
system involves cost as firms have to pay compensation to the bank for services. Therefore, the
lock-box system will prove useful and economical for large firms which receive a large number of
cheques from a wide geographical area.
(c) Minimum Number of Bank Accounts: Sometimes a firm may have more bank accounts and
we know it is the policy of banks to have some specified minimum balance in the account, resulting
blocking of some part of the cash in each such account. So, by closing the super flous accounts the
firm can release funds for investment in profitable channels.
(d) Other Methods: Some other methods for managing collection of cash are -
 Offering cash discounts so that in their anxiety to avail this facility, the customers would be
eager to make payments early.
What a customer has to pay, the period of payment etc. should be notified accurately and
in advance i.e. prompt billing.
Personal visit to customers for receiving cheques particularly of large amounts.
Control on inter-bank transfer of cash.
Setting a maximum limit of cash which each bank of the firm will maintain at a time. The
excess balance should be immediately transferred by wire to the principal bank of the firm.
(B) Slowing Disbursement: The operating cash requirement can be reduced by slow disbursement of
accounts payables. Slow disbursements represent a source of funds requiring no interest payments.
But this should not impair the credit rating or reputation of the firm. There are several techniques to
delay payment of accounts payable. Some of important method are as below : -
1. Centralised Disbursement Centre: The firm should follow the centralised system for
disbursements as against decentralised system for collections. Under centralised system, as all
payments are made from a single control account, there will be delay in presentation of cheques for
payment by parties who are away from the place of control account. Thus, the larger is the delay or
presentation of cheques for collection by the creditors the smaller bank balance will have to be
maintained by the firm.
2. Avoidance of Early Payments: According to the terms of credit, some credit period is allowed
to the buyers. The finance manager should try to control over the timing of payments so as to ensure
that bills are paid only as they become due. When a firm makes payment on due dates, it should
neither lose cash discount nor its prestige on account of delay in payments. Thus all payments
should be made on due dates, neither before nor after.
3. Playing the Float: It is a technical process by which a firm can make maximum utilisation of
cash. Float means the amount blocked in cheques issued but yet to be collected and encashed. In
other words, float is the difference between the balance shown in firm’s cash book (bank column)
and balance in the pass book of the bank. The difference between the total amount of cheques
drawn on a bank account and the balance shown on the bank’s book is caused by transit and
processing delay. For example, If the party is at some distant station then cheque will come through
post and it may take a longer period before it is presented. If the finance manager can accurately
estimate when the cheque issued will be deposited and collected, he can invest the ‘float’ during the
float period to earn a return. However playing the float should not result into loss of credit worthiness
of the firm.
9.6.3 Determination of Optimum Level of Cash
A business firm maintains the optimum cash balance for transaction and precautionary motives. This amount
will depend on risk return trade off. When the firm runs out of cash or it has low liquidity, then it will have
either to sell short-term securities or borrow cash. In both these situations, the firm has to bear transaction
cost. On the contrary, if firm maintains high level of cash balance, the opportunity to earn interest is lost. So,
the potential interest lost on holding large cash balance involves opportunity cost to the firm.
The optimal level of cash is determined by the trade-off between transaction cost and opportunity cost as
shown in the following figure:
Y
Point of Minimum
Total Cost t
s
To t Co
tal s ty
Co ni
Cost (Rs.)
tu
p or
Op
Transaction Costs
O P X
Level of Cash
Diagram
Figure - 9.1
It is clear from the above diagram that if the firm maintains large cash balances, its transaction cost will
decline but opportunity cost will increase or vice-versa. At point P the sum of the two costs i.e. total cost is
the minimum. This is the point of optimal cash balance which a firm should seek to achieve.
9.6.4 Optimum investment of surplus cash
Cash kept by the firm in excess of its normal need is called the surplus cash. Due to changing working
capital needs or unpredictable requirements the finance manager is required to consider the minimum cash
balance that the firm should keep to avoid the cost of running out of funds. This minimum level may be
termed as’Safety level of Cash’. Formula’s used for this level are :-
a) During Normal Periods: Safety level of cash = Desired days of cash x Average daily cash outflows.
b) During Peak Periods:Safety level of cash = Desired days of cash at the peak period x Average of
highest daily cash outflows Firm can breakup its surplus into these categories:
i) Surplus which is made available for meeting unforeseen disbursements should be invested in
assets which can be immediately sold without much loss.
ii) Surplus which is made available for some specific payments like dividend, capital expenditure
should be invested in securities whose maturities coincide with the date of payments.
iii) Surplus which is not required for any specific purpose like general reserve, can be invested in
securities with long term maturity and thus firm can earn more return. Having determined both the
temporary and permanent cash surplus and after considering the following factors, the finance manager
should decide the channels of investment : -
a) Safety: Safety in investment means absence of risk. The risk associated with a loss in
value of principal amount invested in marketable securities is the most important aspect of
selection process. Therefore, the firm should select those securities which have no risk of
default of interest or recovery of principal. The rule of selction of marketable securities is to
invest in less risky securities and be prepared to sacrifice extra return for the sake of safety.
b) Liquidy: Liquidy refers to the abiliy to transform a security into cash. To ensure liquidity,
the money should be invested in marketable (short term) securities including Government
treasury bills and short term fixed deposits with banks.
c) Maturity: Maturity refers to the time period over which interest and principal are to be
paid. The price of long-term securities fluctuates more widely with the interest rate changes
than the price of short term securities. Hence, long-term securities are relatively more risky.
Therefore, for safety reasons, the firm prefers to invest excess cash in short-term securities.
9.7 Cash Management Models

To help in determining optimum cash balance, several types of cash management models have been designed.
Out of such models, two of them are : (1) Baumol’s Model, i.e., optimum cash balance under certainty, and
(2) The Miller-Orr Model i.e., Optimum cash balance under uncertainty are quite popular.
9.7.1 Baumol’s Model : (Economic Order Quantity Model, 1952)
Baumol’s model, suggested by William J. Baumol, considers cash management similar to an inventory
management problem. It is a formal approach in determining a firm’s optimum cash balance under certainty.
According to this model, optimum cash level is that level of cash where the carrying costs and transactions
costs are the minimum. The carrying cost refers to the cost of holding cash (opportunity cost) namely, the
interest foregone on marketable securities. The transaction cost refers to the cost involved in getting the
marketable securities converted into cash. It can be understood by following diagram : -
CASH (Rs.)
C/2 AVERAGE
TIME
Figure - 9.2
For preparing the above diagram it is assumed that the demand of cash is steady for a given period
of time. During this period the firm can recover cash after selling the investments. Suppose opening cash
balance with firm is C and as and when this balance is spent on various expenses, the firm sells the investment
hence when cash balance becomes zero, the funds are transferred from investment to cash.
This optimum cash balance according to this model will be at that point, where these two costs are
minimum.
The formula for determining optimum cash balance is : -
2UP
C=
S
Here, C = Optimum cash balance

U = Annual or monthly cash disbursement
P = Fixed cost per transaction
S = Opportunity cost of holding cash (one rupee p.a. or p.m.)
The Baumol’s model has the following assumptions : -
i) The firm can forecast its cash requirement with certainty.
ii) Cash disbursement will be steady during a given period.
iii) The sequence of cash receipt and disbursement will continue to be the same.
iv) Whenever the firm converts its securities into cash, its transaction cost will be the
same.
v) The firm’s opportunity cost of holding cash is known and it is the same over time.
Illustration 1 : XYZ Ltd. estimates its total cash disbursement Rs. 12,60,000 for the next year. The firm
will have to incur Rs. 20 per transfer. Marketable securities yield 8% per annum. Determine the optimum
cash balance according to Baumol’s Model.
2UP
Solution : C=
S
2 x 1260000 x 20
C=
0.08
= Rs. 25100
Limitation of Baumol’s Model: The assumptions do not fit in practical environment. Practically cash
disbursements are found to be variable and uncertain and variance will be there in cash receipts and
disbursements during each month or days in a month. Transaction and opportunity cost also varies over
time.
9.7.2 Miller-Orr Model
Miller-Orr (MO) Model helps in determining the optimum level of cash when the demand for cash is not
steady and cannot be known in advance. MO model deals with cash management problem under the
assumption of random cash flows by laying down control limits for cash balances. These limits comprise of
(i) upper limit, (ii) lower limit, and (iii) return point. Setting of the control limits depend upon the fixed cost
associated with a securities transaction, the opportunity cost of holding cash and the degree of likely fluctuations
in cash balances. These limits satisfy the demands for cash at the lowest possible cost. The following
diagram illustrates the Miller-Orr Model :
h
UPPER CONTROL LIMIT
CASH (Rs.)
z
RETURN
POINT
o
TIME LOWER CONTROL POINT
Figure - 9.3
The MO Model is more realistic as it allows variations in cash balance within lower and upper limits.
Recent developments in Cash Management: Both technological advancement and desire to reduce
cost of operations has led to some innovative techniques in managing cash. Some of them are : -
a) Electronic Fund Transfer
b) Zero Balance Account
c) Petty Cash Imprest System
d) Virtual Banking
9.8 Investment in Marketable Securities

The marketable securities are the short-term money market instruments that can easily be converted into
cash, hence these are considered as a part of liquid assets.
Management of marketable securities is an integral part of investment of cash as this may serve both the
purposes of liquidity and cash. As the working capital needs are fluctuating, it is possible to park excess
funds in some short term securities, which can be liquidated when need for cash is felt.
The following short term investment opportunities are available to companies in India to invest their surplus
cash : -
1. Bank Deposits: All the commercial banks offer short-term deposit schemes at varying rates of
interest depending upon the deposit period. A firm having excess cash can make a deposit for even
a short-period of few days only. These deposits provide full safety, facility of pre-mature payment.
2. Inter-Corporate Deposits: A frim having excess cash can make a deposit with other firms also.
When a company makes a deposit with another company such deposit is known as ‘Inter-Corporate
deposit’. These deposits are usually for a period of three months to one year. Higher rate of interest
is an important feature of these deposits. However, these are generally unsecure and this lack of
safety is the main drawback of these type of short-term investments, but returns are quite attractive.
3. Treasury Bills: Treasury bills are short-term government securities. The usual practice in India is
to sell treasury bills at a discount and redeem them at par on maturity. The difference between the
issue price and the redemption price, adjusted for the time value of money is return on treasury bills.
These bills are highly safe investments and are easily marketable.
4. Bill Discounting: A frim having excess cash can also discount the bills of other firms in the same
way as commercial banks do. On the maturity date of the bill, the firm will get the money. However,
the discounting of bill as a marketable security is subject to two limitations. i.e. (i) the safety of this
investment depends upon the credit rating of the acceptor of the bill, and (ii) usually the pre-mature
payment of the bill is not available.
5. Negotiable Certificates of Deposits: NCD’s are papers issued by banks acknowledging fixed
deposits for a specified period of time. Commercial Papers are negotiable instruments.
6. Money Market Mutual Funds: Money market mutual funds (MMMFs) focus on short-term
funds like marketable securities such as TBs, CPs, CDs or call money. They have a minimum lock-
in period of 30 days, and after this period, an investor can withdraw his or her money any time at a
short notice or even across the counter in some cases. They offer attractive yields. MMMFs have
become quite popular with institutional investors and some companies. UTI’s MMMF schemes are
most successful so far.
9.9 Summary
Management of cash and marketable securities is one of the key areas of working capital management.
Cash is required to meet a firm’s transaction and precautionary needs. A firm needs cash to make payments
for acquisition of resources and services for the normal conduct of business. It keeps additional funds to
meet any emergency situation. Some firms may also maintain cash for taking advantages of speculative
changes in prices of input and output.
The aim of finance manager in cash management is to minimize the investments in cash and at the same time
ensure that the firm has sufficient liquidity.
The main objective of cash management is to trade-off liquidity and profitability in order to maximise the
firm’s value. Credit standing of the firm, relations with bank, management policies regarding holding inventory,
liquidity preference etc. effects cash requirement of a firm. The finance manager can formulate strategies of
cash management by (i) determining optimum level of cash (ii) cash planning and control (iii) managing the
cash flows (iv) investing surplus cash. Cash budget is probably the most important tool of cash management.
The basic strategies that can be employed to minimise the operating cash balance are (a) Accelerating cash
collection - Concentration banking, Lock box system deserve specific mention as principal methods of
establishing a decentralised collection network. (b) Slowing disbursements - Centralised disbursement centre,
Avoidance of early payments and Playing the float are the important techniques for slowing disbursement,
but this slow down should not impair the credit rating or reputation of the firm.
A firm should hold an optimum balance of cash, and invest any temporary excess amount in marketable
securities. In choosing these securities, the firm must keep in mind safety, maturity and liquidityof its investment.
9.10 Key Words
 Cash Planning: It is a technique to plan and control the use of cash.
 Cash Budget: A cash budget is a summary statement of the firm’s expected cash inflows and
outflows over a projected time period.
 Cash Turnover: The number of times the firm’s cash is used during each year.
 Transaction Motive: It refers to holding cash to meet anticipated obligations whose timing do not
perfectly coincide with cash inflows.
 Precautionary Motive: Holding cash to meet the unpredictable cash obligations of the firm.
 Cash Management: It involves the management of cash in such a way that sufficient cash is
always available to meet the obligations of the firm.
 Concentration Banking: A mean of accelerating the flow of cash of a firm by establishing strategic
collection centres.
 Marketable Securities: Short term money market instruments that can easily be converted into
cash.
 Mail Float: The time gap between the postage of cheques by the debtors and the receipt of the
same in the firm is called mail float.
 Processing Float: Time taken within the firm before depositing the cheque in the bank.
 Collection Float: Time difference between depositing the cheques and their actual realisation.

1. What is ‘cash’ in cash management? What are the motives of holding cash?
2. “A number of methods are being employed to speed up the collection process and maximise available
cash”. Explain these methods.
3. What are the objectives of cash management?
4. Discuss the functions of cash management?
5. What is Baumol Model of cash management?
6. What is Miller-Orr Model of cash management?
7. Write a short note on the investment of idle cash in readily marketable securities.
8. Write short notes on : -
a) Concentration Banking b) Lock Box System
c) Optimum Cash Balance d) Playing the Float
9. Explain the techniques that can be used to accelerate the firm’s collection.
10. How can the optimum level of operating cash balance be determined?
11. Explain the criteria that a firm should use in choosing the short term investment alternative in order
to invest surplus cash.
12. From the following information compute optimum cash balance of a firm by using Baumol’s Model.
Monthly cash requirement Rs. 6,000
Fixed cost per transaction Rs. 10
Interest rate on marketable securities 6%
(Ans. - Rs. 15422)

- Chandra Prasanna - Financial Management : Theory and Practice, Tata Mcgraw Hills, New Delhi
- Mehta D.R. - Working Capital Management, Printice Hall, New Delhi.
- Agarwal M.R. - Management Accounting ; National Publishing House, Jaipur.
- Hampton John J. - Financial Decision Making Concepts, Problems and Cases, Printice Hall, New
Delhi.
- Kuchhal S.C. - Financial Management - An analytical and conceptual approach, Chaitanya,
Allahabad.
- Khan, Jain - Principal of Financial Management, Tata Mcgraw Hills, New Delhi.
- Pandey I. M. - Financial Management, Vikas, New Delhi.
Unit - 10 : Cost of Capital
Structure of Unit:
10.0 Objectives
10.1 Introduction
10.2 Meaning and Definitions of Cost of Capital
10.3 Classification of Cost of Capital
10.4 Cost of Different Sources of Capital
10.4.1 Debt Capital
10.4.2 Preference Shares
10.4.3 Equity Shares
10.4.4 Retained Earnings
10.5 Weighted Average Cost of Capital (WACC)
10.6 Significance of Cost of Capital
10.7 Problems in Determining Cost of Capital
10.8 Summary
10.0 Objectives
 Meaning and definitions of cost of capital

 Classification of cost of capital
 Cost of different sources of capital
 Debt capital, Preference shares, Equity shares, Retained earnings
 Weighted average cost of capital (WACC)
 Significance of cost of capital
 Problems in determining cost of capital
10.1 Introduction
The cost of capital is an important factor while planning the capital structure of an organization. The cost of
capital is concerned with what a firm has to pay for the capital it uses to finance new investments. The capital
may be in the form of debt, retained earnings, preference shares and equity shares. Every firm, for its
survival and growth, has to earn a sufficient return to cover its costs of capital and also to have surplus for
its growth. If a firm’s rate of return on its investment exceeds its cost of capital, the wealth ofequity stockholders
is enhanced. It is, because, the firm’s rate of return on its investments is greater than its cost of capital, the
rate of return earned on equity capital (after nearing the costs of other forms of financing) will exceed the
rate of return required by equity stockholders. Hence, the wealth of equity stockholders will increase.
10.2 Meaning and Definitions of Cost of Capital

‘Cost of Capital’ is a concept having manifold meanings. Cost of capital, for an investor is the measurement
of disutility of funds in the present as compared to the return expected in the future. From the firm’s point of
view, its meaning is somewhat different. From its point of view, cost of capital is the required rate of return
needed to justify the use of capital. This very idea has been subscribed by the following authorities also:
“The cost of capital is the minimum required rate of earnings or the cut off rate for capital expenditure”.
Solomon Ezra
“The cost of capital is the rate of return a company must earn on an investment to maintain the value of the
company”. M.J. Gorden
‘’Cost of capital is the rate of return, the firm requires from investment in order to increase the value of the
firm in the market rate”. John J. H.
“The cost of capital is the minimum rate of return which a firm requires as a condition for undertaking an
investment”. Milton H. Spencer
“The cost of capital represents a cut off rate for the allocation of capital to investment of projects. It is the
rate of return on a project that will leave unchanged the market price of the stock”.
James C. Van Home
Conclusion : Thus, it is clear from the above that the cost of capital is the minimum rate of return which a
company is expected to earn from a proposed project so as to make no reduction in the earning per share
to equity shareholders and Its market price. It is the combined coal of each type of source by which a firm
raises the funds.
10.3 Classification of Cost of Capital

1. Historical Cost and Future Cost: Historical cost are those which are calculated on the basis of
existing capital structure. Future cost relates to the cost of funds intended to finance the expected
project, historical costs are useful for analyzing the existing capital structures. Future costs are
widely used in capital budgeting and capital structure designing decisions.
2. Specific Cost and Composite Cost: The cost of individual source of capital is referred to as the
specific cost and the cost of capital of all the sources combined is termed as composite cost. It is,
thus the weighted cost of capital.
3. Average Cost and Marginal Cost: The average cost is the average of the various specific costs
of the different components of capital structure at a given time. The average cost is relevant for
overall investment decision as on enterprise employs a mix of different sources. The marginal cost
of capital is that average cost which is concerned with the additional funds raised by the firm. It is
very important in capital budgeting decisions. Marginal cost tends to increase proportionately as the
amount of debt increases.
4. Explicit Cost and Implicit Cost: An explicit cost is the discount rate which equates the present
value of cash inflows with the present value of cash outflows. In other words, it is the internal rate of
return of cash flows.
Implicit cost is also known as opportunity cost. It may be defined as the rate of return associated with the
best investment opportunity for the firm. It is generally said that cost of retained earnings is an opportunity
cost in the sense that it is the rate of return at which the shareholders could have invested these funds had
they been distributed among them.
10.4 Cost of Different Sources of Capital

In making investment decisions, cost of different types of capital is measured and compared. The source,
which is the cheapest is chosen and than capital is raised. It is necessary to determine the specific cost of
each source in order to determine the minimum obligation on a company. (Generally, the following are the
sources of capital:
Specific cost of different sources of raising funds are calculated In the following manner :
10.4.1 Cost of Debt Capital
Funds can be borrowed both for short term as well as for long term. Short term debt is required to satisfy
working capital needs. The cost of debt finance can be defined in terms of the required rate of return that the
debt financed investment must yield to prevent damage to the stockholders position. The cost of debt can
be computed in the following manner:
(a) Cost of Short Term Debt: Short term funds are borrowed for short period of time and repaid
within the operating period. Cost of short term debt is the percentage of burden in relation to net
proceeds of the debt. In this context, burden can be defined as the annual rate of interest accepted
to be paid plus other related costs. When funds are borrowed, some expenses such as brokerage,
stamps duty, legal expenses etc. are to be incurred by borrower. So, it is necessary to compute cost
of debt on net proceeds. It can be understood with the help of the following example.
Illustration 1: Mr. X wants to borrow Rs. 1,00,000 from State Bank of India. The rate of interest
is 14% p.a. The loan is repayable in one year. For this purpose Rs. 1,000 will be incurred by Mr. X.
The actual cost of loan will be as follows :
Solution :
Net Proceeds = Rs. 1,00,000 – Rs. 1,000 = Rs. 99,000
Annual Interest charges = Rs. 14,000
Interest
Cost of Loan (before tax) =  100
Net Proceeds
Rs.14,000
=  100  14.14%
Rs.99,000
The above cost is before tax. Interest is a deductible expense for the purpose of income tax. Hence,
the cost of loan after tax will be reduced. In the above example, if tax rate is 50%. The cost of loan
after tax will be as follows :
Cost of Loan (after tax) = Before Tax Cost (I-T)
= 14.14% (1-.50)
= 7.07%
(b) Cost of Long Term Debt: According to Weston and Brigham, “The cost of debt is defined
as the rate of return that must be earned on debt financed investment in order to keep unchanged
the earning available to equity shareholders”. Long term debts include bonds, debentures, bank
loan, term loan, public deposits etc. A company must earn minimum return on debt capital to protect
the interest of shareholders. For example. A company issues 12% debentures for Rs. 10 lakhs at
par. It must earn at least Rs. 1,20,000 p.a. to protect the interest of shareholders. If company earns
less than Rs. 1,20,000, the return to shareholders will be affected adversely and the market value,
of share will also decrease.
Cost of Debentures or Bonds: A company borrows capital in order to maximize the profits for its
shareholders i.e., to pay higher dividend to them. It continues to use this source of finance untilthe incremental
return is higher than the incremental cost of debt capital.
According to Sec. 2(12) of the Indian Companies Act, 1956 the term debenture includes debenture stock,
bonds and any other securities of a company whether constituting a charge on assets of the company 01 not
Interest is paid to the debenture holders at a fixed rate. The interest on debentures is payable even if the
company does not earn the profits.
Debentures or Bonds can be issued at par, at premium or at discount. When debentures or bonds are
issued, a company has to incur some issue expenses such as underwriting commission, printing and other
expenses, brokerage etc. These expenses are deducted from issue price while computing net proceeds.
Debentures can be classified into two categories :
(a) Irredeemable Debentures: These are also known as perpetual debentures. Irredeemable
debentures are those whose principal is not repaid to the debenture holders by the company during
its life time.
Computation of Cost of Debentures
(i) When Debentures or Bonds Issued at Par: If debentures or bonds are issued at par, the cost of
debentures or bonds will be :
I
(i) Cd (before tax) =  100
NP
Cd = Cost of debt
I = Annual Interest Charges
NP = Net Proceeds.
I
(ii) Cd (after tax) =  100 (I  T)
NP
T = Tax rate
OR
Cd (before Tax) (I-T)
Illustration 2: X Ltd. issues 10,000 14% Debentures of Rs. 100 each at par. The underwriting commission
and brokerage are Rs. 25,000. Assuming that tax rate for the company is 50%; calculate the cost of debt of
the company before tax and after tax.
Solution :
I
Net Pr oceeds
Rs.1,40,000
=  100
Rs.9,75,000
= 14.36%
(ii) Cd (after tax) = Cd (before Tax) (I-T)
= 14.36% (1-50)
= 7.18%
(ii) When Debentures or Bonds are Issued at Premium or Discount: In case the debentures
or bonds are issued at premium or discount, the cost of debt should be calculated on the basis of net
proceeds realized on account of issue of such debentures or bonds.
Important Points:
(i) It should be noted that interest is always calculated on face value (Paid up) of debentures.
(ii) Net proceeds should be calculated as follows :
(a) When debentures are issued at par:
Net Proceeds = Face Value - Flotation Cost.
(b) When debentures are issued at premium:
Net Proceeds = Face value + Premium on issue of deb –
issue exp. or flotation costs.
(c) When debentures are issued at discount:
Net Proceeds = Face value - Discount on issue –
Issue expenses or flotation cost.
(iii) In the absence of information brokerage, underwriting commission etc. may be calculated on face
value of debentures.
Illustration 3: A Ltd. wants to issue 5,000 9% Irredeemable Debentures of Rs. 100 each and for which
the company will have to incur the following expenses :
Underwriting commission 2%
Brokerage 0.5%
Printing and other expenses Rs. 5,000
Calculate the cost of debt (before as well as after tax) if the Debentures are issued at (i) 5%
discount, and (ii) 10% premium. The tax rate for the company is 45%.
Solution :
(i) In case the Debentures are issued at 5% discount:
Calculation of Net Proceeds:
Rs.
Fact Value Rs. 100.00
Less : Underwriting commission 2.00
Brokerage (0.5% of Rs. 100) 0.50
Printing (Rs. 5,000 -f 5,000) 1.00
Discount on issue of Debentures 5.00 8.50
Net Proceeds 91.50
I
NP
Rs.9
=  100  9.84%
Rs91.50
(ii) Cd (after tax) = Cd before Tax (I-T)
Cd (after tax) = 9.84% (1-.45)
= 5.41%
(ii) In case the Debentures are issued at 10% premium:
Rs.
Fact Value . 100.00
Add : Premium on issue of debenture 10.00
Rs. 110.00
Less : Underwriting commission 2.00
Brokerage (0.5% of Rs. 100) 0.50
Printing (Rs. 5,000 -f 5,000) 1.00 3.50
Net Proceeds 106.50
I
NP
Rs.9
=  100  8.45%
Rs.106.50
(ii) Cd (after tax) = Cd before Tax (I-T)
Cd (after tax) = 8.45% (1-.45)
= 4.65%
(b) Cost of Redeemable Debt: Redeemable debentures provide for the payment of the principal
amount on the expiry of a certain period. Generally, these debentures are redeemed at par or at
premium. If the redeemable debentures are issued by the company, the cost of debentures can be
computed by using the following formula:
 RV  NP 
I 
 n   100
Cd (before tax) =  RV  NP 
 2 
 
Cd = Cost of debt
I = Annual interest charges
RV = Redeemable value or price
NP = Net proceeds
n = Number of years of maturity
Tax Adjustment: When tax payable is computed, the interest paid on debt is deducted from
income. The higher the interest charges, the lower will be the amount of tax payable by the firm, the
cost of debt after tax will be calculated as follows :
Cd (after tax) = Cd before tax (I–T)
T = Tax rate
Illustration 4: (When debentures are issued at par and redeemable at par)
Gaurav Ltd. issued 14% Redeemable Debentures of Rs. 100 each at par for Rs. 10,00,000. The issue
expenses amount to Rs. 40,000, the debentures are to be redeemed after 7 years. Assuming corporate tax
rate at 50%. Calculate cost of debentures before tax and after tax.
Solution:  RV  NP 
I 
 n   100
Cd (before tax) =
 RV  NP 
 2 
 
 Rs.100  Rs.96 
14   
 7   100
=  Rs.100  Rs.96 
 2 
 
Rs.14.57
=  100  14.87%
Rs.98
Cd (after tax) = Cd before Tax (I–T)
= 14.87% (1-.50)
= 7.435 %
Illustration 5: (When Debentures are issued at discount and redeemable at par) Rama Ltd. is
considering to issue Rs. 5,00,000 of Rs. 1,000 9% Debentures at a discount of 5%. These debentures are
repayable after 8 years. However the company will pay Rs. 16 per debenture as issue expenses. Assume
50% corporate tax rate.
Calculate the after tax cost of debentures.
Solution:
 RV  NP 
I 
 n   100
 2 
 
 Rs.1,000  Rs.934 
Rs.90   
 8   100
=  Rs.1,000  Rs.934 
 2 
 
Rs.90  Rs.8.25
=  100
Rs.967
Rs.98.25
=  100  10.16%
Rs.967

= 10.16% (1-.50)
= 5.08 %
Working Note
Calculation of Net Proceeds: Rs.
Face value of Debenture Rs. 1000
Less :Issue Expenses 16
Discount on issue (5% of Rs. 1,000) 50 66
Net Proceeds 934
Illustration 6: (When debentures are issued at premium and repayable at par)
Hari Ltd. wants to issue Rs. 10 lakhs of 12% Debentures of Rs. 500 each. These debentures are to be
redeemed after 10 years at par. The company will pay the following issue expenses :
Underwriting commission 1.5%
Brokerage 0.5%
Printing and other expenses Rs. 10,000
Calculate the cost of debentures (before tax as well as after tax), if the debentures are issued at (i) 5%
premium (ii) 10% premium.
Assuming that company’s tax rate is 50%.
Solution:
(i) When Debentures are issued at 5% premium:
Face value of Debenture 500
Add : Premium on issue 5% 25
525
Less : Issue Expenses Rs.
Underwriting commission 7.50
Brokerage 2.50
Printing and other expenses
(Rs. 10,000 ¸ 2,000) 5.00 15
Net Proceeds 510
Calculation of Cost of Debentures:
 RV  NP 
I 
 n   100
 2 
 
 Rs.500  Rs.510 
Rs.60   
 10   100
=  Rs.500  Rs.510 
 2 
 
Rs.60  Rs.1
=  100  11.68%
Rs.505
= 11.68% (1-.50)
= 5.84 %
(ii) When Debentures are issued at 10% premium:
Rs.
Face value 500
Add : Premium on issue 10% 50
550
Less : Issue Expenses : (as above) 15
Net Proceeds 535
Calculation of Cost of Debentures:
 RV  NP 
I 
 n   100
 2 
 
 Rs.500  Rs.535 
Rs.60   
 10   100
=  Rs.500  Rs.535 
 2 
 
Rs.60  Rs.3.50
=  100  10.92%
Rs.517.50
Cd (after tax) = Cd (before Tax) (I–T)
= 10.92% (1-.50)
= 5.46 %
Illustration 7: (When Debentures are issued at discount and repayable at premium)
Rajeev Ltd. issued 10,000, 12.5% Debentures of Rs. 100 each at 4% discount. These debentures are
redeemable after 10 years. Under the terms of debenture trust, these debentures are to be redeemed at 5%
premium. The cost of floatation amount to Rs. 30,000.
Calculate before tax and after tax cost of debentures assuming a tax rate of 50%.
Solution:
 RV  NP 
I 
 n   100
 2 
 
 Rs.105  Rs.93 
Rs.12.5   
 10   100
=  Rs.105  Rs.93 
 2 
 
Rs.13.70
=  100  13.84%
Rs.99
= 13.84% (1-.50)
= 6.92 %
Working note:
Face value Rs. 100
Less : Discount on issue of debentures 4
Floatation Exp. (Rs. 30,000 ¸ 10,000) 3 7
Net Proceeds 93
10.3.2 Cost of Preference Share Capital
Preference shares are the fixed cost bearing securities. A fixed rate of dividend is payable on preference
shares. Although, payment of dividend on preference shares is not compulsory but it is generally paid
whenever the company makes sufficient profits. Preference shares can be divided into two parts for the
purpose of computation of cost of capital (i) Irredeemable Preference shares (ii) Redeemable Preference
Shares.
(i) Cost of Irredeemable Preference Share Capital: Irredeemable preference shares can be
redeemed only when company goes into liquidation, According to the Companies (Amendment)
Act, 1988, no company can issue irredeemable preference shares or shares which are redeemable
after 10 years from the date of their issue. The cost of irredeemable preference share capital is
calculated as follows :
DPS
Cp (after tax) =  100
NP
Where, DPS = Divided payable per preference share
NP = Net proceeds per share
Cp = Cost of preference share capital
Tax Adjustment: It should be noted that preference share dividend is paid out of after tax profits.
Hence, the cost of preference share capital is not adjusted for taxes. The cost of preference share
capital is automatically computed on after tax basis. If we want to calculate cost of capital before
tax, the following formula should be used :
Cp After tax
Cp (before tax) = I-T 
T = Corporate Tax rate
Illustration 8: Shah Ltd. issues 10,000, 8% Preference Shares of Rs. 100 each. Cost of issue is Rs. 3 per
share. Assume tax rate 50%. Calculate after tax cost of preference share capital if these shares are issued :
(a) at par; (b) at a discount of 5%; (c) at a premium of 10%.
Solution:
(a) When Preference Shares are issued at par:
Net Proceeds = Rs. 100 - Rs. 3 = Rs. 97
Cp (after tax) = DPS

 100
NP
= Rs.8
 100  8.25%
Rs.97
(b) When Preference Shares are issued at 5% discount:
Net Proceeds = Rs. 100 - Rs. 5 - Rs. 3 = Rs. 92
Rs.8
Cp (after tax) =  100  8.69%
Rs.92
(c) When Preference Shares are issued at 10% premium:

Net Proceeds = Rs. 100 + Rs.10 - Rs. 3 - Rs.107
Rs.8
Cp (after tax) =  100  7.48%
Rs.107
(ii) Cost of Redeemable Preference Share Capital: Redeemable preference shares are those shares
which can be redeemed on maturity date. The cost of redeemable preference share capital can be
calculated as follows :
 RV  NP 
DPS   
 n   100
Cp (before tax) =  RV  NP 
 2 
 
Cp = Cost of redeemable preference share capital.

n = No. of years in which shares are to be redeemed
RV = Redeemable value or Maturity value
NP = Net Proceeds
DPS = Dividend Per Preference Share.
Illustration 9: X Ltd. issues 10,000, 9% Preference Shares of Rs. 100 each at par redeemable after 5
years at a premium of 5%. The cost of issue (under writing commission, printing and other expenses etc.) is
Rs. 3 per share. The corporate tax rate is 50%.
Calculate the cost of preference share capital (before tax as well as after tax)
Solution:
 RV  NP 
DPS   
 n   100
 2 
 
 Rs.105  Rs.97 
Rs9   
 5   100
=  Rs.105  Rs.97 
 2 
 
Rs.10.60
=  100  10.49%
Rs.101
Cp After tax
10.49%
=  20.98%
1-.50
Working Note:
Net Proceeds = Face Value - Issue expenses
= Rs. 100-Rs. 3 = Rs. 97
10.4.3 Cost of Equity Share Capital
Cost of equity share capital is the minimum rate of return that the company must earn on equity financed
portion of its investments in order to leave unchanged the market price of its stock. It is sometime argued
that equity share capital is free of cost. It is, because, it is not legally binding for company to pay dividends
to ordinary shareholders. However, this is not true. In fact, the equity shareholders invest their funds in
shares with the expectation of getting dividend from the company. Thus, equity shares involve a return in
terms of dividend expected by the equity shareholders.
Methods of Computing Cost of Equity Share Capital:
The following methods are used for computing cost of equity share capital :
(i) Dividend Yield Method
(ii) Earnings Yield Method
(iii) Dividend Yield and Growth in Dividend Method
(iv) Realized Yield Method.
(i) Dividend Yield Method: It is also known as dividend price ratio method. According to this
method, the cost of equity share capital is calculated on the basis of a required rate of return in terms
of future dividends to be paid on equity shares for maintaining their present market price. This
method is based on the assumptions that the investors give prime importance to dividends and risk
in the form remains unchanged. This method does not seem to consider the growth in dividend. The
following formula is used for computation of cost of existing equity shares :
DPS
Ce (after tax) =  100
MPS
Ce = Cost of Equity Share Capital
DPS = Dividend Per Share
MPS = Market Price per Share
Illustration 10: Varsha Ltd. issued 10,000 Equity Shares of Rs. 100 each at par. The company has been
paying 20% dividend to equity shareholders for the past five years and expects to maintain the same in the
future also. Market price of equity share is Rs. 160.
Calculate the cost of equity share capital.
Solution:
DPS
MPS
Rs.20
Ce =  100  12.5%
Rs.160
(ii) Earnings Yield Method: This is also called ‘Earnings Price Ratio’ method. According to this
approach, the earning per share determines the market price of equity shares. Under this method,
the cost of equity share capital is equal to the rate which must be earned on incremental issues of
equity shares so as to maintain the present value of investment. The following formula is used for
computation of cost of equity share capital:
EPS
Ce =  100
MPS

EPS = Earnings Per Share
This method of computing cost of equity capital may be employed in the following cases : (i)
When the earnings per share are expected to remain constant.
(ii) When all earnings are distributed to the shareholders in the form of dividends.
(iii) The market price of the share is influenced only by earnings per share.
Illustration 11: Jain Tubes Ltd. has issued 10,000 equity shares of Rs 100 each fully paid. It has earned
profit after tax R| 1,80,000. The market price per share is Rs. 200. Calculate the cost of equity share capital
on the basis of earning yield method assuming that all earnings has among shareholders.
Solution:
EPS
Ce =  100
MPS
Rs.18
=  100  9%
Rs.200
Profit After Tax
EPS = No. of Equity Share
Rs. 1,80,000
=  Rs. 18
10,000
(iii) Dividend Yield and Growth in Dividend Method: According to this method, the cost of
equity is determined on the basis of the expected dividend rate plus the rate of growth in dividend.
The rate of growth in dividend is determined on the basis of amount of dividends paid by the
company for the last few years. According to this approach the cost of equity share capital may be
determined by using the following formula :
DPS
Ce =  100  G
MPS
Ce = Cost of Equity Capital
MPS = Market Price Per Share
G = Growth rate in dividend
Illustration 12: Mahadev Ltd. has issued 20,000 equity shares of Rs. 100 each ige rate of dividend paid
by the company is 21%. The earnings of the company have recorded a growth rate of 5% per annum. The
current market price of an equity share of company is Rs. 150.
Find out cost of equity share capital.
Solution:
DPS
Ce =  100  G
MPS
Rs. 21
=  100  5%
Rs. 150
= 14% + 5% = 19%
(iv) Realised Yield Method: According to this method, the rate of return actually realised by
shareholders forms the basis for determining the cost of equity capital. The advocate of this approach
argue that the rate of earnings as well as the market price of shares are always subject to fluctuations
on account of so many factors. Therefore the return actually realised is a true indicator of the return
expected by the shareholders. The realised return is discounted al the present value factor and then
compared with the value of investment. This approach is based on the following assumptions :
(i) The risks of the company remain same.
(ii) The shareholders continue to expect the same rate of return for bearing the given risk.
(iii) The reinvestment opportunity rate of the shareholders is equal to the realised yield.
Illustration 13: Mr. Rajat purchased 100 shares of Hero Honda Ltd. at a cost of Rs. 428 on 1st January
2000. The face value of share is Rs. 100 each. He held them for 5 years and finally sold them on 31st Dec.
2004 for Rs. 600. The amount of dividend received by him in each of these 5 years was as follows :
Year Dividend Per Share
2000 Rs. 12
2001 Rs. 14
2002 Rs. 15
2003 Rs. 15
2004 Rs. 18
Solution:
In order to calculate the cost of equity capital, it is necessary to calculate the internal rate of return. It can be
calculated by ‘trial and error’ method.
Year Di vidend Discount facto r Pres ent va lue
a t 10%
Rs. Rs.
2000 12 .9 09 1 0.91
2001 14 .8 26 1 1.56
2002 15 .7 51 1 1.27
2003 15 .6 83 1 0.25
2004 18 .6 21 1 1.18
2004 6 00 (sale .6 21 3 72.6
Proceeds)
4 27.7 7
The purchase price of the share is Rs. 428, which is equal to the present value of cash inflows over a period
of 5 years (dividends and capital receipt on sale) at 10%. thus, the cost of equity capital can be taken at
10%.
• Cost of Newly Issued Equity Shares: When new equity shares are issued by the company, it
has to incur some expenses such as underwriting commission, brokerage, printing and other expenses.
These expenses are deducted from the issue price or market price (If it is given) and net proceeds
is computed. The cost of equity capital is computed on the basis of net proceeds and dividend per
share and earnings per share.
The following formulae are used to compute the cost of equity capital:
1. Divided Yield Method:
DPS
Ce =  100
NP
2. Earning Yield Method:
EPS
Ce =  100
NP
3. Dividend Yield Method and Growth in Dividend Method:
DPS
Ce =  100  G
NP
Illustration 14: From the following information of Santosh Ltd., calculate the cost of new equity shares of
the company :
(i) Current selling price Rs. 150 per share.
(ii) Flotation cost are expected to be 3% of current selling price.
(iii) The expected dividend on new shares amounts to Rs. 16 per share.
(iv) The following are the dividends paid by the company for the last 5 years.
Year Dividend Per Share
Rs.
2000 10.50
2001 11.00
2002 12.50
2003 12.75
2004 13.25
Solution:
(i) Calculation of Growth Rate in Dividend:
The dividend declared by the company have increased from Rs. 10.50 to Rs. 13.25 during the last 4 years
(and not 5 years, since dividends at the end of 2000 are being compared with dividends at the end of 2004).
Rs. 13.25
Compound Factor =  1.262
Rs. 10.50
Compound interest table (See Appendix 3 at the end of this book) suggests that Re 1.00 Compounds to
Rs. 1.262 in 4 years at the compound rate of 6%. Therefore, the growth rate in dividends is 6%.
(ii) Cost of Equity Capital DPS:
DPS
Ce =  100  G
NP
Rs. 16
=  100  6%
Rs. 145.50
= 11%+ 6% =17%
Working Note:
Net Proceeds = Market Price Per Share - Floatation Cost Per Share
= Rs. 150 - Rs. 4.50 (3% of Rs. 150)
= Rs. 145.50
Illustration 15: X Ltd. is considering an expenditure of Rs. 6 lakhs for expanding its operations. The
relevant information is as follows :
No of existing equity shares 1 lakh
Market value of existing share Rs. 60
Net earnings after tax Rs. 9 lakhs
Compute the cost of existing share capital and of new equity share capital assuming that new shares will be
issued at a price of Rs. 96 per share (Face value Rs. 100 each). The estimated cost of new issue will be Rs.
3 per share.
Solution:
(i) Cost of Existing Equity Share Capital :
EPS
Ce =  100
MPS
Rs.9
=  100  15%
Rs.60
Net Profit After Tax

EPS = No. of Equity Shares
Rs. 9,00,000
=  Rs.9
1,00,000
(ii) Cost of New Equity Share Capital:
EPS
Ce =  100
NP
= Rs.9
 100  9.68%
Rs.93
10.4.4 Cost of Retained Earnings
Retained earnings are the profits which have hot been distributed by the company to its shareholders and
have been retained in the company to be used for future expansion. They are represented by the uncommitted
or free reserves and surplus. Retained earnings do not involve any cash cost or out of pocket cost. Therefore,
some people argue that retained earnings are cost free. However, it is not true, Retained earnings involve an
opportunity cost. From shareholder’s point of view, the opportunity cost of retained earnings is the rate of
return that they can obtain by Investing after tax dividend in the similar securities, if earnings are paid to thorn
as dividend in cash. The following adjustments are made while computing cost of retained earnings.
(i) Income Tax: An individual pays income tax on dividend hence he would only be able to invest
the amount remained after paying individual income lax on such earnings. Similarly, an individual
also pays tax on capital gain. Hence, adjustment of income tax is made.
(ii) Brokerage, Commission etc.: When the amount of dividend is invested, some expenses like
brokerage commission etc. are incurred by the investor. These expenses are deducted from invested
amount.
The following formulae may be used for computation of cost of retained earnings:
Cr = Ce (I–Tp) (I–B)
OR
DPS (I-Tp) (I-B)
Cr =  100
MPS
OR
EPS (I-Tp) (I-B)
Cr =  100
MPS
OR
DPS
Cr =  100 + G [(1-Tp)(1-B)]
MPS
Where :
Cr = Cost of Retained Earnings
DPS = Expected Dividend Per Share
Tp = Personal tax rate
B = Brokerage Cost
Illustration 16: Sony Ltd. retains Rs. 5 lakhs out of its current earnings. The expected rate of return to the
shareholders, if they had invested the funds elsewhere is 10%. The brokerage is 3% and the shareholders
came in 30% tax bracket. Calculate the cost of retained earnings.
Solution:
Cr = Ce (I - Tp) (I-B)
Cr = .10(1-30) (1-.03)
= .10 (.70) (.97)
= 0.0679 or 6.79%
Illustration 17: Calculate cost of retained earnings in each of the following cases :
(a) Mr. X holds 500 shares of Rs. 100 each in Vimco Ltd. The company has earned Rs. 18 per
share and distributed Rs. 10 per share as dividend among the shareholders and the balance
is retained. The market price of the share is Rs. 160 each. Personal Income tax applicable
to Mr. X is 30%.
(b) The following information was obtained from Laxmi Ltd.:
Current market price of a share Rs. 140
Cost of floatation/brokerage per share 3% on market price
Growth in expected dividends 5%
Expected dividend per share on new shares Rs. 14
Shareholders marginal/personal income tax 30%
Solution:
(a) Amount retained on 500 shares @ Rs. 8 per share is Rs. 4,000. New shares to be acquired
out of Rs. 4,000 are 25 @ 160. Earnings on 25 shares @ Rs. 18 per share would be Rs.
450.
D(I-Tp)
Cr =  100
MPS
D = Expected dividend
MPS = Market price of shares to be acquired.
Rs.450 (1-.30)
=  100
Rs. 4,000
= 7.875%
or
EPS(I-Tp)
Cr =  100
MPS
Rs.18 (1-.30)
=  100 = 7.875%
Rs. 160
Here: MPS = Market price per share
EPS = Earnings per share
 DPS 
(b) Cr =  MPS  100  g 1-Tp  1-B 
 
 Rs.14 
=  Rs.140  100  5% 1-.30  1-.03 
 
= (10% + 5%) (.7) (.97)

= 15% ´ .7 ´ .97 = 10.19%
Adjustment of Tax on Capital Gain: When a shareholder has to pay income tax on capital gain, the
following formula should be used while computing cost of retained earnings :
DPS (1-Tp)
Cr =  100
MPS (1-Tc)
D = Expected dividend per share
Tc = Personal capital gain tax rate
MPS = Market price per share
Illustration 18: Find out the cost of retained earnings from the following information :
Dividend per share Rs. 9.00
Personal income tax rate 25%
Personal capital gain tax rate 10%
Market price per share Rs. 100
Solution:
DPS (1-Tp)
Cr =  100
MPS (1-Tc)
Rs.9(1  0.25)
=  100
Rs.100 (1-0.1)
Rs.6.75
=  100  7.5%
Rs.90
10.5 Weighted Average Cost of Capital (WACC)

A company has to employ owner’s fund as well as creditors’ funds to finance its projects so as to make the
capital structure of the company balanced and to increase the return to the shareholders. Weighted average
cost of capital is the average cost of various sources of financing. According to CIMA the weighted average
cost of capital “as the average cost of the company’s finance (equity, debentures, bank loans) weighted
according to the proportion each element bears to the total pool of the capital, weighting is usually based on
market valuations current yields and costs after tax.”
Weighted average cost of capital is also known as composite cost of capital, overall cost of capital or
average cost of capital. The composite cost ol capital is the weighted average of the cost of various sources
of funds, weights being the proportion of each source of funds in the capital structure.
The following steps are used to calculate the weighted average cost of capital :
(i) Calculate the cost of the specific sources of funds (i.e., cost of lit, cost of equity share
capital, cost of preference share ital, cost of retained earnings etc.). These should be calculated
after tax.
(ii) Multiply the cost of each source by its proportion in the capital structure.
(iii) Apply the following formula :
 XW
Cw =
W
Cw = Weighted average cost of capital
X = Cost of different sources of capital
W = Weights given to different sources of capital
 XW = Summation of the product of the specific cost of capital
with the relative proportions.
W = Summation of weights.
Assignment of Weights: The assignment of weight to specific sources of funds is a difficult task. Several
approaches are followed in this regard but two of them are commonly used which are
(i) Book value weights: Book value weights mean the weights according to the values shown in
respect of the different sources of finance in the balance sheet (or in the books of accounts).
(ii) Market value weights: Market value weights mean the weights of different components of
capital, according to the value prevailing in the market. The cost of capital of the market value is
usually higher than it would be if the book value is used. The market value weights are more logical
to be adopted due to the following reasons :
(i) It represents the true value of funds invested by investors.
(ii) Historic book value have no relevance in calculation of real cost of capital.
(iii) It represents near to the opportunity cost of capital.
However, the market value weights suffer from the following limitations :
(i) It is difficult to determine the market values because of frequent fluctuations.
(ii) With the use of market value weights, equity capital gets greater importance.
Illustration 19: The Capital Structure of Gupta Agra Industries Ltd.
Rs.
Equity Shares (Rs. 9 each) 20,00,000
Retained Earnings 10,00,000
9% Preference Shares (Rs. 100 each) 5,00,000
12% Debentures (Rs. 100 each) 15,00,000
50,00,000
The equity shares of the company sales for Rs. 30. It is expected that company will pay Rs. 3 per share this
year. Corporate tax rate is 50%. Assume 20% as income tax rate of individual shareholder. Compute
weighted average cost of capitnl of existing capital structure.
Solution:
Calculation of Different Source of Capital (i) Cost of Equity Shares
(i) Cost of Equity Shares:
DPS
MPS
Rs.3
=  100  10%
Rs.30
(ii) Cost of Retained Earnings:
DPS(1-Tp)
Cr (after tax) =  100
MPS
Rs.3(1  .20)
=  100  8%
Rs.30
(iii) Cost of preference Shares:
DPS
NP
Rs.9
=  100  9%
Rs.100
(iv) Cost of Debentures:
I
Cd (after tax) =  100(1  T)
NP
12
=  100(1  .50)  6%
100
Computation of Weighted Average Cost of Capital
Sources (1) Amount (W ) After Tax Cost To ta l after ta x cost
(2) (X) (XW)
(3) (2) x (3) = (4)
Rs. Rs.
Equ ity Sh ares Retained 20,0 0,000 10 % 2,0 0,00 0
Earning s Preference 10,0 0,000 8% 80 ,000
Shares Deben tures 5,00 ,000 9% 45 ,000
15,0 0,000 6% 90 ,000
50,0 0,000 4,1 5,00 0
W XW
Weight ed Average Co st of Capi tal =

 XW  100
W
Rs.4,15,000
=  100  8.3%
Rs.50,00, 000
Illustration 20: Calculate weighted average cost ol capital from the following inhumation :
Rs.
4,000 Equity shares (Fully paid up) 4,00,000
3,000 6% Debentures 3,00,000
2,000 6% Preference Shares 2,00,000
Earnings per equity share has been Rs. 10 during the past years and equity shares are being sold in the
market at par. Assume corporate tax at 50 per cent and shareholder’s tax liability 25 per cent.
(Raj. B.Com. 1993)
Solution:
Calculation of Different Source of Capital Cost of Equity Share Capital:
(i) Cost of Equity Shares Capital:
DPS
MPS
Rs.10
=  100  10%
Rs.100
(ii) Cost of Debentures:
I
Cd (after tax) =  100(1  T)
NP
Rs.6
=  100(1  .50)
Rs.100
= 6% ´ .50 = 3%
(iii) Cost of Preference Shares:
DPS
NP
Rs.6
=  100  6%
Rs.100
(iv) Cost of Retained Earnings:
DPS(1-Tp)
Cr (after tax) =  100
MPS
Rs.10(1  .25)
=  100  7.5%
Rs.100
Computation of Weighted Average Cost of Capital
Sources Amo unt After Tax To tal after tax
(D (W) Co st (X) cost (XW)
(2) (3 ) (2 )x(3 ) = (4 )
Rs. Rs.
Equi ty Shares Cap ital 4, 00,0 00 10% 40 ,000
Debentures 3, 00,0 00 3% 9 ,000
Preference Shares Cap ital 2, 00,0 00 6% 12 ,000
Ret ained Earning s 1, 00,0 00 7.5% 7 ,500
10, 00,0 00 68 ,500
W XW
Weighted Average Co st of Capital =

 XW  100
W
Rs.68,500
 100  6.85%
Rs.10,00, 000
Illustration 21: From the following capital structure of a company find out the weighted average cost of
capital using (a) book value weights and (b) market value weights.
Sources Boo k V alue Market Value After Tax Co st %

Rs. Rs .
E quit y Share Capit al 45, 000 90,00 0 14
(Rs. 1 0 per share)
Retained Earn ings 15, 000 — 13

Preference Share Cap ital 10, 000 10,00 0 10
Debent ures 30, 000 30,00 0 5
Solution:
(a.) Taking Book Value Weights
Co mputati on of Weig hted Avera ge Cost o f Capital
Sources Amount After Ta x Tota l after ta x
d) (W) Cost % (X) co st (XW)
(2) (3) (2)x(3 ) = (4 )
Rs. Rs
Equ ity Shares Capit al 4 5,00 0 14 6,30 0
Ret ained Earning s 1 5,00 0 13 1,95 0
Preference Shares Cap ital 1 0,00 0 10 1,00 0
Debentu res 3 0,00 0 5 1,50 0
1,0 0,00 0 10,75 0
W XW

XW 100
W
R s.10, 750
=  100  10.75%
Rs.1,00,000
(b) Ta ki ng Market Value W eights

Co mputati on of Weig hted Avera ge Cost o f Capital
So urces Amount After Ta x To tal after tax
(1) (W) Cost % (X) co st (XW)
(2) (3) (2) x (3) = (4)
Rs .
Equ ity Shares Capital 9 0,00 0 14 12,8 l
Preference Shares Capi tal 1 0,00 0 10 1,0 00
Debentu res 3 0,00 0 5 1,5 00
1,3 0,00 0 15,1 00
W XW

 XW  100
W
Rs.15,100
 100  11.615%
Rs.1,30,000
10.6 Significance of Cost of Capital
The cost of capital is very important concept in financial management. Prior to the development of the
concept of cost of capital the problem was ignored or by passed. The progressive management always
takes notice of the cost of capital while taking a financial decision. The concept is quite relevant in the
following managerial decisions :
Significance of Cost of Capital:
1. Capital Budgeting Decisions: Cost of capital may be used as the measuring rod for adopting as
investment proposal. In various methods of capital budgeting cost of capital is the key factor in
deciding the project out of various proposals pending before the management. It measures the
financial performance and determines the acceptability of all investment opportunities by discounting
cash flows under present value method. The cost of capital being the minimum rate of return desired
is used to compare with the actual rate of return (internal rate of return). Thus, the cost of capital
provides the criterion of accepting or rejecting the proposals in capital expenditure decisions.
2. Capital Structure Decisions: While designing an optimal capital structure, the management should
raise capital from different sources in such a way that it optimizes the risk and cost factors. Raising
of loans may be cheaper on account of income tax benefits, but it involves heavy risk because a
slight fall in the earning capacity of the company may bring the firm near to cash insolvency. It is,
therefore, necessary that cost of cash source of funds is carefully considered and compared with
the risk involved in it.
3. Evaluation of Financial Performance: The cost of capital framework can be used to evaluate
the financial performance of top management. If the actual profitability, of the project is more than
the projected and the actual cost of capital, the performance may be said to be satisfactory.
4. Allocation of Capital: This concept is very useful in allocation of capital to various investment
proposals. It is the corner stone of the investment decisions. The main goal of financial management
is the wealth maximization of its shareholders. So the company must choose only those investment
opportunities that are financially beneficial to the shareholders.
5. Helpful in Dividend Policy and Working Capital Management: The measurement of the cost
of capital helps the management in taking decisions relating to dividend policy and working capital
requirements.
10.7 Problems in Determining Cost of Capital

The determination of cost of capital is not an easy task. The financial manager is confronted with a large
number of problems. These problems can briefly be summarized as follows :
Problems in Determining Cost of Capital:
1. Conceptual Controversy: There is major controversy whether or not the cost of capital is dependent
upon the method and level of financing by the company. According to traditional theorists, a firm
can change its overall cost of capital by changing debt-equity mix. On the other hand, the modern
theorists, reject the traditional view and holds that cost of capital is independent of the method and
level of financing.
2. Computation of Cost of Equity: Determination of cost of equity is a difficult task because the
equity shareholders value the equity shares of company on the basis of a large number of factors,
financial as well as psychological.
3. Determination of Cost of Retained Earnings: The cost of retained earnings is determined
according to the approach adopted for computing the cost of equity shares which is it self a
controversial problem.
4. Future Cost Versus Historical Cost: It is argued that for decision making purposes, the historical
cost is not relevant. The future cost should be considered. It, therefore, creates another problem
whether to consider marginal cost of capital or average cost of capital.
5. Problems of Weight: The assignment of weights to each type of funds is a complex. The finance
manager has to make a choise between the book value to each source of funds and the market
value of each source of funds. The result would be different in each case.
10.8 Summary
1. Cost of Debt Capital:
I
(a) Cd (before tax) =  100
NP
Cd = Cost of debt
NP = Net Proceeds.
T = Tax Rate
I
Cd (after tax) =  100 (I  T)
NP
OR
Cd (before Tax) (I-T)
(b) Cost of Redeemable Debt
 RV  NP 
I 
 n   100
 2 
 
Cd = Cost of Debt
NP = Net Proceeds
n = number of years of maturity
Cd (after tax) = Cd (before Tax) (I-T)
T = Tax Rate
2. Cost of Preference Shares:
(a) Cost of Irredeemable Preference Shares
DPS
NP
DPS = Divided payable per preference share
NP = Net proceeds per share
Cp = Cost of preference share capital
Cp After tax
T = Corporate Tax rate
(b) Cost of Redeemable Preference Shares
 RV  NP 
DPS   
 n   100
 2 
 
Cp = Cost of redeemable preference share capital.
n = No. of years in which shares are to be redeemed
NP = Net Proceeds
DPS = Dividend Per Preference Share.
T = Tax Rate
3. Cost of Equity Shares:

(a) Dividend Yield Method
DPS
MPS
(b) Earning Yield Method
EPS
Ce =  100
MPS
(c) Dividend Yield and Growth in Dividend Method
DPS
Ce =  100  G
MPS
Ce = Cost of Equity Capital
(d) Cost of Newly Issued Equity Shares
Divided Yield Method:
DPS
Ce =  100
NP
Earning Yield Method:
EPS
Ce =  100
NP
Dividend Yield Method and Growth in Dividend Method:
DPS
Ce =  100  G
NP
4. Cost of Retained Earnings:
Cr = Ce (I–Tp) (I–B)
OR
DPS (I-Tp) (I-B)
Cr =  100
MPS
OR
EPS (I-Tp) (I-B)
Cr =  100
MPS
OR
DPS
Cr =  100 + G [(1-Tp)(1-B)]
MPS
Cr = Cost of Retained Earnings
DPS = Expected Dividend Per Share
B = Brokerage Cost
5. Weighted Average Cost of Capital (WACC):
 XW
Cw =
W
Cw = Weighted average cost of capital
X = Cost of different sources of capital
W = Weights given to different sources of capital
 XW = Summation of the product of the specific cost of capital
with the relative proportions.
W = Summation of weights.

1. “Debt is the cheapest source of funds”, Elucidate.
2. Explain the significance of cost of capital in capital expenditure decisions.
3. Write a short note on cost of retained earnings.
4. Define “Cost of Capital”? How will you determine the cost of capital from different sources?
5. Define cost of capital and discuss its importance in capital structure decisions.
6. “Retained earnings and deprecistion funds provide cost ofree capital”? Do you agree with this
statement? If not, then explain the method of determining their costs.
7. Explain the problems faced in determining the ‘cost of capital’. How is it relevant in capital expenditure
decisions?
8. X Ltd. Is considering to issue 8,000 10% debentures of Rs. 500 each. These debentures are
repayable after 10 years. The company has to incur Rs. 22 per debenture as issue expenses.
Assume 60% corporate tax rate.
Calculate the cost before tax and after tax if the debentures are issued:
(i) at par (ii) at a discount of 5% (iii) at a premium of 10%
(Ans. Before tax (i) 10.67% (ii) 11.48% (iii) 9.18%
After tax (i) 4.27% (ii) 4.59% (iii) 3.67%
9. Compute the after tax cost of 14% debentures from the following data :which are redeemable after
10 years :
No. of debentures issued 1,000
Face value Rs. 100
Issue price Rs. 90
Redeemable price . Rs. 105
Floatation cost Rs. 2,000
Tax rate 40%
Ans. : 9.76%
10. A Ltd., issued 1,000 10% preference share of Rs. 100 each, cost of issue is Rs. 2 per share.
Calculate cost of preference share capital if these shares are issued :
(i) at par (ii) at 5% premium (iii) at 2% discount.
Assume 50% tax rate.
(Ans. : Aftertax (i) 10.2% (ii) 9.7% (iii) 10.4%
Before tax (i) 20.4% (ii) 19.4% (iii) 20.8%)
11. Vimal Ltd issued 50,000, 12% preference shares of Rs. 100 each at 10% premium. The cost of
issue was Hs. 4 per share. These shares are redeemable at par after 6 years from date of issue.
Corporate tax rate applicable to this company is 35%. Compute pre and post tax cost of preference
shares.
(Ans. : After tax 10.68% and before tax 16.43%)
12. S agar Ltd. requires Rs. 50,00,000 for a project. The following proposals are under consideration:
(i) To issue 12% debentures ofRs. 100 each.
(ii) To issue 9% preference shares of Rs. 100 each.
Issue expenses will be Rs. 1,00,000 in each case. Assume tax rate 35%. Both are redeemable after
8 years. You are required to compute post tax cost of debt and post tax cost of preference shares
and suggest which proposal is better and why.
(Ans. : Cost of debt 8.04% and cost of preference shares 9.34%.
Issue of debentures should be preferred.)
13. Capital structure of C Ltd. is as under:
Equity shares of Rs. 100 each 10,00,000
10% Preference shares of Rs. 100 each 5,00,000
8% Debentures of Rs. 100 each 3,00,000
24,00,000
The company earned a profit before interest and tax Rs. 4,74,000. The market price of equity
share Is Rs. 160 and preference share is Rs. 120 each. Company maintains dividend pay out ratio
at 50%. Tax rate is 35%.
You are required to calculate cost of equity shares on the basis of:
(i) Earnings Yield Method,
(ii) Dividend Yield Method.
(Ans. : After tax (i) 15.16% (ii) 8.08%)
14. The average rate of dividend paid by Anima Ltd. for the last five years is 21%. The earnings of the
company have recorded a growth rate of 3% per annum. The market value of the equity shares is
estimated to be Rs. 105. Find out the cost of equity share capital.
(Ans. : 23%)
15. From the following information find out cost of retained earnings:
Dividend per share Rs. 3
Personal income tax rate 30%
Personal Capital gain tax rate 20%
Market price per share Rs. 25
Brokerage on investment of dividend 3%
(Ans. 10.185%)
16. Ashutosh Limited company has the following capital structure :fc,
Equity Shares (Rs. 10 each) 4,00,000
9% Preference share capital (Rs. 100 each) 1,00,000
12% Debentures (Rs. 100 each) 3,00,000
10,00,000
The equity shares of the company sales for Rs. 25. It is expected that company will pay dividend of
Rs. 2 per share this year. Corporate tax rate is 50%. Assume 25% as income tax rate of individual
shareholders. Calculate the weighted average cost of capital.
(Ans. : 7.1%)
17. PawanManufacturers Ltd. has total assets of Rs. 16,00,000 which has been financed with Rs.
5,20,000 of debt, Rs,, 9,00,000 of equity share capital and Rs. 1,80,000 of general reserve.
Company’s current year profit before interest and tax is Rs. 1,35,000. It pays 8% interest on
borrowed funds. Company has 9,000 equity shares of Rs. 100 each selling at a market price of Rs.
120 per share. Tax rate for the company is 35%.
You are required to compute weighted average cost of capital.
(Ans. : 10.1275%)

- Khan & Jain : Financial Management, Tata Mc Graw Hill Co.
- Bierman, H. and Smidt., S. : Capital Budgeting Decisions, MacMillan
- S. N. Maheshwari : Financial Management, Sultan Chand & Co.
- Ravi, M. Kishore : Financial Management, Taxmann’s Publications
- Van Horne, J.C.: Financial Management & Policy, Prantice Hall
- Lawrence, D. Sohall & Chanles W. Haley: Introduction to Financial Management, Tata Mc Graw
Hill
- Kuchhal, S.C.; Financial Planning An Analytical Approach, Chaitanya Publishing House
- Ramchandaran, H. : Financial Planning & Control, S. Chand & Co.
- Agarwal & Agarwal : Financial Management, Ramesh Book Depot, Jaipur
- Malodia, G. L. : Financial Management, Jodhpur Publishing House, Jodhpur
Unit - 11 : Capital Budgeting
Structure of Unit:
11.0 Objectives
11.1 Introduction
11.2 Meaning and Definition of Capital Budgeting
11.3 Characteristics of Capital Budgeting
11.4 Need and Significance of Capital Budgeting
11.5 Capital Budgeting Process
11.6 Components of Capital Budgeting
11.7 Capital Budgeting Techniques
11.7.1 Traditional Techniques
11.7.2 Discounted Cash flow Techniques
11.8 Comparison of Net Present Value and Internal Rate of Return
11.9 Summary
11.0 Objectives
 Meaning and Definition of Capital Budgeting

 Characteristics of Capital Budgeting
 Need and Significance of Capital Budgeting
 Capital Budgeting Process
 Components of Capital Budgeting
 Capital Budgeting Techniques
 Traditional Techniques and Discounted Cash flow Techniques :
 Comparison of Net Present Value and Internal Rate of Return
11.1 Introduction
Capital budgeting is the process of making investment decisions in capital expenditures. A capital expenditure
may be defined as an expenditure the benefit of which are expected to be received over period of time
exceeding one year. Capital budgeting deals exclusively with major investment proposals which are essentially
long term projects and is concerned with the allocation of firm’s scarce financial resources among the
available market opportunities. It is many sided activity which includes a search for new and more profitable
investment proposals and the making of an economic analysis to determine the profit potential of each
investment proposal. Capital budgeting is also known as capital expenditure decisions. Long term investment
decisions, management of fixed assets etc.
11.2 Meaning and Definition of Capital Budgeting

Capital budgeting may be defined as the decision making process by which a firm evaluates the purchase of
major fixed assets including land, building, plant and machinery, equipments. It refers to long term planning
process that involves investing the firm’s resources for a period longer than a year. Some important definitions
are as follows :
“Capital budgeting is long term planning for making and financing proposed capital outlay”.
Charles T. Horngren
“Capital budgeting consists in planning the development of available capital for the purpose of maximising
the long term profitability (return on investment) of the firm”.
R. M. Lynch
“Capital budgeting involves the planning of expenditures for assets, the returns from which will be realised in
future time periods”. Milton H. Spencer
“Capital budgeting is concerned with the allocation of the firm’s scarce financial resources among the available
market opportunities. The consideration of investment opportunities involves the comparison of the expected
future streams of earnings from a project, with the immediate and subsequent expenditures for it”.
G.C. Phillippats
“The capital budgeting is essentially a list of what management relieves to be worth while projects for the
acquisition of new capital assets together with the estimated cost of each project.”
Robert N. Anthony
“The capital expenditure budget represents the plans for the appropriations and expenditures for fixed
assets during the budget period. Keller & Ferrara
Conclusion: Capital budgeting is long term planning for making and financing proposed capital outlay. It is
a process by which available resources are allocated among competitive long term investment opportunities
so as to promote the greatest profitability of a firm over a period of time. It refers to the total process of
generating, evaluating, selecting and following up on capital expenditure alternatives.
11.3 Characteristics of Capital Budgeting

The main characteristics of capital budgeting are as follows :
(1) Capital budgeting is concerned with expenditure of capital nature.
(2) Capital budgeting deals with benefits over a number of years future.
(3) Capital expenditure plans involve a huge investment in I assets.
(4) Capital expenditure once approved represents long I investment that can not be reversed or
withdrawn without sub staining a loss.
(5) Any error in evaluation of investment projects may lead to sum consequences.
11.4 Need and Significance of Capital Budgeting

Capital budgeting decisions are of paramount importance in financial decision making. These decisions are
related with fixed assets which in generating earnings of the firm. These decisions are the most crucial and
critical and they have significant impact on the profitability aspect of the firm. Capital expenditure decisions
have placed greater emphasis due following :
Need and Significance of Capital Budgeting:
1. Long Term Planning :Capital expenditure is a strategic investment :of some magnitude and is of
a non-routine nature. It has economic life and its benefits continue over series of years.
2. Optimum use of Funds :Capital investment decisions require an amount of funds. Capital is a
scarce resource of business. So it is essential to utilize capital in such a manner so that wealth of l
shareholders may be increased Capital budgeting ensures optimum utilization of larger the business.
3. Analysis of Risk :Capital budgeting helps in analysing the risk involved in various projects
under consideration. Capital expenditure involve a greater risks as they require huge investment.
4. Replacement Decisions : Capital budgeting helps in taking decisions regarding replacement of
old asset by a new one. The new asset may be useful and profitable for the business. A comparative
study is made between these options and profitable decisions may be taken.
5. Selection of Best Proposal :Capital budgeting suggest the best proposal available. This is done
by using various modern techniques of capital budgeting
6. Maximization of Profit : Fixed assets generate earnings and require huge investment. Capital
budgeting decisions ensure the best utilization of fixed assets. Cost control and reduction in cost
ensure maximization of profit of the business.
7. Arrangement of Funds : There are many sources for collecting funds and each has its own cost
and merits and demerits. Capital budgeting decision helps in determining economic source of capital.
8. Helps in Cash Budgeting : Capital budgeting helps in preparing cash budget of the firm. It is
helpful in forecasting of cash requirements.
9. Protection from Losses : Capital expenditure decisions are not reversible. A wrong decision may
be cause of business failure. Capital budgeting protects from such: may occur due to lack of
knowledge.
10. Control over Capital Expenditure : Capital budgeting helps in controlling the capital
expenditures. Actual performance may be compared with budgeted results and necessary actions
may be taken by management.
11. Helps in Formulation of Depreciation Policy :Capital budgeting helps in determining depreciation
policy of fixed assets. A proper method of depreciation should be adopted to calculate correct cost
of product and also to reduce tax liability.
11.5 Capital Budgeting Process

Capital budgeting process involves the following steps:
Capital Budgeting Process:
1. Origination of Investment Proposals : The first step in capital budgeting process is the conception
of a profit making idea. The idea may originate from the top management level taking for longer
view in the interest of the company. A periodic review and comparison of earnings, cost, procedures
and product line should be made by the management to facilitate the origination of such idea.
2. Evaluation of Projects : Appraisal of capital projects is important aspect of capital budgeting.
Capital appraisal is concerns with evaluating the costs involved in a capital investment proposal and
benefits that accrual from it. The costs and benefits are estimated in the form of cash outflows and
cash inflows. This step also involves the selection of an appropriate criterion for judging the desirability
of the projects.
3. Screening and Selection : Capital expenditure requests should be properly screened. The budget
committee screens the requests in order to weed out those projects which are obviously undesirable,
the projects which are under consideration are divided into three categories : (i) Most essential
projects (ii) Projects which should be accepted (iii) Desirable and deferrable projects.
After screening the projects selection is made on the basis of criteria of the firm. Such criteria should
encompass the supply and cost of capita I the expected returns from alternative investment
opportunities.
4. Project Execution : The funds are appropriated for capital expenditure after the final selection of
investment proposals. The project execution committee must ensure that the funds are spent in
accordance with appropriations made in the capital budget.
5. Follow up : Systematic procedure should be developed to review the performance of project
during their life and also after completion, follow up comparison of actual performance with original
estimates not only ensures better forecasting but also helps sharpen the technique; improving future
forecasts. Such an evaluation also has advantage of forcing department heads to be made realistic
and careful.
11.6 Components of Capital Budgeting

The following are the basic components of capital budgeting analysis:
(1) Estimating Cash Outflows : Initial investment or outflows at zero time period refers to the sum of
all cash outflows invest the project initially or during the life time of the project. It includes cost of
asset, transportation costs, installation costs, and working ca: requirements etc.
(2) Estimating Cash Inflows : Cash inflow refers to estimated future earnings or annual operating
savings accruing from the investment proposal. The earnings will be the difference of estimated
revenues I earned and estimated costs to be incurred during the life of the project: earnings or
annual savings should be calculated on cash basis, However, cash inflows are estimated on after tax
basis. Since the depreciation considered as an allowable expenditure under tax law, so it she.
deducted from the accounting profit for computation of tax. For computation of cash inflows
depreciation should be added to net earnings after tax depreciation. It can be expressed as follows:
Cash Inflow = Net Profit after tax + Depreciation
Computation of Cash Inflows :
(i) On th e b asis of Sales.
R s.
Annual Sal es Revenu e ... ...
Les s : Op era tin g E xp ens es
Direct M at eri al .. ....
Direct W ages .. ....
Facto ry Overhead s (inclu din g depreciatio n) .. ....
Offi ce overhead s .. ....
Sel ling and Di stri butio n cost s .. ....
Fixed Exp enses (in cl udin g in teres t o n .. .... ... ...
borrowing s)
Inco me before tax o r EB T ... ...
Les s: In co me Tax ... ...
Net Incom e aft er t ax or EAT ... ...
Add: Depreciat ion ... ...
Net C ash i nflows (E AT + Depreciat io n) ... ...
(ii) On the basi s of Sav ings
Rs.
(a) Esti mated Sa vings
Estimated Savings in Wages ......
Estimated Savings in Scrap ...... . .....
(b) Esti mated Additi onal Costs
Ad dit ion al Co st of Maint enance ......
Ad dit ion al Co st of supervis ion ......
Co st o f indirect materials ......
Net Sav ings befo re tax and . .....
dep reciation (a)-(b)
Les s: Depreciatio n . .....
Net Sav ings befo re tax . .....
Les s :Inco me Tax . .....
Net Sav ings aft er t ax . .....
Add : Dep reciat ion . .....
Net Sav ings aft er t ax and before . .....
depreciatio n o r Annual Cash inflow
Depreciation : Depreciation is an item of non cash cost. There are different methods of charging depreciation
viz. straight line method, diminishing balance method, sum of digits methods etc.
(i) Straight Line Method — Under straight line method equal an of depreciation is charged every
year, under this method depreciation calculated as follows:
Deprecation (Annual) = Cost of Asset - Scrap Value

Estimated Life in Years
(ii) Written Down Value Method : Under this method depreciation is provided in initial years and
less in later years. According this method, the depreciation is charged on the remaining value of the
at the beginning of that period. Every year the charge for depreciation is deducted from the book
value and thus the book value and sub depreciation charge go on diminishing every year. This
method is also as diminishing balance method.
(3) Determining Cut-off Rate : The minimum rate of return the firm would expect to have for accepting
a particular proposal s pre-determined. Generally, it is the firm’s marginal cost of capital.
(4) Ranking the Proposals : Ranking the different investment proposals in order of priority will help
management in taking decisions.
(5) Analysing Risk : Before selecting the proposal, risk uncertainty should be assessed properly
and suitable steps should be to evaluate the profitability on the basis of the assessment of inherent
risk and uncertainty.
(6) Non-monetary Aspects : Non-monetary considerations also be weighted such as image of the
firm, moral of employees etc.
11.7 Capital Budgeting Techniques

The capital budgeting requires an estimate of future events expressed in the form of cash flows. The capital
budgeting techniques assist the firm to know which proposal would contribute the maximum value to the
firm. There are many techniques for evaluating and ranking the investment proposals. These techniques can
be categorized as follows:
11.6.1 Traditional Techniques
(a) Urgency Method: Under this method, decisions for investing the funds are taken on the basis of
urgency of the situation and not on the basis of any well conceived plan, because situation demands
immediate action in order to avoid disruption in production process. For example, if there is a
breakdown in production process due to loss of any component of the machinery which requires
immediate replacement in order to avoid disruption in the production. It shall be given first priority
without any delay on the part of management. In this way urgency is the sole criterion for investing
the funds in the project.
(b) Pay-back Period Method: Pay back period is the simplest method of evaluating the projects.
Pay back period represents the number of years required to recover the original cash
outlay invested in a project. It shows the period where total cash inflows equals the total cash
outflows. In making a comparison between two or more projects, the projects having the lesser
number of pay back years will be accepted. According to this method, various prefects are ranked
according to the length of their pay back period in such a manner that the investment with a shorter
pay back period is preferred to the one which has longer pay back period.
Computation of Pay-back Period :
(a) Even Cash Inflows : If the cash inflow is uniform from year to year, the pay back period is
calculated by simply dividing the initial investment by the annual cash inflow. It can be calculated as
follows :
Pay back Period = Initial Investment
Annual Cash Inflows
Illustration 1 : Following are the details of the two projects :
P ro je c t A P ro je c t B
In it ia l I n ves tm e nt Rs . 2,0 0,00 0 R s. 3,00 ,000
Es tim a te d li f e [ in ye a r s) 5 ye ar s 6 yea r s
Es tim a te d sc ra p v a lu e R s. 1 0,00 0 Rs . 3 0 ,000
A nn u a l N e t e arn i n gs b e fo r e ta x b ut R s. 2 4,00 0 Rs . 3 0 ,000
a f te r de pr e ci at io n
Ta x r a t e 50 % 50%
C a lc u la t e p ay ba ck p e r iod and sug g e st w h ic h p r o je ct sh o uld b e se le c te d .
S olu t io n:
C alc u la ti on of C as h In flo w s
P roj e c t A P ro j ec t B
N e t E a rn ings Be f or e T a x R s. R s.
Le ss : I nc om e T a x @ 5 0% 24 ,0 00 3 0,0 00
12 ,0 00 1 5,0 00
N e t E a rn ings A ft e r Ta x 12 ,0 00 1 5,0 00
A dd : D e pr e c ia tio n 38 ,0 00 4 5,0 00
A nn u a l C a sh I nf lo w s 50 ,0 00 6 0,0 00
I nit ia l In ve st me nt
P a y Ba c k P e r iod = A n nua l Ca s h In flow s
R s 2 ,0 0,0 0 0
P a y b a ck P erio d f or P r oje c t A = R s 50 ,00 0 = 4 ye a r s
P a y b a ck P erio d f or P r oje c t B = Rs. 3,00 ,00 0 = 5 ye a rs

Rs . 6 0, 00 0
Suggestion : According to pay back period method project A she be selected because it has
shorter pay back period.
Illustration 2 : Mehta Engineering Company is considering purchase of a new machine for its
expansion programme. There are possible machines suitable for the purpose. Their details are as
follows:
Pa rticula rs Machine Machine Machine
X Y Z
Rs. Rs. Rs.
Cap ital Cost 1,00 ,000 1,0 0,000 1,0 0,000
Sales at st andard price 1,80 ,000 1,6 0,000 1,5 0,000
Net Cost o f Production :
Direct M at erial 12 ,000 1 0,000 9 0,000
Direct Labo ur 13 ,000 1 4,000 1 6,000
Facto ry Overhead s 20 ,000 1 8,000 1 9,000
Admini stration Overheads 16 ,000 2 2,500 1 7,000
Sellin g and Di stri but ion 14 ,000 8,000 2 4,000
Overhead s
So luti on :
Statement Showing the Cash I nflo ws of Three Machines
Part icu lars Machin e M achi ne Machi ne
X Y Z
Rs. Rs. Rs.
Sales at St an dard Price (i) 1 ,80,0 00 1,6 0,00 0 1,5 0,00 0
Less : Cost of Production :
D irect Material 12,0 00 10,0 00 9, 000
D irect Labour 13,0 00 14,0 00 16, 000
Fact ory Overheads 20,5 00 18,0 00 19, 000
Ad min istrat ion Overhead s 16,0 00 2,5 00 17, 000
D istribution Ov erheads 14,0 00 8,0 00 24, 000
Depreciatio n 19,0 00 22,5 00 24, 000
Total Co st (ii) 94,0 00 95,0 00 1 ,09, 000
Profit befo re Tax (i) - (ii) 86,0 00 65,0 00 41, 000
Les s : Inco me Tax 50 % 43,0 00 32,5 00 20, 500
Profit aft er T ax 43,0 00 32,5 00 20, 500
Add : Dep reciation 19,0 00 22,5 00 24, 000
Annual Cash In flo ws 62,0 00 55,0 00 44, 500
In itial I nvestment
Pay Back Perio d = An nual Cash Inflo ws
Machine X = Rs. 1,0 0,00 0 = 1.61 years

Rs . 62, 000
Rs. 1,00 ,000 = 1.82 years
Rs. 55, 000
Machine Y = Rs. 1,0 0,00 0 = 1.8 2 years
Rs .55,0 00
Machine Z = Rs.1, 00,000 = 2. 25 years
Rs 44, 500.
Machine ‘X’ is maximum profitable because its pay back period is minimum.
Illustration 3 : Raja Industries Limited is producing articles mostly on hand labour and is considering
to replace it by a new machine. There are two alternative models A and B of the new machine.
Prepare a statement of profitability showing the pay back period from the following information :
Machine A Machine B
Estimated Life of Machine 4 years 5 years
Cost of Machine Rs. 90,000 Rs. 1,80,000
Estimated Savings in Scrap Rs. 5,000 Rs. 8,000
Estimated Savings in Direct Wages Rs. 60,000 Rs. 80,000
Additional Cost of Maintenance Rs. 8,000 Rs. 10,000
Additional Cost of Supervision Ignore taxation. Rs.12,000 Rs. 18,000
Solution :
Statement Showi ng Annual Cash Inflo ws
Machin e A Machin e B
Rs. Rs.
Est im at ed Savings in Scrap 5. 000 8,000 80,0 00
Est im at ed Savings in Direct Wages 50 .000
Tot al Savin gs (a) 65 .000 88 ,000
Add itio nal Cost of maintenance 8, 000 10,00 0 18, 000
Add itio nal Cost of Supervis ion 12 .000
Total Add itio nal Cost (b) 20 ,000 28 ,000

Net Cash Inflo w (a) - (b) 45 ,000 60 ,000
Original Invest ment
Pay Back Period = A nnual Cash Inflo ws
Rs. 90 ,000
Machin e A = Rs 45, 000 = 2 years
Rs. 1, 80,00 0
Machin e B = Rs. 60,00 0 = 3 yeas
Machine A has shorter pay back period, hence it should be preferred.
(b) Uneven Cash Inflows : If the annual cash inflows are uneven then the calculation of pay back
period takes a cumulative form. We accumulate the annual cash inflows till the recovery of initial
investment. In case the investment is recovered in between a year, it is presumed that cash inflows
accrue evenly throughout the year. In such a case pay back period is calculated on proportionate
basis. The pay back period can be calculated as follows:
No. of completed Years + Original Outlay remaining to be recovered
Annual Cash inflow of next year
Evaluation of the Project : The pay back period can be used as an accept or reject criterion. It
can be used as a method of ranking projects. It gives highest ranking to the project which has the
shortest pay back period and the lowest ranking to the project which has the highest pay back
period.
In case of evaluation of a single project, it may be accepted if the pay back period is less than the
period fixed by the management.
Illustration 4 : From the following information rank the investment proposals according to pay
back period.
Project Initial Outlay Annual Cash flow Life (in years)
Rs. Rs.
A 25,000 3,000 10
B 3,000 1,000 5
C 12,000 2,000 8
D 20,000 5,000 10
E 40,000 8,000 7
Solution:
Ranking According to Pay back Period Method
Initial Outlay Annual Cash Pay back period Rank
Inflow (2)(3)
(1) (2) (3) (4) (5)
A 25,000 3,000 8.33 years 5
B 3,000 1,000 3 years 1
C 12,000 2,000 6 years 4
D 20,000 5,000 4 years 2
E 40,000 8,000 5 years 3
Merits of Pay back Period :

Pay back period is the most popular and widely recognized traditional method of evaluating capital
projects. Some merits of this method are as follows:
1. Easy and Simple : It is easy to calculate and simple to understand. The simplicity of pay
back period is considered as a virtue by business executives which is evident from their
heavy reliance on it for appraising investment proposals in practice.
2. Fear of Obsolescence : This method is useful in the projects with short economic lives
and those with high rate of obsolescence.
3. Liquidity : This method gives importance to the speedy recovery of investment in capital
assets. It stresses the liquidity as well as solvency of a firm as a guiding principle in the
capital budgeting decisions.
4. Uncertainty: It is useful in the industries which are subject to uncertainty, instability or
rapid technological changes because the future uncertainty does not permit projection of
annual cash inflows beyond a limited period.
5. Handy Device : It is handy device for evaluating investment proposals, where precision
in estimates of profitability is not important.
Demerits of Pay back Period :
Used alone pay back period may lead to incorrect conclusions. Demerits of this method are as
follows:
1. Considers only period of Pay back :A major limitation of pay back period method is
that it ignores all cash flows after the pay back period. It ignores, the fact that projects may
have different profit stream after the pay back period is over and may lead to serious
under-investment as the post pay back period profitability is not considered.
2. Ignores Profitability: It does not an appropriate method of measuring the profitability
of an investment project, as it does not consider the entire cash inflows generated by the
project.
3. Overlooks Capital Cost: This method overlooks the cost of capital which is an important
consideration in making sound investment decisions.
4. Over Emphasis on Liquidity: This method gives undue weight age to short-term
considerations to the exclusion of long-term objects. A project with long pay back period
may be preferable if its economic life is also longer and the total surplus during the entire life
of the projects is substantial.
5. Determination of Minimum Pay Back Period : There is no rat ional basis
determining the minimum acceptable pay back period. It is generally a subjective decision
of the management which creates so many administrative difficulties.
6. Ignores Present Value of Cash Flows:Pay back period ignores the present value of
future cash flows. It gives equal weight to returns of a equal amounts even though they
occur in different periods.
7. Ignores Size and Cost of Project : This method ignores the size and cost of the
projects because it gives emphasis on pack back period only.
Improvement in Pay-back Period :
In spite of many limitations, pay back period method is much popular in western countries. To
increase the utility of pay back period, the following refinements should be applied:
(i) Post Pay Back Profitability : It considers returns receivable beyond the pay back
period It recognizes the entire life of the project and quantum of profits. According to this
method the project which has greatest post back profitability may be accepted.
Computation of Post Pay Back Profitability :
(a) When cash inflows accrue evenly throughout the life of project:
Post pay back profitability = Annual Cash inflow (Estimated life of project - Pay
back period) + Scrap value
(b) When cash inflows accrue unevenly throughout the life of project.
Post pay back profitability = Total Cash inflow in life of project +Scrap value -
Initial Investment
Illustration 5 : Two projects X and Y are before consideration of the management of Syntex Ltd.
The particulars are as under:
Project X Project Y
Initial Investment Rs. 1,00,000 Rs. 1,00,000
Estimated Life in years 5 6
Net Earnings after tax before depreciation
Year Rs. Rs.
1 50,000 25,000
2 40,000 30,000
3 35,000 34,500
4 23,000 40,500
5 12,000 50,000
6 — 30,000
You are requested to suggest the better project using (i) Pay back period (b) Post pay back
profitability.
Solution :
(i) Calculation of Pay back Period
P ro ject X Project Y
Yea r Ca sh Inflows Cumula tive Ca sh Inflows Cumulative
Cash Inflows C ash Inflows
Rs. Rs. Rs. Rs.
1 5 0,00 0 50 ,000 25 ,000 25,00 0
2 4 0,00 0 90 ,000 30 ,000 55,00 0
3 3 5,00 0 1,2 5,00 0 34 ,500 89,50 0
4 2 3,00 0 1,4 8,00 0 40 ,500 1 ,30,0 00
5 1 2,00 0 1,6 0,00 0 50 ,000 1 ,80,0 00
6 — — 30 ,000 2 ,10,0 00
Rs . 1,0 0,00 0-Rs. 90,0 00
Pay b ack Perio d (Pro ject X) = 2 + Rs 3500 0
= 2 + 10,0 00 = 2. 86 years
35,00 0
Rs. 1,00, 000-Rs. 8 9,500

Pay b ack Perio d (Pro ject Y) = 3 + Rs. 40, 500
10, 500
= 3 + 40, 500 = 3. 26 years
According to pay back period project X is better because it has shorter period than project Y.
(ii) Calculation of Post Pay back Profitability :
Post pay back Profit = Total Cash inflows in life - Initial Investment
Project X = Rs. 1,60,000 - Rs. 1,00,000 = Rs. 60,000
Project Y = Rs. 2,10,000 - Rs. 1,00,000 = Rs. 1,10,000
Project Y shows greater post pay back profitability than project X. Hence, it may be preferred.
(ii) Pay back Reciprocal Method : Pay back reciprocal is the time adjusted rate of return on
investment. It is used as a method of evaluating capital expenditure proposals. It gives a rough
approximation of the internal rate of return. It can be expressed as follows :
Annual Cash Inflows
Pay back Reciprocal = x 100
Initial investment
OR
______ 1______ x 100
Pay back Period
This method is used when the project generates even cash inflows and the project has a long
economic life it must be at least twice the pay back period.
Illustration 6 : A project cost Rs. 5,00,000 and generates annual cash inflow Rs.1,25,000. Calculate
pay back period and pay back reciprocals.
Solution ::
Init ial Invest ment
(i) Pay back Period Annual Cash Inflow
Rs. 5,0 0,000 = 4 years
Rs. 1,2 5,000
Annual Cash Inflow

(ii) Pay back Period Init ial Invest ment x 100
Rs. 1,25 ,000 x 1 00 = 25 %
Rs. 5,00 ,000
(c) Average Rate of Return Method: The average rate of return is defined as the ratio of average
profit to average investment. The general aim of investment is to maximize net profit after tax, it is
appropriate to consider net profit after tax for the purpose of accounting rate of return. Average rate
of return method is also known as accounting method, unadjusted rate of return method and return
on investment method. According to this method capital projects are ranked in order of their earnings.
Project which yields the highest earnings is selected The return on investment can be expressed in
two ways :
(i) Rate of Return on Original Investment : Under this method average annual earnings
is divided by original investment. It is expressed in percentage. It can be calculated as
follows:
Average Annual Earnings after tax x 100
Original Investment
(ii) Rate of Return on Average Investment : This is most appropriate method of rate of
return on investment. Under this method, average profit after depreciation and tax is divided
by the average investment. The rate of return on average investment can be computed as
follows:
ARR = Average Annual Earnings after Tax x 100
Average Investment
OR
Average Annual Earnings: Average annual earnings is computed by adding whole earnings
over the entire economic life of the project and dividing the total by number of years of
economic life of the project. Net earnings or earnings are taken after tax and depreciation.
Average Investment : Average investment is calculated by dividing original investment by
two or by a figure representing the mid point between the original outlay and the salvage
value of the investment. It can be calculated as follows :
Average Investment = Original Investment - Scrap Value
2
OR
Original Investment
2
Illustration 7 : Finolex Pipes Ltd. is contemplating an investment of Rs. 1,00,000 in a new plant,
which will provide a salvage value of Rs. 8,000 at the end of its economic life of 5 years. The profits
after depreciation and tax are estimated to be as under:
Year R s.
1 5,00 0
2 7,50 0
3 12,5 00
4 13,0 00
5 8,00 0
Calcu lat e acco unting rate of return.

So luti on :
ARR = Average annual profits aft er depreciation and tax
Average In vestment
Rs. 9 ,200 x 10 0 = 17. 04%
= Rs.54,0 00
Rs. 5 ,000 + Rs. 7,50 0 + Rs . 12, 500 +
Average Annual Pro fits = ____ _Rs. 13, 000 + Rs. 8,000 ____ __
5
= Rs. 9,200
Average Inv es tment = Origin al Invest ment + Scrap Value
2
= Rs.1,00 ,000 + Rs.8 ,000 =Rs 5400 0
Illustration 8 : A project costs Rs. 1,50,000 and has a scrap value of Rs. 30,000. Its streams of
income before depreciation and taxes during first five years is Rs. 30,000; Rs. 36,000; Rs. 42,000;
Rs. 48,000 and Rs. 60,000. Assuming tax rate at 50% and depreciation on straight line basis.
Calculate the average rate of return (ARR) for the project.
Solution :
(i) Computation of Average Net Income after tax
Average Net Income before Depreciation and Tax Rs.
Rs. 30,000 + 36,000 + 42,000 + 48,000 + 60,000 = 43,200
5
Less: Depreciation (Annual)
Rs. 1,50,000 - Rs. 30,000 24,000
5 ______
Average Net Income before tax 19,200
Less : Income tax 50% 9,600
Average Net Income after tax 9,600
(ii) Computation of Average Investment :
Initial Investment + Scrap Value
2
= Rs. 1,50,000 + Rs. 30,000 = 90,000
2
Average Net Income after Tax x 100
ARR =
Average Investment
= Rs. 9,600 x 100 = 10.67%

Rs.90,000
Illustration 9 : From the following particulars of a capital project, calculate unadjusted rate of
return :
Initial Capital outlay Rs. 1,20,000
Salvage Value Nil
Annual Cash inflows Rs. 30,000
Life in years 8
Solution :
Unadjusted Rate of Return Annual Cash Inflow - Depreciation x 100
Average Investment
= Rs. 30,000 - Rs. 15,000 x 100 = 25%
Rs. 60,000
Initial Investment = Rs. 1,20,000 = Rs.60,000
Average Investment = 2 2
Merits of Average Rate of Return (ARR)

The following are the merits of the average rate of return method :
1. Simple : It is very simple and easy to understand and to use
2. Considers Profitability : It gives due weightage to the profitability of the project.
Under this method projects having higher rate of return will be accepted. These are
comparable with returns on similar investment derived by other firms.
3. Appropriate Method : This method takes into account savings over the entire economic
life of the project. Therefore, it provides a better means of comparison of projects than pay
back method.
Demerits of Average Rate of Return :
The following are demerits of the average rate of return method :
1. Ignores Time Factor : It ignores the time value of money. A project having low initial
inflows and high future inflows would have the same average return as a project having the
inflows in the reverse order.
2. Use of Accounting Profit : It uses accounting profits and not the cash inflows in
appraising the investment projects.
3. Ignores Re-investment of Profits : This method ignores the fact that profits can be
reinvested and profits can be earned on such reinvestment, which in turn will affect the rate
of return.
4. Determination of Fair Rate of Return : The method does not determine the fair rate
of return on investment. The use of arbitrary rate of return may cause serious distortions in
the selection of capital projects
5. Incremental Cash Outflows : It considers only net investment and not the incremental
cash outflows i.e. new investment minus the sale proceeds of the old equipment. The concept
of incremental cash outflows should be taken to arrive at a correct financial decision.
11.7.2 Discounted Cash Flow Techniques
Discounted cash flow method is also known as time adjusted method. The methods are improvements over
pay back period and the accounting rate of return since these consider return after pay back period as well
as time value of money. In recent years, the method has been recognized as the most meaningful technique
for financial decisions.
The method is based on the assumption that rupee one received today is worth more than rupee one to be
received in future. The following methods are used to judge the profitability of different proposals on the
basis of this method:
(a) Present Value Method: Present value method recognizes that cash flow streams at different
time periods differ in value and can be compared only when they are expressed in terms of a
common denominator. The following steps are involved in this method :
1. Determination of cash outflows i.e. initial investment and subsequent outlay.
2. Determination of future cash inflows for different periods.
3. Determination of discounting rate i.e. cut off rate. It is generally taken to be equal to cost of
capital.
4. Computation of Present Value Factor (P.V.F.) with the help of discounting rate.
5. Compute present value of all cash inflows for different periods and add them together. Salvage
value and working capital released at the end of the project’s economic life are also considered as
cash inflows and are duly discounted to present value. It is calculated as follows : -
Present Value = Cash Inflows x P.V.F.
6.Cash outflows at zero period of time are not discounted, initial amount is taken as present value of
cash outflows, however, cash outflows at subsequent periods are discounted by the same present
value factor.
Computation of Present Value Factor (P.V.F.)
The present value of cash inflows can be calculated with the help of following formula:
P.V.F. = 1
(1+1)n
P.V.F. = Present value factor of rupee one
r = Required earning rate or discounting rate
n = Number of years
Acceptance Criterion : The present value of the future cash inflows or streams are compared with
the present value of the outlays. If the present of the cash inflows is equal to or greater than the
investment proposal/outlay, the project may be accepted. If, however, it is less, the proposal may
be rejected. It can be shown as under:
When PV > I, Accept the proposal
When PV < I, Reject the proposal
Here, I = Initial Investment or Capital Outlay
PV = Present Value of Future Cash Inflows.
(b) Net Present Value Method: Net present value (NPV) method is also known as excess
present value or net gain method. The net present value of the project is the difference between the
sum of the present value of its cash inflows and present value of cash outflows (i.e. initial investment
or capital outlays).
It can be expressed as follows :
Total Present Value. Initial
Net Present Value (NPV) = of Cash Inflows - Investment
The following steps are involved under this method :
(1) The present value of cash inflows and the present value of investment outlay (i.e. cash out flows)
should be calculated using discounting rate.
(2) The Net Present Value (NPV) is found cut by subtracting the present value of cash outflows
from the present value of cash inflows.
Acceptance Criterion : If the net present value is positive, the project should be accepted; if
negative it should be rejected. Symbolically
If NPV > Zero Accept the proposal
If NPV < Zero Reject the proposal.
If the two projects are mutually exclusive, the one with higher net present value should be choosen.
Under this method, projects can be ranked in order of net present value i.e., first rank will be given
to the project with &»e highest positive NPV.
Illustration 10 : Project M initially costs Rs. 50,000. It generates the following cash flows:
Y e ar C a sh In flow s P re se n t V alu e of R e 1 at
10%
R s.
1 18 ,000 0.90 9
2 16 ,000 0.82 6
3 14 ,000 0.75 1
4 12 ,000 0.68 3
5 10 ,000 0.62 1
Taking the cut off rate at 10%, suggest whether the project should be accepted or not. Use net
present value method.
Solution
Calculation of Present Value of Cash Inflows
Year Cas h I nfl ows P.V. factor Present Val ue of
@ 10% Ca sh Inflow
Rs. Rs.
1 18, 000 0.90 9 16, 362
2 16, 000 0.82 6 13, 216
3 14, 000 0.75 1 10, 514
4 12, 000 0.68 3 8,1 96
5 10, 000 0.62 1 6,2 10
To tal Presen t 54, 498
Value
Net Present Value = Total Present Value of Cash Inflows - Initial Investment
= Rs. 54,498 - Rs.50,000 = Rs. 4,498
Suggestion:. Project should be accepted.
Illustration 11 : Pawan Brothers is considering the purchase of a machine. Two machines X and Y
each costing Rs. 1,00,000 are available Earnings after taxation (EAT) are expected to be as under:
Y ea r M ac hi ne X M ac h in e Y D i sc ou nt F ac to r a t
1 0%
Rs . R s.
1 30,0 00 10 ,000 0 .909
2 40,0 00 20 ,000 0 .826
3 50,0 00 30 ,000 0 .751
4 35,0 00 35 ,000 0 .683
5 15,0 00 40 ,000 0 .621
1,70, 000 1,3 5,00 0
Calculate Net Present Value (NPV) of two alternatives assuming depreciation is charged on straight
line basis.
Solution :
(i) Calculation of Cash inflows of Machine X and Machine Y
Machine X Machine Y
Year EAT D epreciati C ash EAT Depreciati Cash
on on
Inflow Inflow
Rs. Rs. Rs. Rs. Rs. Rs
1 30,0 00 20,0 00 50, 000 10,0 00 20,000 30, 000
2 40,0 00 20,0 00 60, 000 20,0 00 20,000 40, 000
3 50,0 00 20,0 00 70, 000 30,0 00 20,000 50, 000
4 35,0 00 20,0 00 55, 000 35,0 00 20,000 55, 000
5 15,0 00 20,0 00 35, 000 40,0 00 20,000 60, 000
(ii) Calculation o f Present Value of Cash Inflow s :
Yea r Machine X Machine Y

Discount Cash Present Cash Inflow P resent
Factor @ Inflow Value Value
1 0%
Rs. Rs. Rs. Rs.
1 0 .909 50,000 45,450 30,00 0 , 2 7,27 0
2 0 .826 60,000 49,560 4 0,00 0 3 3,04 0
3 0 .751 70,000 52,570 5 0,00 0 3 7,55 0
4 0 .683 55,000 37,565 5 5,00 0 3 7,56 5
5 0 .621 35,000 21,735 60,00 0. 3 7,26 0
0 .909 2,70,000 2,06,880 2, 35,0 00 1, 72,685
Net Present Value = Total Present Value - Initial Investment

Machine X = Rs. 2,06,880 - Rs. 1,00,000 = Rs. 1,06,880
Machine Y = Rs. 1,72,685 - Rs. 1,00,000 = Rs. 72,685
Working Notes:
(i) It is assumed that economic life of the both machines is 5 years
(ii) It is assumed that after the expiry of economic life salvage of both machines will be nil.
(iii) Depreciation has been calculated as under :
Depreciation = Initial Investment
Estimated Life
= Rs.1,00,000 = Rs.20,000
5
Illustration 12 : DCM Ltd. is considering an investment proposal. The project will cost Rs. 50,000.
The project has a life expectancy of five years and no salvage value. The company’s tax rate is
55%. The company uses straight line depreciation. The estimated cash flows before tax (CFBT)
from the proposed investment proposal are as follows :
Year CFBT (Rs.)
1 10,000
2 11,000
3 14,000
4 15,000
5 25,000
Calculate Net Present Value (NPV) at 10% discount rate and suggest whether the proposal should
be accepted or not.
First of all we should determine annual depreciation to compute net profits (CFBT - Depreciation)
on which the company is to pay taxes. This will be shown as follows :
(i) Calculation of Cash Inflows (CFAT)
Y e ar C F BT D ep r e ci ati N et T axe s @ N e t P r ofit C a sh
on P r ofits 55 % a ft e r Ta x in fl ow s
(2 )-(3)= (C F A T )
(6)+ (3)
(1 ) ( 2) (3 ) (4) (5) (6) (7 )
R s. R s. Rs. R s. Rs . R s.
1 10 ,000 10, 000 N il Nil N il 10, 000
2 11 ,000 10, 000 1,00 0 55 0 450 10, 450
3 14 ,000 10, 000 4,00 0 2, 200 1,80 0 11, 800
4 15 ,000 10, 000 5,00 0 2, 750 2,25 0 12, 250
5 25 ,000 10, 000 15,00 0 8, 250 6,75 0 16, 750
11,2 50 61, 250
( ii ) Ca lc ula t ion o f N et P res en t V a lue (N P V )

Y ea r C a sh In flow s Pr e se n t V alu e To ta l Pr e se nt V alu e
(C F A T) Fac tor @ 10 % C FA T x P.V . F a cto r
R s. R s. R s.
1 1 0,000 0.9 09 9, 090
2 1 0,450 0.8 26 8, 632
3 1 1,800 0.7 51 8, 862
4 1 2,250 0.6 83 8, 367
5 1 6,750 0.6 21 10 ,401
T ota l P re se nt V a lu e of CF A T 45 ,352
Le ss : In itia l I nve st me nt 50 ,000
N e t Pre se nt V a lue (N P V ) -4,64 8
Since Net Present Value (NPV) is negative so the proposal should not be accepted.
Illustration 13 : A company is examining two mutually exclusive investment proposals. The
management uses Net Present Value (NPV) method to evaluate new investment proposals. Advice
the company to which proposal should be taken up by it. Depreciation is charged at straight line
method:
Year Pro po sal A Pro po sal B
(CF BT) (CFBT)
Rs. Rs.
1 19, 000 19, 000
2 19, 000 23, 000
3 19, 000 25, 000
4 19, 000 19, 000
76, 000 86, 000
Cost of Capital 10% 10%
Cost of the project Rs.23,000 Rs.25,000
Life 4 years 4 years
Salvage Value Rs. 3,000 Rs. 5,000
Tax Rate 50% 50%
Solution :
Determine CFAT (Cash inflows). For this purpose calculate depreciation and find out net profit
before tax on which the company is to pay taxes.
Calculation of Cash Inflows (CFAT) for Proposal A
Y ea r CF BT Deprecia ti Net Ta xes @ Net Pro fi t C ash
on Profits 50% after Tax inflows
before tax (CFA T)
(2)-(3 ) (6)+(3)
(1 ) (2) (3) (4) (5) (6) (7)
Rs. Rs. Rs. Rs. Rs. Rs.
1 19 ,000 5,000 1 4,00 0 7,0 00 7, 000 12 ,000
2 19 ,000 5,000 1 4,00 0 7,0 00 7, 000 12 ,000
3 19 ,000 5,000 1 4,00 0 7,0 00 7, 000 12 ,000
4 19 ,000 5,000 1 4,00 0 7,0 00 7, 000 12 ,000
3, 000
76,000 20,000 56,000 28,000 28,000 51,000
Calculation of Cash Inflows (CFAT) for Proposal B
C as h
N et P ro fi t s
D e pr e c iat i T axe s N e t P ro fi t i n flo w s
Y e ar C F BT b ef o re tax
on @ 50 % af t e r T ax (C F A T )
(2 ) -( 3)=
(6)+ ( 3)
( 1) (2) ( 3) (4) ( 5) ( 6) (7)
R s. R s. Rs. R s. R s. Rs .
1 19 ,000 5, 000 1 4,000 7,0 00 7, 000 1 2,00 0
2 23 ,000 5, 000 1 8,000 9,0 00 9, 000 1 4,00 0
3 25 ,000 5, 000 2 0,000 10, 000 10 ,000 1 5,00 0
4 19 ,000 5, 000 1 4,000 7,0 00 7, 000 1 2,00 0
5 ,000
86 ,000 20 ,000 6 6,000 33, 000 33 ,000 5 8,00 0
Calculation of Present Value of Cash Inflows
Proposal A B
P.V.
Present Present
Year Factor Ca sh in flow Cas h Infl ow
Va lue Value
@ 1 0%
Rs R s, R s. Rs .
1 0. 909 1 2,000 1 0,908 1 2,000 10,9 08
2 0. 826 1 2,000 9 ,912 1 4,000 11,5 64
3 0. 751 1 2,000 9 ,012 1 5,000 11,2 65
4 0. 683 1 2,000 8 ,196 1 2,000 8,19 6
5 0. 683 3 ,000 2 ,049 5,000 3,41 5
(S alvage (S alvage
val ue) val ue)
4 0,077 45,3 48
Net Present Value = Total Present Value - Initial Investment
Proposal A (NPV) = Rs. 40,077 - Rs. 23,000 = Rs. 17,077
Proposal B (NPV) = Rs. 45,348 - Rs. 25,000 = Rs. 20,348
Proposal B shows greater NPV, Hence, it should be chosen.
Illustration 14 : No project is acceptable unless the yield is 10%. Cash inflows of a certain project
along with cash outflows are given below :
Year Outflow (Rs.) Inflows (Rs.)
0 1,50,000 -
1 30,000 20,000
2 30,00
3 60,000
4 80,000
5 30,000
The salvage value at the end of 5th year is Rs.40,000. Calculate net present value.
Year 1 2 3 4 5
Discount factor at 10% .909 .826 .751 .683 .621
So lu ti on
C a lc u l at io n o f P re se n t V a lu e o f C a sh O utf lo w s
Y e ar O u t f low s P .V . F ac t or a t P r es e nt V alu e
1 0°
R s. Rs .
0 1 ,50 ,0 0 0 1.0 0 1 ,5 0, 00 0
1 3 0,0 0 0 0 ,9 0 9 2 7,2 70
1 ,7 7, 27 0
C a lc u la t io n o f P r es en t V a lu e of C a s h In fl o w s
Y e ar C a sh I nf low s P .V . F ac t or a t P re se nt V a lu e
10 %
R s. R s.
1 2 0,0 0 0 .9 0 9 1 8,1 80
2 3 0,0 0 0 .8 2 6 2 4,7 80
3 6 0,0 0 0 .7 5 1 4 5,0 60
4 8 0,0 0 0 .6 8 3 5 4,6 40
5 3 0,0 0 0 .6 2 1 1 8,6 30
5 4 0,0 0 0 .6 2 1 2 4,8 40
( Sa l vag e)
1 ,8 6 ,13 0
Net Present Value (NPV) = Total Present Value - Present value of
Cash Outflows
= Rs. 1,86,130-Rs. 1,77,270
= Rs. 8,860
Merits of Net Present Value Method :
The following are the merits of net present value method :
1. Considers Entire Economic Life : This method takes into account the entire economic
life of an investment and income there from. It gives the true rate of return offered by a new
project.
2. Weightage to Time Factor : it gives due weight to time factor of financing. In the
words of Charles T. Horngren, “Because the discounted cash flow method explicity and
rountenely weights the time value of money, it is the best method to use for long range
decisions”.
3. Suitable Method for Uneven Cash Inflows : It is the most suitable method for
evaluating project where the cash flows are uneven.
4. Maximum Profitability : It takes into consideration the objective of maximum
profitability.
Demerits of Net Present Value Method :
The following are the demerits of net present value method :
1. Complicated Method : It is difficult and complicated. It involves a large amount of
calculations.
2. Determination of Discount Rate : It is difficult to determine the exact rate of discount
to be applied. The cost of capital which is commonly used is by it self difficult of assessment.
3. Size of Projects : When projects involve different amounts of investment, the method
may not provide satisfactory answers.
4. Computation of Economic Life of Project : The economic life of an investment is
very difficult to forecast exactly
(c) Profitability Index or Present Value Index (PVl): The profitability index is the relationship that exists
between the present values of net cash inflows and the net present values of cash outflows. To obtain
correct result in comparing projects of unequal size, the calculation of present value can be extended to
compute the ‘Present Value Index’. It can be calculated as follows :
Present Value of Cash Inflows
Present Value Index (PVl) =
Present Value of Cash Outflows
The project is viable if the ratio is equal to or greater than 1. Projects can be ranked on the basis of
profitability index. Highest rank will be assigned to the project with highest profitability index, while the
lowest rank will be given to the project having lowest profitability index.
This method is also known as Benefit Cost ratio because the numerator measures benefits and the denominator
costs.
(d) Internal Rate of Return (IRR): Internal Rate of Return (IRR) is the rate of discount which equates
the aggregate present value of expected future cash inflows with the aggregate present value of cash outflows
of a project. In other words, it is the rate at which net present value of the project is zero.
It is called internal rate be cause it depends mainly on the outlay and proceeds associated with the project
and not on any rate determined outside the investment. This method is known as Time adjusted rate of
return, Discounted cash flow rate of return method, marginal efficiency of capital etc.
As we have discussed earlier, the present value method in which required earning rate is selected in advance,
but under internal rate of return method, rate of discount or interest is determined.
Computation of Internal Rate of Return
(a) When the annual cash inflows are equal over the life of the asset : In the case of those
projects which result in uniform or even cash inflows the internal rate of return can be calculated by
locating present value factor as follows :
Present Value Factor = Initial Investment
Annual Cash Inflow
After the P.V. Factor is calculated as above, it is located in the annuity table on the line representing
the number of years corresponding to the economic life of the project. In case the factor is in
between two rates, the actual rate of return can be interpolated by applying the following formula:
IRR = LDR + P1 - O (HDR - LDR)
P 1 - P2
IRR = Internal Rate of Return
HDR = Higher discount rate
LDR = Lower discount rate
P1 = Present values of cash inflows at LDR
P2 = Present value of cash inflows at HDR
O = Initial investment or capital outlay
Illustration 15 : A project cost Rs. 50,000 and is expected to generate annual cash inflow of Rs.
12,500. The project has an expected life of 5 years.
Calculate “Internal Rate of Return (IRR).
Solution :
Calculation of Internal Rate of Return (IRR)
Firstly, we find present value factor as follows
Initial Investment__
Present value factor - Annual Cash Inflow
= Rs. 50,000 = 4
Rs. 12,500
Now see present value annuity table for 5 years period at present value factor of 4. As we see from
the table at 8% for 5 years period, the present value is 3.993 which is nearly equal to 4. Thus,
internal rate of return (IRR) is 8% approx.
(b) When the annual cash inflows are unequal or uneven over the life of the asset: When
the annual cash inflows are not equal the internal rate of return is calculated by making trial calculations
in an attempt to compute the exact interest rate which equates the present value of cash inflows with
the present value of cash outflows. In the process, cash inflows are to be discounted by a number
of trial rates. The following steps are involved in the process of computation of internal rate of
return:
(i) Determining First Trial Rate : The first trial rate is determined on the basis of present
value factor, which is calculated as follows :
____Initial Investment______
Present Value Factor = Average Annual Cash Inflow
Here Average Annual Cash Inflow = _____Total Cash Inflows___
Economic Life of the Project
After calculating present value factor, use annuity table and find estimated arbitrary internal
rate of return. Thereafter calculate the total present value of cash inflows for different periods.
(ii) Applying Second Trial Rate : After applying the first trial rate, if the Net Present
Value (NPV) is positive, apply higher rate of discount. If the higher discount rate still gives
a positive net present value, increase the discount rate further until the NPV becomes
negative. If the NPV is negative at this higher rate, the internal rate of return must be between
these two rates. To calculate exact internal rate of return (1RR), apply formula given earlier.
Illustration 16 : Project A and Project B cost Rs. 1,00,000 and Rs. 50,000 respectively. Their
cash flows are given below, you are required to find out internal rate of return for each project and
decide on that basis which project is more profitable :
Year Cash Infl ows

P roject A P roject B
Rs. Rs.
1 10, 000 20, 000
2 30, 000 20, 000
3 60, 000 20, 000
4 40, 000 20, 000
5 20, 000 -
Solution :
The internal rate of return will have to be calculated by trial and error method and interpolation
technique will have to be used in order to get exact internal rate of return, which will equate the
present value of the total cash inflows with the initial cost of each project. Firstly, we calculate
present value factor for both the projects :
____Initial Cost of Project_____
Present Value Factor = Average Annual Cash Inflow
P.V. Factor for Project A = Rs.1,00,000 = 3.125
Rs. 32,000
P.V. Factor for Project B = Rs. 50,000 = 2.5
Rs. 20,000
To determine first trial rate, we see that present value factor for project A for 5 years comes to 18%
(Present value for 5 years is 3.127 which is nearly equal to 3.125).
Similarly, For Project B, It comes to 22% for 4 years period.
Merits of Internal Rate of Return :
The Internal Rate of return method has the following advantages :
1. Considers Time Factor : Like the net present value method, it takes into account
the time value of money and can be usefully applied in situations with even as well as uneven
cash flow at different periods of time.
2. Considers the Entire Economic Life : It considers the profitability of the project for
its entire economic life.
3. Determination of Cost of Capital not Essential : Under this method, the calculation
of the cost of capital is not a perquisites for applying this method of appraisal.
4. More Realistic : The internal rate of return is more realistic and is consistent with the
rate of interest paid on borrowings or the yield from shares.
5. Risk and Uncertainty : This approach provides for risk and uncertainty by
recognizing the time factor. Projects having different degrees of risk can be easily compared.
Demerits of Internal Rate of Return :
The following are the demerits of internal rate of return method
1. Complicated : This method involves a good amount of calculations. In spite of that
computation of IRR is quite tectious and complicated and also difficult to understand.
2. Unjustified Assumption : This method is based upon the assumption that earnings
are reinvested at the internal rate of return for remaining life of the project which is not a
justified assumption.
3. Multiple Rates : It gives multiple rates when the cash flows alternate between positive
and negative. In such cases, in the absence of a single rate of return, it is difficult to evaluate
the project.
11.8 Comparison of Net Present Value and Internal Rate of Return

The Net Present Value method and the Internal Rate of Return method are similar in the sense thatboth take
into account the time value to money.
In fact, both these methods are discounted cash.flow techniques. However, there are certain basic difference
between these two methods of capital budgeting :
Basis of Difference Net Present Va lue Internal rate of
Metho d Return Method
1 . Int erest Rate Under th is met hod Under t his m et hod
interest is an k nown int erest is an unk nown
facto r. fact or.
2 . Re-i nvest ment Assu mption Re-in vestment is Re-invest ment of

assumed t o b e at the cut fund s is ass um ed to
off rat e. be at t he IRR.
3 . Obj ect ive o f Rate o f Return NPV M et hod att empt to It seek s t o fin d o ut t he
find out the amo unt max imu m rat e of
which can be i nvest ed int erest at which t he
in a p art icular pro ject so amo unt interest at
that its proj ect ed whi ch the amo unt
earni ngs may suffice to in vested in t he pro ject
rep ay t his amo unt w ith could be repaid ou t of
interest at the market t he cash in flows
rate. arisin g from that
pro ject .
4 . Desired Rate o f Retu rn Under th is met hod Under IRR m et hod
present v alue is cash flo ws are
determi ned by di scount ed a a
disco unting the future su itable rat e b y trial
cas h inflow s at a and error m et hod
predetermin ed rat e whi ch eq uates t he
cal led cut off rat e. present v alue of cash
in flo ws t o t he amo unt
of i nit ial in vest ment.
5 . Di fferen t conclu sio ns NPV metho d is mo re It may give resu lts in
appropriat e t han IRR consist ent w ith NPV
becaus e of t he met hod especially in
consistency in case of mutually
appli cat ion to all exclus ive pro ject s.
propo sals.
Limitations of Capital Budgeting

1. Estimation of Cash Inflows: The techniques of capital budgeting require estimation of future cash
inflows and outflows. The future is always uncertain and data collected for future may not be exact.
Obviously the results based upon wrong data may note be fruitful.
2. Un-measurable Factors: There are certain factors like morale of the employees, goodwill of the
firm, etc., which can not be correctly quantified but which otherwise substantially influence the
capital decision.
3. Influence of Government Policies : Cash inflows are spread over a longer period. Difficulties
arise in estimating the effect of taxation which is subject to changes in the government policies.
4. Ascertainment of Cost of Capital : Ascertainment of cost of capital is essential for the capital
budgeting decisions. Cost of capital is ascertained on the basis of various assumptions. Hence
ascertainment of cost of capital is not an easy task.
5. Different Results: Different evaluation techniques show different results. The selection of most
appropriate method is very difficult task.
11.9 Summary
1. Net Cash Inflows = Net Sales – Operating Expenses – Depreciation – Tax + Depreciation
OR
EBIT – Interest – Tax + Depreciation
OR
EBT – Tax + Depreciation
OR
EAT + Depreciation
2. Pay back Period :
Initial Investment
(i) Pay back Period = Annual Cash Inflows
(ii) Post pay back period :
(a) If cash inflows are even
Annual Cash Inflows (Economic Life of Project – Pay back Period)
(b) If cash inflows are uneven
Total Cash inflows – Initial Investment
Criterion :
If pay back period < Standard pay back : Accept the proposal
If pay back period > Standard pay back : Reject the proposal
3. Average Rate of Return or Accounting Rate of Return
Net Annual Earnings after tax x 100
ARR = Initial Investment
Net Annual Earnings after tax x 100
ARR = Average Investment
OR
Net Annual Cash Inflows – Annual Depreciation x 100
ARR = Average Investment
Average Investment = Initial Investment + Scrap Value
2
Criterion :
IF ARR > Minimum Desired Rate Accept the Proposal
IF ARR < Minimum Desired Rate Reject the Proposal
4. Present Value Method
Total Present Value. Initial
(i) Net Present Value (NPV) = of Cash Inflows - Investment
Criterion :
If NPV > Zero Accept the Proposal
If NPV< Zero Reject the Proposal
(ii) Profitability Index or Present Value Index (PVI)
Present Value of Cash Inflows
Present Value Index (PVl) = Present Value of Cash Outflows
5. Internal Rate of Return (IRR)
(i) When cash inflows are Even = Initial Investment
Annual Cash Inflow
(ii) When cash inflows are Uneven = Initial Investment
Average Annual Cash Inflow
IRR = LDR + P1 - O (HDR - LDR)

P 1 - P2
IRR = Internal Rate of Return
HDR = Higher discount rate
LDR = Lower discount rate
P1 = Present values of cash inflows at LDR
P2 = Present value of cash inflows at HDR
O = Initial investment or capital outlay
Criterion :
If IRR > Cost of Capital Accept the Proposal
If IRR < Cost of Capital Reject the Proposal

1. Tiny Ltd., is considering three projects A, B and C. Following are the particulars in respect of them.
Project A Project B Project C
Initial Cost (in Rs.) 1,00,00 1,50,00 1,80,0
0 0 0
Economic life (in years) 7 10 15
Estimated Scrap Value (in Rs.) 2,000 10,000 Nil
Annual Savings after tax (in Rs 11,000 16,000 28,000
Using pay back period method state which of the three projects should be given preferences.
(Ans. : A-4 years; B-5 years; C-4.5 years)
Project A should be preferred
2. The following is the data regarding two machines X and Y :
Particulars X Machine Rs. Y Machine Rs.
Capital Cost Sales 1,50,000 1,50,000
Sales 2,50,000 2,00,000
Direct Labour 25,000 15,000
Direct Material 20,000 25,000
Factory Overhead 30,000 25,000
Office Cost 10,000 5,000
Selling Costs 5,000 5,000
Expected life 2 years 3 years
Rate of sales is the same throughout the life. Tax rate is 50% of net earnings. Calculate pay-back
period and post-pay-back profitability. Also suggest which machine is better.
(Ans. : Pay back period : 1.28 years; 1.71 years; Post pay back profitability: Rs. 84,600; Rs.
1,12,875)
3. Bharati Watch Company is considering the purchase of a machine. Two machines are available in
the market. A and B, each costing Rs 1,00,000. Earnings after tax but before depreciation are
expected to be as follows:
Cash Inflows
Year Machine ARs. Machine BRs.
1 25,000 12,500
2 37,500 37,5000
3 50,000 50,000
4 25,000 37,500
5 12,500 25,000
Evaluate the two alternatives according to pay back method and per pay back profitability.
(Ans. : (i) Pay back period : 2.75 years; 3 years (ii) Post pay back profitability: Rs. 50,000;
Rs. 62,500)
4. Jain Industries Ltd. is preparing to take up a project which will need an investment of Rs.1,05,000.
It will have a scrap value of Rs. 5,000 at the end of its useful life of five years. The net income before
depreciation and tax is estimated as follows :
Year Net Income (in Rs.)
1 20,500
2 25,000
3 37,500
4 40,000
5 ___ 45,000
__1,68,000
Depreciation is to be charged according to the straight line method. Tax rate is 35%. Calculate
accounting rate of return.
(Ans. : ARR-16.07%; 8.42%)
5. Z Ltd. is considering the purchase of a machine. Two machines are available A and B. The cost of
Machine is Rs, 60,000. Each machine has an expected life of 5 years. Net profits before tax but
after depreciation during the expected life of machine are given below :
Year A Machine B Machine
Rs. Rs.
1 15000 5,000
2 20,000 15,000
3 25,000 20,000
4 15,000 30,000
5 10,000 20,000
Total 85,000 90,000
Using the method of return on investment ascertain which of the alternatives will be more profitable.
The average rate of tax may be taken at 50%.
(Ans. : A-14.17%, 28.33%; B-15%, 30%)
6. Shivam Book Company has two options of investment at the beginning of the year. Using the Net
Present Value method evaluate the profitability of the investment. The details of which are as
follows :
Project I Project II
Rs. Rs.
Investment 1,40,000 1,50,000
Projected Income
(After depreciation and tax) Rs. Rs.
1st year 50,000 32,500
2nd year 45,000 32,500
3rd year 25,000 32,500
4th year __10,000 __32,500
1,30,000 1,30,000
The economic life of both projects is estimated to be 4 years. The present value of Re. 1.00 to be
received at the end of the year at 10% p.a. is given below :
Year 1 2 3 4 5
Present Value Factor .909 .826 .751 .683 .621
Also give your recommendations in the above projects under the profitability index.
(Ans. : NPV-Project I: Rs. 79,140; Project II: Rs. 71,830
PVI-Projectl: 1.57; Project 11-1.48 Project I should be preferred)
7. An investor who must have a minimum rate of return of 12% per annum has two protects in view,
both requiring an initial outlay of Rs.30,000. Project A gives annual excess of receipts over
disbursements equal to Rs. 6,000ano has a salvage value of Rs.10,000 at the end of 10 years.
Project B gives an annual excess of receipts over disbursements equal to Rs. 5,000 but has salvage
value of Rs. 20,000 at the end of 10 years. Which project should be prefer? At 12% p.a. the
present value of Re. 1 received annually for 10 years is Rs.5.650 and the value of Re. 1 received
at the end of 10th years is Rs.0.322.
(Ans. : NPV : A Rs. 7,120; B Rs. 4,690; Project A should be preferred).
8. X Ltd. is planning to increase its present capacity and is considering the purchase of new machines.
Machines A and B are available at a price of Rs. 70,000 and Rs. 80,000 respectively. The company
can buy either of two machines. The cut off rate required by the company is 20%. Cash flows have
been estimated as follows :
Cash Flows
Year Machine A Rs. Machine B Rs.
1 22,000 16,000
2 30,000 24,000
3 40,000 36,000
4 32,000 48,000
5 _16,000 _30,000
1,40,000 1,54,000
Present value of Re. 1 at the discount rate of 20% p.a. for the first five years is 0.833, 0.694, 0.579,
0.482 and 0.402 respectively. Which of the two machines should the company buy and why?
(Ans. : NPV: A-Rs. 14,162; B-Rs. 6,024; PVI: A-1.2023; B-1.0753)
9. Kiran Papers Ltd. is planning to start a new project with following data .
Project cost Rs. 1,40,000
Estimate life 5 years
Salvage value Nil
Projected annual profit after charging depreciation and all other charges but before taxation is as
follows :
Rs.
1st year 40,000
2nd year 45,000
3rd year 48,000
4th year 52,000
5th year __54,000
2,39,000
Depreciation is charged @ 20% p.a. on straight line method. Tax rate is 40%. Calculate internal
rate of return by using the following interest rates:
Year P.V. Factor at 28% P.V. Factor at 30%
1 .781 .769
2 .610 .591
3 .477 .455
4 .373 .350
5 .291 .269
(Ans. IRR: 28.33%)
10. A Ltd. desires to purchase a new machine in order to increase present level of production. The cost
of machine will be Rs.70,000 and the net cash flows during its life will be as under:
Year Net Cash Flow
(Rs.)
1 50,000
2 40,000
3 20,000
4 10,000
5 10,000
Minimum rate of return laid down by the management is 25% p.a. Is the investment desirable?
Discuss it according to Internal rate of return method.
Discount Factor
Year 35% 40%
1 .741 .714
2 .549 .510
3 .406 .364
4 .301 .260
5 .223 .186
(Ans. : IRR 37.62%)
11. Ajay Steel Ltd. is considering for purchase of a machine. There are two possible machines which
will produce the additional output. Details of these machines are as follows :
Machine XRs. Machine YRs.
Cost of Machines 60,000 60,000
Sales 1,000,000 80,000
Cost of Production:
Materials 8,000 10,000
Labour 10,000 6,000
Factory Overheads 12,000 10,000
Administration Costs 4,000 2,000
Selling Costs 2,000 2,000
Expected life of machines in years 2 3
Other informations—
(i) The costs shown above relate to annual expenditure resulting from each machine,
(ii) Sales are expected to continue at the rates shown for each for the full life of each machine,
(iii) Tax to be paid may be assumed at 50% of net earnings. : interest on capital,
(iv) The appropriate rate of interest for converting to present value may be taken at
10%.
On the basis of the facts given above, show the most prof: investment using the following methods:
(i) Pay back period
(ii) Return on investment
(iii) Net present value method (P.V. factors at 10% rate are 0.909, 0.826, 0.751 for I, II and III
year respectively)
(Ans. : (i)X-1.28 years; Y-1.71 years; (ii) X-56.67%; Y-50%
(iii) X-Rs. 21,545; Y-Rs. 27,010; Machine Y is better).
12. Two alternative capital expenditure proposals, each costing rupees one lakh, provide the following
net cash inflows :
Year 1 2 3 4 5
Project X (Rs.) 30,000 40,000 50,000 30,000 20,000
Project Y (Rs.) 10,000 30,000 40,000 60,000 40,000
Evaluate these proposals on the basis of:
(i) Pay-back period method
(ii) Post-pay-back profitability
(iii) Return on investment method
(iv) Net present value method.
Use a discount rate of 10% per annum. Discount factor at 10;-.various years is as follows:-
Year 1 2 3 4 5
Discount Factor 0,909 0.826 0.751 0.683 0.621
(Ans. : (i) X- 2 3/5 years; Y-31/3 years; (ii) X-Rs. 70,000; Y-Rs. 80,000
(iii) X-28%; Y-32%; (iv) X-Rs. 30,770; Y-Rs. 29,730

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- Ramchandaran, H. : Financial Planning & Control, S. Chand & Co.
- Agarwal & Agarwal : Financial Management, Ramesh Book Depot, Jaipur
- Malodia, G. L. : Financial Management, Jodhpur Publishing House, Jodhpur
Unit - 12 : Dividend Policy
Structure of Unit:
12.0 Objectives
12.1 Introduction
12.2 Concept and Meaning of Dividend Policy
12.3 Determinants of Dividend Policy
12.4 Types of Dividend
12.5 Dividend Models and Value of Firm
12.6 Summary
12.0 Objectives
After completing this unit, you would be able to understand:
 Meaning of Dividend
 Meaning of Dividend Policy
 Different types of dividends
 Determinants of dividend policy
 Different dividend models
 The value of firm
 Computation of value of firm
 Characteristics and utility of leverages
12.1 Introduction
When a company makes profit at the end of the year from its operating activities, the management of
company must decide that what to do with those profits. They can decide to retain the profits within
the company or may be decide to partly remain in company and remaining profits distribute to the
shareholders of the company. If they decide to pay profits to the shareholders, then they have to
determine appropriate ratio of distribution and amount retain in the business. The part of profits which
have to be distribute among the owners of the company i.e. shareholders, is called as dividend. For
distribution of dividend, company frame a dividend policy according which company takes decision in
respect of payment of dividend in present and in future. On the basis of dividend policy a company
determines that in what proportion profit should be distribute to the shareholders and to be retained in
the business. The retained portion of the profits in business is use in long term finance.
In simple terms, a company runs its business during any previous year and at the end of the previous year
company’s net result of operating activities is profit. The shareholders are owner of a company so they have
right on such profits. Company may be distributing such profits among the shareholders or may be retained
in the business. If company decides to distribute whole or a part of this profit among the shareholders, such
distributable profit is Dividend. The board of directors declares the dividend. In other words we can say
that the dividend may be defined as divisible profits which are distributed amongst the members of company
in proportion of their share holding in the company. According to ICAI, New Delhi, “a dividend is a
distribution to shareholders out of profits or reserves available for this purpose.”(Source: Guidance
notes on ‘Terms used in Financial Statements’, ICAI) The dividend declared by the board in annual general
meeting (AGM). Quantum of the dividend depends on the company’s financial requirements and also depends
on the availability of the divisible profits.
12.2 Concept and Meaning of Dividend Policy

For the financial manager of a company, it is crucial to take decision regarding to dividend because s/he
have to determine about the amount of profit to be distributed among the shareholders and the amount of
retained earnings. Amount of dividend and retained earnings have a reciprocal relationship. Market value of
shares depends on the payout ratio. While taking the dividend decision the management takes into account
the effect of the decision on the shareholders’ wealth.
A dividend policy is a company’s approach to distributing profits back to its owners or stockholders. If a
company is in a growth mode, it may decide that it will not pay dividends, but rather re-invest its profits
(retained earnings) in the business. If a company does decide to pay dividends, it must then decide how
often to do so, and at what rate. Large, well-established companies often pay dividends on a fixed schedule,
but sometimes they also declare “special dividends.” The payment of dividends impacts the perception of a
company in financial markets, and it may also have a direct impact on its stock price. A company takes three
major decisions i.e. Investments, financing and dividend. Dividend decision is most significant decision in all
of these.
12.3 Determinants of Dividend Policy

The main determinants of dividend policy of a firm can be classified into:
1. Capital Market Considerations: Capital market consideration is also a determinant of dividend
policy. If the company has easy access to the capital market in such case company should follow a
liberal dividend policy and if company has limited access to capital market, it can opt a low dividend
payout ratio. Such companies rely on retained earnings as a major source of financing for future
growth.
2. Dividend Payout Ratio: Dividend payout ratio refers to the percentage of the net earnings distributed
to the shareholders as dividends. On the basis of dividend policy owners of the company takes the
decision to pay out earnings or to retain them for reinvestment in the firm. A sufficient amount of
dividend creates satisfaction among the shareholders and the retained earnings constitute a source
of finance. So, it is necessary that a) dividend policy should maintain a balance between current
dividends and future growth which maximizes the price of the firm’s shares and b) The dividend
payout ratio of a firm should be optimum so that firm can able to maximize the wealth of the firm’s
owners and providing sufficient funds to finance growth.
3. Legal, Contractual and Internal Constraints and Restrictions: A company is not legally
bounded for declaration of dividend but, they have to specify the conditions under which dividends
must be paid. Such conditions pertain to capital impairment, net profits and insolvency. It may be
that a company accepts important contractual restrictions (when the company obtains external
funds) in respect of payment of dividends. These restrictions may cause the firm to restrict the
payment of cash dividends until a certain level of earnings has been achieved or limit the amount of
dividends paid to a certain amount or percentage of earnings. Internal constraints are unique to a
firm and include liquid assets, growth prospects, financial requirements, availability of funds, earnings
stability and control.
4. Inflation: In case of situation of inflation, the funds generated from depreciation may not be sufficient
to replace obsolete equipments and machinery. In such situation, a company should rely upon
retained earnings as a source of fund to replace those assets. Thus, dividend payout ratio negatively
affected due to inflation.
5. Age of Corporation: A newly establish company will invest their earning for expansion and plant
improvement and may adopt a rigid dividend policy. But if company is well established, it can frame
a more consistent policy in respect of dividend. So, we can say that dividend policy is also affected
by the age of the corporation.
6. Stability of Earnings: If a company having stability of earnings, such company can maintain
consistency in its dividend policy. Stability of earnings depends on nature of business e.g. firms
dealing in luxurious or fancy goods can earn more profits. So, we can say that the nature of business
has an important bearing on the dividend policy.
7. Requirement of Additional Capital: In case of small companies, they face the difficulties of
additional finance for expansion programs. Every company retains a part of their profits for
strengthening their financial position. Thus, such Companies distribute dividend at low rates and
retain a big part of profits
8. Liquidity of Funds: If a company decides to pay dividend in cash then it may be only if company
has sufficient funds. So, availability of cash and sound financial position is equally affected to dividend
policy. Payment of dividend represents a cash outflow. More availability of funds and good liquidity
position of company show the better ability to pay dividend. If cash position is weak, stock dividend
will be distributed and if cash position is good, company can distribute the cash dividend.
9. Trade Cycles: Business cycles also exercise influence upon dividend Policy. Dividend policy is
adjusted according to the business oscillations. During the boom, prudent management creates
food reserves for contingencies which follow the inflationary period. Higher rates of dividend can
be used as a tool for marketing the securities in an otherwise depressed market. The financial
solvency can be proved and maintained by the companies in dull years if the adequate reserves
have been built up.
10. Government Policies. Various Government Policies: Fiscal, industrial, taxation etc. affect to
the earnings capacity of the enterprise. The dividend policy has to be modified according to the
changes in government policies.
11. Taxation Policy: Taxation policy of government also affects the decision of distribution of dividend.
In case of high taxation rate a major part of earnings will be paid to government by way of tax,
hence rate of dividend will be lowered down. In case of low taxation, the company will be able to
pay dividend at higher rate.
12. Policy of Control: Policy of control is another determining factor is so far as dividends are concerned.
If the directors want to have control on company, they would not like to add new shareholders and
therefore, declare a dividend at low rate. Because by adding new shareholders they fear dilution of
control and diversion of policies and programs of the existing management. So they prefer to meet
the needs through retained earnings. If the directors do not bother about the control of affairs they
will follow a liberal dividend policy. Thus control is an influencing factor in framing the dividend
policy.
13. Legal Requirements: The companies’ act 1956 prescribes guidelines in respect of declaration
and payment of dividend. These guidelines issued in order to protect the interest of creditors e.g. a
company is required to provide for depreciation on its fixed and tangible assets before declaring
dividend on shares. It proposes that Dividend should not be distributed out of capita, in any case.
12.4 Types of Dividend

I. Dividend on the Basis of Security: There are two types of securities on which company pays
dividend i.e. 1) Preference shares 2) Equity shares. Company pays following two types dividend on
these securities:
a) Preference Dividend- On preference Share Company pays dividend at fix rate. At the
time of issue of preference shares, company declares the rate of dividend on these shares.
Since dividend on these shares is fixed, so, mostly discussion on dividend policy is relates
to the equity dividend.
b) Equity Dividend- In case of equity shares the rate of dividend cannot be pre determined.
Dividend on equity shares is paid at the rate recommended by the board of directors and
approved by the shareholders in Annual General Meeting (AGM). The board of directors
has the right in respect of payment of dividend, the rate of dividend and the medium of
dividend.
II. Dividend on the Basis of Time: On the basis of time, there are two types of dividend-
a) Interim Dividend- When a company earns huge profits or we can say that abnormal
profits during any particular year and directors wish to distribute these profits among the
shareholders, then company declares dividend at any time between two AGM. It is called
interim dividend. In other words, we can say that interim dividend is the dividend which can
be declare and distribute at any time within the financial year. Interim dividend may be
declare if, Article of association permits for it. Interim dividend is an extra dividend paid in
cash within the year without requirement of approval in AGM.
b) Regular Dividend- It is annual dividend declares after approval in AGM. This dividend
pays by the company after completion of financial year. The rate of dividend depends on
the financial performance of the company in particular year.
III. Dividend on the Basis of Mode of Payment: On the basis of mode of payment, dividend may
be classified in following three categories-
a) Cash Dividend- Mostly, shareholders are interested in cash dividend. When company
pays dividend in cash, it indicates outflows of cash from company to its shareholders.
Company pays cash dividend out of current sources available in the company or by taking
short term loans from banks and other financial institutions. A company may take decision
of cash payment of dividend, when sufficient funds are available and liquidity position of
company is sound. Cash dividend is most desirable mode of payment of dividend. It built
confidence and faith in investor’s mind about company.
b) Stock Dividend- If any company has a huge amount of reserves & surplus but suffering
from problem of shortage of liquidity of funds. In such case, if company wants to distribute
reserves & surplus among the shareholders, then the company issue new shares to existing
shareholders at free of cost. Shareholders receive shares In place of cash dividend. Such
shares are known as “Bonus shares” or “Stock dividend”. In this process whole or a part of
profits converts into share capital, so, it also called as “Capitalisation of profits”.
c) Scrip or Bond Dividend: If any company is facing a financial crisis, in such circumstances
company pays dividend in the form of shares and debentures of other companies. This form
of dividend is called as scrip or bond dividend. The main difference of scrip dividend and
bond dividend is of time period. In case of scrip dividend, securities belong to short term
securities and in case of bond dividend it is long term securities.
12.5 Dividend Models and Value of Firm

(A) Walter’s Dividend Model: Walter’s model supports the principle that dividends are relevant. The
investment policy of a firm cannot be separated from its dividend policy and both are inter-related.
The choice of an appropriate dividend policy affects the value of an enterprise.
Assumptions of This Model: The company does not rely upon external funds. It means that retained earnings
are the only source of finance.
1. Internal rate of return (r) and cost of capital (k) are constant.
2. There is no change in the key variables, namely, beginning earnings per share (E), and dividends per
share (D). The values of D and E may be changed in the model to determine results, but any given
value of E and D are assumed to remain constant in determining a given value.
3. The firm has an infinite life.
Formula: Walter’s model
P = D
Ke – g
Where: P =Price of Equity share
D = Dividend Per share
Ke = Cost of equity shares
After accounting for retained earnings, the model would be:
P= D
Ke – rb
Where: r = Expected rate of return on firm’s investments
b = Retention rate (E - D)/E
Equation showing the value of a share (as present value of all dividends plus the present value of all capital
gains) – Walter’s model:
P = D + r (E-D)/Ke
Ke Ke
Where: D = Dividend per share and
E = Earnings per share
Example 1:
Tanoo Ltd. has the following facts:
Cost of capital (ke) = 0.10
Earnings per share (E) = Rs. 10
Rate of return on investments ( r) = 8%
Dividend payout ratio: Case A: 50% Case B: 25%
Show the effect of the dividend policy on the market price of the shares.
Solution:
Case A:
D/P ratio = 50%
When EPS = Rs. 10 and D/P ratio is 50%, D = 10 x 50% = Rs. 5
P = 5 + .08(10-5)/.10 => Rs. 90
.10 .10
Case B:
D/P ratio = 25%
When EPS = Rs. 10 and D/P ratio is 25%, D = 10 x 25% = Rs. 2.5
P = 2.5 + .08(10-2.5)/.10 => Rs. 85
.10 .10
Example 2: The details regarding to three companies are below:
A Ltd. B Ltd. C Ltd.
r =15% r = 10% r = 12%
Ke = 10% Ke = 10% Ke = 10%
E = Rs. 50 E = Rs. 50 E = Rs. 50
Compute the value of an equity share of each company applying Walter’s formula when dividend payout
ratio is (a) 0% (b) 20% (c) 40% (d) 80%.
A L td. B Ltd. C L td.

(a)W he n d ivide nd pa yo ut rat io is P = 0 + .10(50-0)/.10 P = 0 + .12(50-0)/.10
0% .10 .10 .10 .10
P = 0 + .15(50-0)/.10 = Rs. 500 = Rs. 600
.10 .10
= Rs. 750
(b) W he n d ivide nd pa yo ut ratio P = 10 + .10(50-10)/.10 P = 10 + .12(50-10)/.10
is 20% .10 .10 .10 .10
P = 10 + .15(50- 10)/.10 = Rs. 500 = Rs. 580
.10 .10
= Rs. 700
is 40% .10 .10 .10 .10
P = 20 + .15(50- 20)/.10 = Rs. 500 = Rs. 560
.10 .10
= Rs. 650
is 80% .10 .10 .10 .10
P = 40 + .15(50- 40)/.10 = Rs. 500 = Rs. 520
.10 .10
= Rs. 550
Conclusions of Walter’s Model: Prof. Walter’s concept may be summarized as under:
1. Growth Firms (When r > ke): The value of shares is inversely related to the Dividend Payout
ratio. As the Dividend Payout ratio increases, the market value of shares decline. Its value is the
highest when Dividend Payout ratio is 0 and should re-invest their entire earnings. So, if the firm
retains its earnings entirely, it will maximize the market value of the shares. The optimum payout
ratio is zero.
2. Declining Firms (When r < ke): The Dividend Payout ratio and the value of shares are positively
correlated. In such case the firms are called declining firms. As the Dividend Payout ratio increases,
the market price of the shares also increases. The optimum payout ratio is 100%. Such firms should
distribute their entire earnings.
3. Normal Firms (When r = ke): The market value of shares is constant irrespective of the Dividend
Payout ratio. In this case, there is no optimum D/P ratio.
Limitations of this model:
1. This model can be applicable only to all equity owned firms because Walter’s model assumes that
the firm’s investments are purely financed by retained earnings.
2. The assumption of r as constant is not realistic because the risk factor of a firm is not always
uniform.
3. The assumption of a constant Ke ignores the effect of risk on the value of the firm.
(B) Gordon’s Dividend Capitalization Model: Gordon’s dividend model contends that dividends
are relevant. This model is of the view that dividend policy of a firm affects its market value of
shares.
Assumptions of This Model: The firm is an all equity firm. No external financing is used and investment
programmes are financed exclusively by retained earnings.
1. Return on investment (r) and Cost of equity (Ke) are constant.
2. The firm has perpetual life.
3. The retention ratio, once decided upon, is constant. Thus, the growth rate, (g = br) is also constant.
4. Ke > br
5. Corporate taxes do not exist.
Arguments of This Model:
1. Dividend policy of the firm is relevant and that investors put a positive premium on current incomes/
dividends.
2. Market value of shares is equal to the present value of its expected future dividends.
3. This model assumes that investors are risk averse and they put a premium on a certain return and
discount uncertain returns.
4. Investors are rational and want to avoid risk.
5. The rational investors can reasonably be expected to prefer current dividend. They would discount
future dividends. The retained earnings are evaluated by the investors as a risky promise. In case
the earnings are retained, the market price of the shares would be adversely affected. In case the
earnings are retained, the market price of the shares would be adversely affected.
6. Investors would be inclined to pay a higher price for shares on which current dividends are paid.
Dividend Capitalization Model: According to Gordon, the market value of a share is equal to the
present value of the future streams of dividends.
P = E(1-b)
Ke – br
Where:
P = Price per share
E = Earnings per share
B = Retention ratio
1-b = Dividend payout ratio
Ke = Cost of Equity
br = g = Growth rate
Example 3: Determination of value of shares, given the following data:
Case A Case B
D/P Ratio 40 30
Retention Ratio 60 70
Cost of Capital 17% 18%
Return on investments 12% 12%
EPS Rs. 20 Rs. 20
Solution:
Case A
P= Rs. 20 (1-.6) = Rs. 81.63
0.17- (0.60 x 0.12)
Case B
P= Rs. 20 (1- 0.70) = Rs. 62.50
0.18 – (0.70 x 0.12)
Gordon’s model thus asserts that the dividend decision has a bearing on the market price of the shares and
that the market price of the share is favorably affected with more dividends.
Example 4: The details regarding to three companies are below:
Palki Ltd. Shivang Ltd. Rrudraksh Ltd.
R > Ke R = Ke R < Ke
r =15% r = 10% r = 8%
Ke = 13% Ke = 10% Ke = 10%
E = Rs. 20 E = Rs. 20 E = Rs. 20
Compute the market value of an equity share of each company applying Gordon’s formula when dividend
payout ratio is (a) 30% (b) 20% (c) 50%.
Palki Ltd. Shivang Ltd. Rrudraksh Ltd.
(a)When dividend payout G=br= .7x.10 = .07 G=br= .7x.08 = .056
ratio is 30% and b=70% P = 20 (1-.7) P = 20 (1-.7)
G=br= .7x.15 = .105 .10-.07 .10-.056
P = 20 (1-.7) = Rs. 240 = Rs. 200 = Rs. 136.36
.13 - 0.070
ratio is 20% and b=80% P = 20 (1-.8) P = 20 (1-.8)
G=br= .8x.15 = .12 .10-.08 .10-.064
P = 20 (1-.8) = Rs. 200 = Rs. 111.11
.13-.12
= Rs. 240
ratio is 50% and b=50% P = 20 (1-.5) P = 20 (1-.5)
G=br= .5x.15 = .075 .10-.05 .10-.04
P = 20 (1-.5) = Rs. 200 = Rs. 166.67
.13-.075
= Rs. 181.82
Conclusions of Gordon’s Model: Gorden’s concept may be summarized as under-
1. Growth Firms (When r > ke): In this case dividend payout ratio decreases so price per share also
decrease. A growth firm should distribute les dividend and should retain maximum earnings.
2. Normal Firms (When r = ke) : In this case there are no any effect of dividend policy on price of
shares. The price of shares remains unchanged. In this case, there is no optimum D/P ratio.
3. Declining Firms (When r < Ke): As the Dividend Payout ratio increases, the market price of the
shares also increases. The optimum payout ratio is 100%. Such firms should distribute their entire
earnings.
(C) Miller and Modigliani Model (MM Model): Miller and Modigliani Model assume that the
dividends are irrelevant. Dividend irrelevance implies that the value of a firm is unaffected by the
distribution of dividends and is determined solely by the earning power and risk of its assets. Under
conditions of perfect capital markets, rational investors, absence of tax discrimination between
dividend income and capital appreciation, given the firm’s investment policy, its dividend policy may
have no influence on the market price of the shares, according to this model.
Assumptions of MM Model:
1. Existence of perfect capital markets and all investors in it are rational.
2. Information is available to all free of cost, there are no transactions costs, securities are infinitely
divisible, no investor is large enough to influence the market price of securities and there are no
floatation costs.
3. There are no taxes. Alternatively, there are no differences in tax rates applicable to capital gains and
dividends.
4. A firm has a given investment policy which does not change. It implies that the financing of new
investments out of retained earnings will not change the business risk complexion of the firm and
thus there would be no change in the required rate of return.
5. Investors know for certain the future investments and profits of the firm (but this assumption has
been dropped by MM later).
Argument of This Model: By the argument of arbitrage, MM Model asserts the irrelevance of dividends.
Arbitrage implies the distribution of earnings to shareholders and raising an equal amount externally. The
effect of dividend payment would be offset by the effect of raising additional funds. MM model argues that
when dividends are paid to the shareholders, the market price of the shares will decrease and thus whatever
is gained by the investors as a result of increased dividends will be neutralized completely by the reduction
in the market value of the shares. The cost of capital is independent of leverage and the real cost of debt is
the same as the real cost of equity, according to this model. Those investors are indifferent between dividend
and retained earnings imply that the dividend decision is irrelevant. With dividends being irrelevant, a firm’s
cost of capital would be independent of its dividend-payout ratio. Arbitrage process will ensure that under
conditions of uncertainty also the dividend policy would be irrelevant.
MM Model:
Market price of the share in the beginning of the period = Present value of dividends paid at the end
of the period + Market price of share at the end of the period.
P0 = D1 + P1
1 + Ke
Where:
Po = Prevailing market price of a share
Ke = Cost of Equity
D1 = Dividend to be received at the end of period 1 and
P1 = Market price of a share at the end of period 1.
The Market price of shares at the end of the period can be calculated by using the following formula:
P1 = P0 (1 + Ke) – D1
Value of the firm can also be calculated by applying the following formula:
nP0 = (n + m) P1 – (1 - X)
(1 + Ke)
Where:
n= number of shares outstanding at the beginning of the period
m= number of shares to be issued at the ending of the period
P1 = Market price of the share at the end of the period
Ke = Cost of equity
I= Total amount required for investment
X= Total net profit of the firm during the period
Example 5: Bhagwati Ltd. whose capitalization rate is 10% has outstanding shares of 25,000 selling at Rs.
100 each. The firm is expecting to pay a dividend of Rs. 5 per share at the end of the current financial year.
The company’s expected net earnings are Rs. 250,000 and the new proposed investment requires Rs.
500,000. Prove that using MM model, the payment of dividend does not affect the value of the firm.
Solution:
1. Value of the firm when dividends are paid:
i. Price per share at the end of year 1:
P0 = 1/(1 + ke) x (D1 + P1)
Rs. 100 = 1/(1 + 0.10) x (Rs. 5 + P1)
P1 = Rs. 105
ii. Amount required to be raised from the issue of new shares:
“ n P1 = I – (E – nD1)
=> Rs. 500,000 – (Rs. 250,000 - Rs. 125,000)
=> Rs. 375,000
iii. Number of additional shares to be issued:
“n = Rs. 375,000 / 105 => 3571.42857 shares or 3572 shares
iv. Value of the firm:
nP0 = (n + m) P1 – (1 - X)
(1 + Ke)
= (25, 000 + 3572) x 105- (Rs. 5, 00,000 – Rs. 2, 50,000)
(1 + 0.10)
= Rs. 25, 00,000
2. Value of the firm when dividends are not paid:
i. Price per share at the end of year 1:
P0 = 1/(1 + ke) x (D1 + P1)
Rs. 100 = 1/(1 + 0.10) x (Rs. 0 + P1)
P1 = Rs. 110
ii. Amount required to be raised from the issue of new shares:
=> Rs. 500,000 – (Rs. 250,000 -0) = Rs. 250,000
iii. Number of additional shares to be issued:
=> Rs. 250,000/Rs. 110 = 2273
iv. Value of the firm:
nP0 = (n + m) P1 – (1 - X)
(1 + Ke)
= (25, 000 + 2273) x 110 - (Rs. 5, 00,000 – Rs. 2, 50,000)
(1 + 0.10)
= Rs. 25, 00,000
Thus, according to MM model, the value of the firm remains the same whether dividends are paid or not.
This example proves that the shareholders are indifferent between the retention of profits and the payment
of dividend.
Limitations of MM Model:
1. The assumption of perfect capital market is unrealistic. Practically, there are taxes, floatation costs
and transaction costs.
2. Investors cannot be indifferent between dividend and retained earnings under conditions of uncertainty.
This can be proved at least with the aspects of i) near Vs distant dividends, ii) informational content
of dividends, iii) preference for current income and iv) sale of stock at uncertain price.
12.6 Summary
 The part of profits which have to be distribute among the owners of the company i.e.
shareholders, is called as dividend.
 A dividend policy is a company’s approach to distributing profits back to its owners or stockholders.
 In case of inflation a company should rely upon retained earnings as a source of fund to replace
those assets.
 Walter’s Formula
P= D
Ke – g
 Gorden’ formula
P= E(1-b)
Ke – br
· Modigliani – Miller formula
P0 = D1 + P1
1 + Ke

1. What do you understand by Dividend?
2. What do you understand by Retained earnings?
3. Define dividend policy.
4. State any four determinants of dividend policy.
5. Explain assumptions of Walter’s model.
6. Explain various types of dividend.
7. State assumptions of M-M Model.
8. X ltd. earns Rs. 10 per share is capitalized at 10% and has a return on investment of 15%. Using
Walter’s formula, determine – (1) the optimum payout and (2) the price of share at this payout.
9. Following are the details regarding three companies:
The details regarding to three companies are below:
A Ltd. B Ltd. C Ltd.
R > Ke R = Ke R < Ke
r =15% r = 10% r = 8%
Ke = 12% Ke = 10% Ke = 10%
E = Rs. 15 E = Rs. 15 E = Rs. 15
You are required to calculate the effect of dividend payment on the value of shares of each of the above
companies under the following situations by using Walter’s formula.
(a) When no dividend is paid.
(b) When dividend is paid at Rs. 8 per share.

- Ravi M. Kishore - “Financial Management” 6th edition, 2005 - Taxmen’s, New Delhi.
- M. R. Agrwal – “Financial Management (Principles & practices)”- Garima publications, Jaipur,
2010.
- Dr. R. P. Rustagi – “Basic Financial Management” 4th edition, 2012 – Sultan Chand & Sons, New
Delhi.
- Dr. S. N. Maheshwari – “Elements of Financial Management” 10th revised edition, 2012 - Sultan
Chand & Sons, New Delhi.
Unit -13 : Operating and Financial Leverages
Structure of Unit:
13.0 Objectives
13.1 Introduction and Meaning of Leverage
13.2 Operating Leverage
13.3 Financial Leverage
13.4 Combined Leverage
13.5 Summary
13.0 Objectives
After completing this unit, you would be able to understand:
 Meaning of Leverage
 Different types of leverages
 Meaning of Operating leverage and degree of Operating leverage
 Meaning of Financial leverage and degree of Financial leverage
 Meaning of Combined leverage and degree of Combined leverage
 Computation of different types of leverages and degree of Leverages
 Characteristics and utility of leverages
13.1 Introduction and Meaning of Leverage

Leverage is a business term that refers to borrowing. If a business is “leveraged,” it means that the business
has borrowed money to finance the purchase of assets. The other way to purchase assets is through use of
owner funds, or Equity.
Organizations in today’s fast changing environment face intense competition, economic fluctuations, changing
profile of developing and developed economies, technological breakthroughs and developments, changing
social values, demographic profiles, legal system, regulatory mechanisms, government policies, cultural
profiles, etc. Originally the word ‘Leverages’ is come from Physics. In Physics the word Leverages refers to
‘Weight’. If we convert it into commercial term ‘The weight’ for any businessmen is of fixed expenses. So,
we can say that leverage can be calculated of any firm in a case when fixed expenses are in existing in that
firm. If any firm does not incurs any amount of fixed expenses then leverage can’t be calculate of this firm.
Leverage is a ratio which shows a relationship between Revenue before charging fixed expenses and
Revenue after charging fixed expenses. So, we can say that leverage may be calculated in case of
existence of fixed expenses in the firm. If there are no any fixed expenses then we can’t calculate leverages.
13.2 Operating Leverage

13.2.1 What is Operating Leverage?
In any business concern there are two types of fixed expenses- 1) Fixed expenses of operating nature e.g.
Salaries, Rent, etc. 2) Fixed expenses of fInancial nature e.g. Interest on loan. Essentially, operating leverage
boils down to an analysis of fixed cost and variable cost. Operating leverage is highest in companies that
have a high proportion of fixed operating costs in relation to variable operating costs. This kind of company
uses more fixed assets in the operation of the company. Conversely, operating leverage is lowest in companies
that have a low proportion of fixed operating costs in relation to variable operating costs.
Operating leverage increases as the ratio of fixed costs to variable costs increases. With a high ratio of fixed
costs to variable costs, a small percentage change in sales will lead to a large percentage change in operating
profits. In other words, the percentage increase in sales is magnified. Technically, operating leverage is
defined as the percentage change in EBIT divided by the percentage change in sales.
For understanding the different types of leverage, we have to learn about Income Statement. It can be
explained with the help of following Example:
X & Sons sells 20,000 Units of a product. The selling price per unit is Rs. 10 and variable cost is Rs. 4. If
fixed cost for the year is Rs. 60,000 then, what will be the effect on profit if sales are of (1) 30000 Units; (2)
15000 Units.
Income Statement at Different Levels of Sales
Particulars Units Sold

20,000 30,000 15,000
Sales 2,00,000 3,00,000 1,50,000
Less- Variable Costs 80,000 1,20,000 60,000
Contribution 1,20,000 1,80,000 90,000
Less- Fixed Cost 60,000 60,000 60,000
EBIT 60,000 1,20,000 30,000
% Change in Sales - 1,00,000 x 100= 50,000 x 100= (-)25%
(+)50% 2,00,000
2,00,000
% Change in profits - 30,000 x 100= (-)50%

60,000 x 100= 60,000
(+)100%
60,000
In the above example, a 50% increase in sales from Rs. 2,00,000 to Rs. 3,00,000 result a 100% increase
in profits i.e. from Rs. 60,000 to Rs. 1,20,000. Simultaneously, a decrease of 25% in sales i.e. from Rs.
2,00,000 to Rs. 1,50,000 results a decrease of 50% in profits i.e. from Rs. 60,000 to Rs. 30,000. It is clear
from this example that if a firm incurs fixed cost and there are an increase in sales volume, resultant there will
be more than proportionate increase in profits and if there are decrease in sales volume, resultant there will
be more than proportionate decrease in profits. It is operating leverage and it works in both directions.
13.2.2 Computation of Operating Leverage
For computation of Operating Leverage, first we have to calculate Contribution i.e. Contribution = Sales
– Variable Expenses. Now, contribution will be divided by Earning before interest and tax
(EBIT) and we get Operating Leverage. Expressed as formula :
Operating Leverage = Contribution
EBIT
EBIT= Earnings before interest & tax
Illustration 1:
The installed capacity of X & Sons is 3000 Units and actual production is 2000 units. Selling price per
unit is Rs. 12 and Variable cost is Rs. 7 per unit. Calculate Operating Leverage in following cases:
1. When Fixed Cost is Rs. 2,000 2. When Fixed Cost is Rs. 3,000
3. When Fixed Cost is Rs. 4,000
Solution:
Computation of Operating Leverage
Particulars Case 1 Case 2 Case 3

Sales 24,000 24,000 24,000
Less- Variable Cost 14,000 14,000 14,000
Contribution 10,000 10,000 10,000
Less- Fixed Cost 2,000 3,000 4,000
EBIT 8,000 7,000 6,000
OL = Contribution 10,000/8,000= 1.25 10,000/7,000= 1.42 10,000/6,000= 1.67
EBIT
From this illustration, it is clear that Operating Leverage will be increased, if there are an increment in fixed
cost.
14.2.3 What is Degree of Operating Leverage?
The degree of operating leverage measures the responsiveness of EBIT to change in level of output and it
indicates the response in profits with the alteration of output and sales level. Degree of operating leverage
shows multiplier effect resulting from the use of fixed operating costs. DOL can be expressed as ratio of
the percentage change in operating profit to percentage change in sales. The following formula can be
used for computation of Degree of operating leverage-
Degree of Operating Leverage (DOL) = % Change in profits

% Change in Sales
or
(DOL) = % Change in EBIT
% Change in Sales
Note: In the question, if different levels of sales are not given then, DOL will be computed by
using the following formula:
DOL = Contribution
EBIT
Illustration 2:
Y Corporations has estimated for a new product that, its BEP is 3000 units, if the items sold at Rs. 14: the
variable cost per unit is Rs. 9 and fixed cost per annum is Rs. 15,000. Calculate the degree of operating
leverage if sales volume is 4000 units and 5000 units.
Solution:
Computation of Degree of Operating Leverage
Particulars When sales is When sales is
4000 units 5000 units
Sales 56,000 70,000
Less- Variable Cost 36,000 45,000
Contribution 20,000 25,000
Less- Fixed Cost 15,000 15,000
EBIT 5,000 10,000
OL = __C___ 20,000/5,000= 4 25,000/10,000= 2.5
EBIT
% Change in EBIT - 5,000 x 100 = 100%
5,000
% Change in Sales 14,000 x 100 = 25%
56,000
(DOL) = % Change in EBIT

% Change in Sales
= 100/25 = 4
A 25% increase in sales results in 100% change in operating profits i.e. 4 times increment. It clearly shows
that increase in profits in comparison of increase in sales due to operating leverage. It shows that a 20%
increase in sales will increase the profits by 4 times and 20% reduction in sales volume will reduce the profit
by 4 times.
Illustration 3:
Shivang Limited a producing 10,000 units at present. Other informations are as under:
Selling price Rs.10 p.u.
Fixed operating expenses Rs. 25,000 per annum
Variable expenses Rs. 5 p.u.
On the basis of said information, calculate the degree of operating leverage, if the company sells
(a) 5,000 units and (b) 15,000 units.
Solution: Particulars Present Assume d Assumed
situation situation situation
(a) (b)
Sales in units 10,000 5,000 15,000
Sales @ Rs. 10 per unit 1,00,000 50,000 1,50,000
Less: Variable cost 50,000 25,000 75,000
Contribution 50,000 25,000 75,000
Less: Fixed Cost 25,000 25,000 25,000
EBIT 25,000 Nil 50,000
% change in EBIT (-)100% (+)100%
% change in sales (-)50% (+)50%
Degree of operating leverage (-)100% = 2 (+)100% = 2
% Change in EBIT (-)50% (+)50%
% Change in Sales Unfavorable favorable
13.2.4 Characteristics of Operating Leverage
1. It is related to assets side of the balance sheet.
2. Operating leverage is directly related to sales and variable cost. It depends on the gap between
Sales and variable expenses. A less gap between sales and variable expenses is a cause of high
degree of operating leverage. The degree of operating leverage cannot be computed at BEP because
at this point denominator value i.e. EBIT will be Zero.
3. There is a direct relationship between DOL and Break Even Point. If the sales value at which DOL
is to be calculated is near to BEP, it is a sign of high degree of DOL.
4. Operating leverage related to the fixed cost of operating nature like Salary to employees, Rent etc.
If there are no any such fixed costs, then there will be no operating leverage.
5. Due to increase in sales there will be an increase in operating leverage and high reduction in operating
profits. So, we can say that operating leverage raise a firm’s operating profits but on the other side
it raises business risk of increasing losses.
13.2.5 Utility of Operating Leverage
1. Operating leverages helpful for decision making. Since, it is related to fixed cost so it is helpful in
respect of long term investment decisions. Capital budgeting is essential for long term profit planning.
Operating leverage is essential tool in capital budgeting.
2. Since, it is related to fixed costs which have to be compensating against the operating income. So
we can say that it decide the capacity of the firm to bear the burden of payment of interest on debts
and repayment of certain portion of debts.
13.3 Financial Leverage

13.3.1 What is Financial Leverage?
Financial leverage refers to the use of debt to acquire additional assets. Financial leverage is also known as
trading on equity. There are two types of capital in any firm 1) Fixed cost bearing capital 2) Variable cost
bearing capital. So, if fixed cost capital exists in any firm then financial leverage is present at there. According
to James C. Vane Horn “Financial leverage involves the use of funds obtained at a fixed cost in the hope of
increasing the return to common stock holders.” Financial leverage directly related to capital structure of
company. If proportion of variable cost capital is high than financial leverage will be low and if proportion of
fixed cost capital is high, which also called as trading on equity, then financial leverage will be high.
13.3.2 Computation of Financial Leverage
For computation of financial leverage, first we have to calculate EBIT. Now by we can calculate financial
leverage by using following formula:
Financial Leverage= EBIT
EBT
EBIT = Earnings before interest & tax
EBT = Earnings before tax
Illustration 4:
A company has a choice of the following three financial plans. You are required to calculate the financial
leverage in each case:
Denomination Financial plan (Rs.)
X Y Z
Equity Capital 40000 20000 60000
Debt 40000 60000 20000
Operating Profit (EBIT) 8000 10000 8000
Interest @10% on the debts in all the cases.
Solution:
Particulars Financial plan (Rs.)
X Y Z
EBIT 8000 10000 8000
Less- Interest 4000 6000 2000
EBT 4000 4000 6000
Financial Leverage (FL) = 8000/4000 = 2 10000/4000 = 2.5 8000/6000 = 1.33
EBIT
EBT
In the above illustration it can be observed that the financial leverage of plan X is 2. It means that if EBIT
increases by 1% there will be 2% increase in EBT.
13.3.3 What is Degree of Financial Leverage?
Degree of financial leverage shows a relation between % changes in EBIT to % change in EBT. The DFL
can be measured by using the following formula:
Degree of Financial Leverage (DFL) = % change in EBT
% change in EBIT
Or
% change in EPS
% change in EBIT
Here,
EBT = Earnings before taxes
EPS = Earnings per Share
13.3.4 Computation of Degree of Financial Leverage
Illustration 5:
A company’s per year earnings before interest & taxes amount to Rs. 60,000. It has 10% Debentures of
Rs. 50000, 10% Preference Shares of Rs. 30000 and 4000 Equity shares of Rs. 40000. The tax rate is
50%. Assuming that the EBIT being Rs. 96 000 and Rs. 24000. What would be the earning per share
(EPS) and degree of financial leverage?
Solution:
Particulars Present Assumed situation Assumed situation
situation (i) (ii)
Rs. Rs. Rs.
Earnings before interest & taxes 60000 96000 24000
(EBIT) 5000 5000 5000
Less: Interest 55000 91000 19000
Earnings before taxes (EBT) 27500 45500 9500
Less: Taxes 27500 45500 9500
Earnings after taxes 3000 3000 3000
Less: Preference dividend 24500 42500 6500
Profit for equity shareholders (A) 4000 4000 4000
No. of equity shares (B) Rs. 6.125 Rs. 10.625 Rs. 1.625
Earnings per share (A/B) - +60% -60%
% change in EBIT - 73.46% -73.46%
% change in EPS 73.46/60 = 1.22 73.46/60 = 1.22
DFL = % change in EPS
% change in EBIT
Financial Leverage (FL) = 60000/49000 96000/85000 24000/13000
EBIT = 1.22 = 1.13 = 1.85
EBIT- I - PD
1-t
Here, EBT has been calculated after deducting grossed up value of Preference share dividend i.e. Rs. 6000
(3000 x 100/50) and interest on debentures from EBIT.
Illustration 6:
The financial manager of Arpit ltd. expects that its earnings before interests & taxes in the current year
would amount to Rs. 1, 00,000. The company has 10% debentures of Rs. 2, 00,000, while the 5% Preference
shares amounting to Rs. 4, 00,000. The company has 10,000 equity shares of Rs. 10 each. What would be
the degree of financial leverage in the case if EBIT being-
(a) Rs. 60,000 (b) Rs. 1, 40,000? The tax rate may be assumed at 50%.
Solution:
Computation of Degree of Financial Leverage
Particulars Present Assume d Assume d

situation situation situation
(a) (b)
Earnings before interest & taxes (EBIT) 1,00,000 60,000 1,40,000
Less- Interest 20,000 20,000 20,000
Earnings before tax (EBT) 80,000 40,000 1,20,000
Less- Taxes 40,000 20,000 60,000
Earnings after taxes (EAT) 40,000 20,000 60,000
Less- Preference dividend 20,000 20,000 20,000
Earnings available for equity shareholders 20,000 - 40,000
Earnings per share Rs.2 - Rs. 4
% change in EBIT (-)40% (+)40%
% change in EPS (-)100% (+)100%
Degree of financial leverage (-)100% = 2.5 (+)100% = 2.5
% change in EPS (-)40% (+)40%
% change in EBIT Unfavorable Favorable
13.3.5 Characteristics of Financial Leverage
From the above discussion, we can say that financial leverage have the following characteristics:
1. Financial leverage is related to liability side of the balance sheet.
2. Financial leverage shows that what effect has been made on EPS of the company due to changes in
its operating profits.
3. Low financial leverage indicates a low interest outflow and consequently lower borrowings. High
financial leverage indicates high outflow of interest due to higher borrowings.
4. High ratio of financial leverage is risky for the firm and it constitutes a strain on the profits.
5. Degree of financial leverage is an attribute of the firm’s exposure to financial risk.
13.3.6 Utility of Financial Leverage
1. Financial leverage is useful to determine an optimum capital structure of the firm, where cost of
debts would be minimize and return on equity shareholders fund is maximum.
2. Since, the financial leverage effects to EPS and EBIT. So, we can do a careful analysis of profitability
of the firm at various levels of sales. Since break even point is an important tool of profit planning
and BEP is also used in understanding the concept of financial leverage. Therefore, we can say that
the financial leverage is also an important tool of financial planning.
3. If financial leverage is low it shows that a low amount is distributing by way of interest. Therefore, a
major part of earnings is available for equity shareholders and company can be declared more
dividends. Consequently, goodwill of the company will increase and due to increased goodwill
company can obtain more funds/loans at low interest rates.
13.4 Combined Leverage

13.4.1 What is Combined Leverage?
As we have discussed earlier that the operating leverage measures the change in operating profits due to
changes in sales and it also affects the business risk. Financial leverage measures % change in EBIT and %
change in EBT and it also shows financial risk of the firm. Operating leverage shows the effect of fixed cost
of operating nature and financial leverage shows effects of fixed cost of financial nature. But the total leverage
or combined leverage is not concentrate on particular fixed cost. While we compute the combined leverage,
we compute the potential use of both types of fixed costs, operating fixed cost and financial fixed cost. It
define combined effect of fixed cost whether it is of operating or financial nature.
13.4.2 Computation of Combined Leverage
For computation of combined leverage, first we have to calculate contribution and EBT. Now by we can
calculate financial leverage by using following formula:
Combined Leverage (CL) = Contribution
EBT
Or
Combined Leverage = Operating Leverage x Financial Leverage
CL = Contribution x EBIT = Contribution
EBIT EBT EBT
Illustration 7:
Consider the following information of Wales Ltd. and Calculate combined leverage and Earning per share.
Selling Price per unit Rs. 200
Variable cost per unit Rs. 120
Fixed cost Rs. 10,00,000
Interest on debt Rs. 6,00,000
Preference dividend Rs. 4,00,000
Tax rate 40%
Number of units produced and sold 60,000
Solution:
Selling Price per unit Rs. 200
Less: Variable cost per unit Rs. 120
Contribution per unit Rs. 80
Total Contribution (60,000 Units x Rs.80) Rs. 48,00,000
Less: Fixed Cost Rs. 10,00,000
Earning before interest & Taxes Rs. 38,00,000
Less: Interest Rs. 6,00,000
Earning before taxes Rs. 32,00,000
Less: Taxes (40%) Rs. 12,80,000
Earning after taxes Rs. 19,20,000
Less: Preference dividend Rs. 8,00,000
Profit for equity shareholders Rs. 11,20,000
Combined Leverage (CL) = Contribution
EBT
= 48, 00,000/32, 00,000 = 1.5
Earnings per Share (EPS) = 11, 20,000/60,000 = Rs.18.67
In the above illustration the combined leverage is 1.5. What will the effect on EPS? If sales increase by 10%
then EPS will be increased by 15% i.e. (1.5 x 10%).
13.4.3 What is Degree of Combined Leverage?
Degree of combined leverage indicates the effect of % change in sales on % change in EPS. DCL can be
calculated by using the following formula:
Degree of Combined Leverage (DCL) = % change in EBT
% change in sales
Or
DCL = DOL x DFL
DCL = % change in EBIT x % change in EBT = % change in EBT
% change in sales % change in EBIT % change in sales
13.4.4 Computation of Degree of Combined Leverage
Illustration 8: The capital structure of X Ltd. consists of an equity share capital of Rs.4,00,000 @ Rs. 10
each and Rs. 4,00,000 7.5% Debentures. Sales increased by 20% from 40000 to 48000 units. The selling
price is Rs.7.5 per unit. Variable cost is Rs. 4.5 per unit and fixed cost amount to Rs. 50,000. The corporate
tax rate is 50%.
You are required to compute the degree of operating leverage, degree of financial leverage and degree of
combined leverage.
Particulars 40000 units 48000 units

Sales @ Rs. 7.5 p.u. 3,00,000 3,60,000
Less: Variable cost @ Rs. 4.5 p.u. 1,80,000 2,16,000
Contribution (C) 1,20,000 1,44,000
Less: Fixed Cost 50,000 50,000
EBIT 70,000 94,000
Less: Interest 30,000 30,000
Earnings before taxes (EBT) 40,000 64,000
Less: Tax @ 50% 20,000 32,000
Earnings after tax (A) 20,000 32,000
No. of Equity shares (B) 40,000 40,000
Earnings per share (A/B) Re. 0.50 Re. 0.80
% change in sales - Rs. 60,000 x 100 = 20%
Rs. 3,00,000
% change in EBIT - Rs. 24,000 x 100 = 34.29%
Rs. 70,000
% change in EPS - Re. 0.80-Re. 0.50 x 100 = 60%
Re. 0.50
Degree of operating leverage (DOL) - 34.29 = 1.71
= % change in EBIT 20
% change in sales
Degree of Financial leverage (DFL) - 60 = 1.75
= % change in EPS 34.29
% change in EBIT
Degree of Combined leverage (DCL) - 1.71 x 1.75 = 2.99
= DOL x DFL
13.4.5 Characteristics of Combined Leverage

1. Combined leverage shows combined effect on profits of both types of fixed expenses i.e. Operating
fixed expenses and financial fixed expenses.
2. It shows the potential use of both types of fixed expenses.
3. Due to combined leverage we can identify the relationship between contribution and taxable income.
4. Combined leverage explains the effect of change in sales over change in taxable profits.
13.5 Summary
 Leverages refers to the ability of a firm in employing long term funds bearing a fixed interest charges,
to enhance returns to the owners.
 Operating leverages refers to the effect of fixed charges on the profitability of the firm.
 Higher operating leverage shows that the firm has a high business risk and there will be reduction in
profits due to high amount spent on fixed cost.
 Financial leverage shows an existence of debt capital in capital structure of the firm.
 Financial leverage shows effect of fixed interest charges on profitability of the firm.
 If debt capital is in high volume then financial leverage will be high because of a more amount paid
by the company by way of interest on such debts.
 Financial leverage refers financial risk of the firm.
 Combined leverage refers the potential use of both types of fixed expenses.
 Combined leverage indicates the effect of % change in sales on % change in EPS.

1. What do you understand by Operating Leverage and Financial Leverage?
2. “Financial leverage is two-edged sword”. How?
3. What is the difference between favorable and unfavorable financial leverage?
4. The following information is available for Roshan Ltd.:
Rs.
EBIT 5, 60,000
Profit Before tax 1, 60,000
Fixed Expenses 3, 50,000
Calculate % change in EPS if sales are expected to increase by 5%.
5. A company has sales of Rs. 2, 00,000. The variable costs are 40% of the sales and fixed operating
expenses are amount to Rs. 60,000. The amount of interest on long term loans is Rs. 20,000.
You are required to calculate the operating leverage, financial leverage and composite leverage.
6. From the following information available for four companies, Calculate-
` a. EBIT b. Operating Leverage
c. Financial leverage d. EPS
Particulars A B C D
Selling Price per unit Rs. 20 25 30 35
Variable cost per unit Rs. 15 20 25 30
Quantity Nos. 40000 50000 60000 80000
Fixed Cost Rs. 35000 45000 55000 65000
Interest Rs. 15000 30000 30000 45000
Tax Rate % 40 40 40 40
No. of equity shares 6000 10000 12000 15000
7. What is the relationship between financing by fixed cost bearing capital and financial leverage?
8. State the characteristics of operating leverage and financial leverage?
- Ravi M. Kishore (2005) - “Financial Management”- Taxmenn’s, New Delhi, 6th edition, 2005.
- M. R. Agrwal (2010) – “Financial Management (Principles & practices)”- Garima publications,
Jaipur, 2010.
- Dr. C. P. Jain (2010) – “Prabandh Lekhankan” – Shivam book house (P) Ltd., Jaipur, 2010.
- Dr. M. D. Agrawal & Dr. N. P. Agrawal – “Management Accounting “– Ramesh book depot,
Jaipur.
Unit -14 : Capital Structure: Theories
Structure of Unit:
14.0 Objectives
14.1 Introduction
14.2 Meaning and Definition
14.3 Features of Capital Structure
14.4 Equations and Notations
14.5 Theories of Capital Structure
14.5.1 Net Income (NI) Approach
14.5.2 Net Operating Income (NOI) Approach
14.5.3 Traditional Approach
14.5.4 Modigliani-Miller (MM) Approach
14.6 Summary
14.0 Objectives
The purpose of this unit is to introduce the theories of capital structure of a company.
After you have studied this unit, you should be able to:
 Appreciate the concept of capital structure and its importance
 Understand the features of the capital structure of a firm
 Define and explain the various theories of capital structure
 Critically examine and distinguish the various approaches to capital structure
 Relate the capital structure with the cost of capital and the value of the firm
 Calculate the market value of the firm using appropriate formulae
14.1 Introduction
Often corporate officers, professional investors, and analysts discuss a company’s capital structure. The
concept is extremely important because it can influence not only the return a company earns for its
shareholders, but whether or not a firm survives in recession or depression.
Every business enterprise, whether big, medium or small, needs finance to carry on its operations smoothly
and to achieve its targets. Finance is needed for working capital and for permanent investment. Ideally, it
should neither be more or less than required and should gainfully be employed.
Finance is obtained by businesses from various sources of long term and short term funds. Long term funds
comprise of equity and long term borrowings (debt). Equity is in the form of common stock or preferred
stock and long term borrowings (debt) are in the form of debentures or bonds. The profit earned from
operations is owners’ funds which may be retained in the business or distributed to the owners (shareholders)
as dividend. The portion of profits retained in the business is a reinvestment of owners’ funds and hence a
source of long-term funds. Short-term funds are the working capital requirements of the firm. The short-
term borrowings often keep shifting and thus the proportion of the sources for short-term funds cannot be
rigidly laid down. So, the firm follows a flexible approach. A more definite policy is often laid down for the
composition of long-term funds.
The entire composition of these funds constitutes the overall financial structure of the firm.
14.2 Meaning and Definition

Meaning: The capital structure is how a firm finances its overall operations and growth by using different
sources of funds. It refers to how much of each type of funds a company holds as a percentage of its total
financing. In other words, Capital Structure is referred to as the ratio of different kinds of securities raised
by a firm as long-term finance. Therefore, it is a mix of a company’s long-term debt, specific short-term
debt, common equity and preferred equity.
When people refer to capital structure they are mostly referring to a firm’s debt-to-equity ratio, which
provides insight into how risky a company is. Usually a company more heavily financed by debt poses greater
risk, as this firm is relatively highly levered.
Definitions: According to Gerestonbeg, “capital structure of a company refers to the composition or make
up of its capitalization and it includes all long term capital resources i.e. loans, reserves, shares and bonds.”
Weston and Brigham define, “capital structure is permanent financing of the firm represented by long term
debts.”
14.3 Features of Capital Structure

While developing a capital structure the finance manager should aim at maximizing the long term market
price of equity shares. An appropriate capital structure should have the following features. The relative
importance of each of these feature differ from company to company and may change with changing conditions.
1. Returns: The capital structure should be such that it gives maximum return to the shareholders.
Maximum use of leverage at minimum cost should be made so as to obtain maximum advantage of
trading on equity at minimum cost.
2. Solvency: Company should not use excessive debt in the capital structure, because in times of
higher interest rates it can even threaten the solvency of the company.
3. Flexibility: The capital structure should be flexible enough that the company can alter the debt
equity ratio whenever there is need to alter it. For example banks do not give loans to companies if
debt equity ratio is high, in that case it is important to have flexible capital structure.
4. Goal Oriented: Capital structure should be in congruence with the goals of the company, which
implies that if the policy is that company will not take more debt, than capital structure should be
framed accordingly with more equity and less debt.
14.4 Equations and Notations

In the analysis of capital structure theories, the following basic definitions and equations shall be used.
Market value of Equity = E
Market value of debt= D
Total market value of the firm= V= (E+D)
Interest Payments =I
Tax Rate= T
Net Operating Income or EBIT = NOI = X¯
Net Income or shareholders earnings (EBIT- INT) when taxes do not exist= NI = Y¯
Current Market price per share= Po
Dividend at Time 0 (now)= Do
Expected dividend at the end of Year 1= D1
Debt
Cost of Debt = kd = INT / D
Cost of Debt after Tax= Kd= I (1-T)
D
Value of Debt= D = INT / kd
Equity
Cost of Equity= Ke= D1 /Po
Alternatively:
Cost of Equity, Ke= Ko+(ko-kd) (D/E)
Over all cost of capital(WACC)= Ko
Ko =Kd[D/(D+E)]+Ke[E/(D+E]
=Kd(D/V)+Ke(E/V)
= Kd D + Ke(E) = KdD + KeE = EBIT
V V V V
The above equations and definitions are valid under any of the capital structure theories. The controversy is
with regard to the behavior of the variables like ke, ko, V etc with leverage.
14.5 Theories of Capital Structure

There are four basic Capital Structure theories. They are:
1. Net Income (NI) Approach
2. Net Operating Income (NOI) Approach
3. Modigliani-Miller (MM) Approach
4. Traditional Approach
Generally, the capital structure theories have the following assumptions:
1. The firms employ only two types of capital namely debts ad equity
2. The firms pay 100% of the earnings as dividend. This means that the dividend pay-out ratio is 100%
and there are no earnings that are retained by the firms.
3. The total assets are given which do not change and the investment decisions are assumed to be constant.
4. Business risk is constant over time and it is assumed that it is independent of the capital structure and
financial risk.
5. The firm has a perpetual life.
6. The firm’s operating earnings (EBIT) are not expected to grow.
7. The corporate and personal income taxes do not exist. This assumption was relaxed later on.
8. The firm’s total financing remains constant. The firm’s degree of leverage can be altered either by selling
shares to retire debt or by raising more debt and reduce the equity financing.
9. All the investors are assumed to have the same subjective probability distribution of the future expected
operating profits for a given firm.
14.5.1 Net Income (NI) Approach
Net Income theory was introduced by David Durand. According to this approach, there is a relationship
between the capital structure and the value of the firm. The firm, by increasing the debt proportion in the
capital structure can increase its market value or lower the overall cost of capital (WACC).
Debt is cheap source of finance because its interest is deductible from net profit before taxes. After deduction
of interest, company has to pay less tax and thus it will decrease the over all cost of capital or weighted
average cost of capital (WACC).
High debt content in the debt-equity mix is called financial leverage. Increasing of financial leverage will help
in maximizing the firm’s value. For example, if the debt: equity mix is increased from 50:50 to 80:20, it will
increase the market value of firm and its positive effect on the value of per share.
Assumptions of NI approach:
1. There are no taxes.
2. The cost of debt is less than the cost of equity ( i.e kd < ke )
3. The use of debt does not change the risk perception of the investors, as a result the cost of equity (ke)
and the cost of debt (kd) remains constant with the change in leverage.
4. The overall cost of capital (ko) decreases with the increase in leverage.
l ke
tai .1 0
ap
c
f ko
o
st
o kd
C
.0 5
0. 2 0.4 0.6 0.8 1.0

De gr ee o f le ver age
Figure - 14.1 : The Effect of Leverage on the Cost of Capital Under NI Theory
Illustration 14.1 - NI Theory
Firm A Firm B
Earnings Before Interest and Tax 2,00,000 2,00,000
Interest (I) - 50,000
Equity Earnings (E) 2,00,000 1,50,000
Cost of Equity (Ke) 12% 12%
Cost of Debt (Kd) 10% 10%
Market Value of Equity= E/ Ke 16,66,667 12,50,000
Market Value of Debt =Int/Kd NIL 5,00,000
Total value of Firm (V) 16,66,667 17,50,000
Overall cost of capital (Ko)= EBIT/V 12% 11.43%
Conclusion: Firm B: increasing the debt proportion in its capital structure has increased its market value or
lowered the overall cost of capital (WACC).
14.5.2 Net Operating Income (NOI) Approach
According to this approach the market value of the firm is not affected by the capital structure changes. This
theory, contrary to NI theory, does not accept the idea of increasing the financial leverage. It means change
in the capital structure does not affect the overall cost of capital and the market value of the firm. Thus at
each and every level of capital structure, market value of firm will be same.
The market value of the firm V = (D+E) = EBIT/Ko
V= Value of firm
(D+E)= Debt + Equity
KO = Overall cost of capital
EBIT = Earnings before interest and tax.
The overall capitalisation rate (ko) depends on the business risk of the firm and is independent of financial
mix. Therefore, the market value of firm will be a constant and independent of capital structure changes.
Thus, according to Net Operating Income (NOI) Approach, any capital structure will be optimum.
The critical assumptions of the NOI approach are:
a. The market capitalizes the value of the firm as a whole. Thus the split between debt and
equity is not important.
b. The market uses an overall capitalisation rate to capitalize the net operating income. Overall
cost of capital depends on the business risk. If the business risk is assumed to remain
unchanged, overall cost of capital is a constant.
c. The use of less costly debt funds increases the risk to shareholder. This causes the equity
capitalisation rate to increase. Thus, the advantage of debt is offset exactly by the increase
in the equity-capitalisation rate.
d. The debt capitalisation rate is constant.
e. The corporate income taxes do not exist.
Ke
)t
n
ec
r
e
p Ko
l(
at
i
ap
c
fo
ts Kd
o
C
Leverage
Figure - 14.2 : The Effect of Leverage on the Cost of Capital Under NOI theory
Illustration 14.2- NOI Theory
A firm has an EBIT of Rs. 5,00,000 and belongs to a risk class of 10%. What is the cost of Equity if it
employs 8% debt to the extent of 30%, 40% or 50% of the total capital fund of Rs 20,00,000?
Solution
30% 40% 50%
Debt 6,00,000 8,00.000 10,00,000
Equity 14,00,000 12,00,000 10,00,000
EBIT 5,00,000 5,00,000 5,00,000
Ko 10% 10% 10%
Value of the firm (V= EBIT/Ko)) 50,00,000 50,00,000 50,00,000
Value of Equity (E=V-D) 44,00.000 42,00,000 40,00,000
Interest @ 6% 36,000 48,000 60,000
Net Profit (EBIT-Int) 4,64,000 4,52,000 4,40,000
Ke (NP/E) 10.545% 10.76% 11%
14.5.3 Traditional Approach

Traditional Theory is an intermediate approach between the net income and net operating income theories.
This gives the right combination of debt and equity and always leads to enhanced market value of the firm.
It states that a firm’s value increases to a certain level of debt capital, after which it tends to remain constant
and eventually begins to decrease.
The traditional theory assumes changes in cost of equity (ke) at different levels of debt- equity rate and
beyond a particular point of debt-equity mix, ke rises at an increasing rate, thus reducing the value of the
firm.
The effect of change in capital structure on the overall cost of capital can be divided into three stages as
follows:
Stage I – Introduction of Debt: Increasing Value - The overall cost of capital falls and the value of the
firm increases with the increase in leverage. This leverage has beneficial effect as debts are less expensive.
The cost of equity remains constant or increases negligibly. The proportion of risk is less in such a firm.
Stage II – Further Application of Debt: Optimum Value - A stage is reached when increase in leverage
has no effect on the value of the firm or the cost of capital. Neither the cost of capital falls nor the value of
the firm rises. This is because the increase in the cost of equity due to the assed financial risk offsets the
advantage of low cost debt. Stage wherein the value of the firm is maximum and cost of capital is minimum
-Optimum capital Structure
Stage III – Further Application of Debt: Declining Value - Beyond a definite limit of leverage the cost
of capital increases with leverage and the value of the firm decreases with leverage. This is because with the
increase in debts investors begin to realize the degree of financial risk and hence they desire to earn a higher
rate of return on equity shares. As a result the value of the firm reduces.
This theory follows that the cost of capital is a function of the degree of leverage. Hence, an optimum capital
structure can be achieved by establishing an appropriate degree of leverage.
ke
)t
i
n
u ka
re
(p Stage II
la
ti
p
ac Stage III
fo Stage I kd
ts
o
C
Leverage
L
Figure - 14.3 : The Costs of Capital Behavior Under Traditional View

14.5.4 Modigliani- Miller (M-M) Approach
Modigliani Millar approach, popularly known as the MM approach is similar to the Net operating income
approach. The MM approach favors the Net operating income approach and agrees with the fact that the
cost of capital is independent of the degree of leverage and at any mix of debt-equity proportions.
Modigliani and Miller argued that, in the absence of taxes the cost of capital and the value of the firm are not
affected by the changes in capital structure.
Assumptions of M-M Approach
1. Capital markets are perfect. Thus investors are
- free to buy and sell securities
- able to borrow funds at the same terms as the firms do
- well informed and behave rationally
2. All investors have the same expectation of the company’s net operating income (EBIT) for the
purpose of evaluating the value of the firm.
3. Within similar operating environments, the business risk is equal among all firms.
4. Dividend payout ratio is 100% and therefore no retained earnings.
5. No corporate taxes exist. This was removed later.
Basic Propositions – M-M approach- Without Taxes
M M Hypothesis can be explained in terms of two propositions of Modigliani and Miller
Proposition I: At any degree of leverage, the company’s overall cost of capital (ko) and the Value of the
firm (V) remains constant. This means that it is independent of the capital structure. The total value can be
obtained by capitalizing the operating earnings stream that is expected in future, discounted at an appropriate
discount rate suitable for the risk undertaken.
According to M M, for the firms in the same risk class, the total market value is independent of capital
structure and is determined by capitalising net operating income by the rate appropriate to that risk class.
Proposition I can be expressed as follows:
V = (D+E) = NOI/Ko
Where V= the market value of the firms,
E= market value of equity, D= market value of debt
NOI= Net operating Income
Ko = capitalisation rate appropriate to the risk class of the firm.
)t
in Ke
u
r
e
(p
la
ti
p
ac
fo
ts
o
C
Leverage
Figure - 14.4 : The Cost of Capital Under M-M Proposition I

It is evident from this figure that average cost of capital is constant and is not affected by leverage.
Arbitrage Process: Why should proposition I hold good? The simple principle of proposition 1 is that
two firms identical in all respects except for the capital structures cannot command different market values
nor have different cost of capital.
Arbitrage process is the process of purchasing a security in a market where the price is low and selling it in
a market where the price is high. This will have an effect of increasing the price of the shares that is being
purchased and decreasing the price of the shares that is being sold. This process will continue till the market
price of these two firms become equal or identical. This results in restoration of equilibrium in the market
price of a security asset. This process is a balancing operation which implies that a security cannot sell at
different prices. Thus the arbitrage process drives the value of two homogeneous companies to equality that
differs only in leverage.
Proposition II: For any firm in a given risk class, the cost of equity is equal to the constant average cost of
capital (Ko) plus a premium for the financial risk, which is equal to debt – equity ratio times the spread
between average cost and cost of debt.
Therefore, cost of equity is defined as follows:
Ke= Ko+(ko-kd) (D/E)
 Ke is the required rate of return on equity or cost of equity
 Ko is the company unlevered cost of capital (ie assume no leverage).
 Kd is the required rate of return on borrowings, or cost of debt
 D/E is the debt-to-equity ratio.
A higher debt-to-equity ratio leads to a higher required return on equity, because of the higher risk involved
for equity-holders in a company with debt. The formula is derived from the theory of weighted average cost
of capital (WACC).
)it Ke
n
u
re
p
(l Ko
at
ip
ac Kd
f
o
ts
o
C
Le verage
Figure - 14.5 : The cost of capital under M-M Proposition II

M-M approach - With Taxes: Debt has an important advantage over equity, interest payments on debt
are tax deductible, whereas dividend payments and retained earnings are not. Investors in a levered firm
receive in the aggregate the unlevered cash flow plus an amount equal to the tax deduction on interest. The
value of the levered firm is equal to the value of the unlevered firm plus the interest tax shield which is tax rate
times the debt (if the shield is fully usable).
The following assumptions are made in the propositions with taxes:
 corporations are taxed at the rate Tc on earnings after interest,

 no transaction costs exist, and
 individuals and corporations borrow at the same rate
It is assumed that the firm will borrow the same amount of debt in perpetuity and will always be able to use
the tax shield. Also, it ignores bankruptcy and agency cost.
Proposition I
VL= VU+TCD
Where
 VL is the value of a levered firm
 VU is the value of an unlevered firm
 TCD is the tax rate TC x D the value of debt
 the term assumes debt is perpetual
Proposition II:
rE= ro+D/E (ro- rd) (1- Tc)
Where
 rE is the required rate of return on equity, or cost of levered equity=unlevered equity + financing
premium
 ro is the company cost of equity capital with no leverage (unlevered cost of equity, or return on
assets with D/E = 0)
 rd is the required rate of return on borrowings, or cost of debt
 D/E is the debttoequity ratio
 Tc is the tax rate.
Limitations of MM Hypothesis:
1. Investors would find the personal leverage inconvenient.
2. The risk perception of corporate and personal leverage may be different.
3. Arbitrage process cannot be smooth due the institutional restrictions.
4. Arbitrage process would also be affected by the transaction costs.
5. The corporate leverage and personal leverage are not perfect substitutes.
6. Corporate taxes do exist. However, the assumption of “no taxes” has been removed later.
Relaxing MM Assumptions: The scenarios presented by MM are not necessarily reflective of business
reality. Additional factors for consideration include:
 Financial Distress: as a firm assumes more debt (i.e. increases its financial leverage), its bankruptcy
risk increases. This increased risk should be factored in to any analysis.
 Agency Costs: these are the costs incurred by stockholders to monitor company managers; agency
costs are increased when monitoring mechanisms fail and equity value losses are absorbed.
 Asymmetric Information: MM assumes perfect information, but company managers commonly

know more about the firm than the investing public. This is asymmetric information.
Pecking Order Theory: This theory states that company management prefers to use internal financing
(cash on hand, retained earnings) as these sources are not as readily visible to the public as stock and bond
offerings, which invite scrutiny.
Financing comes from three sources, internal funds, debt and new equity. Companies prioritize their sources
of financing, first preferring internal financing, and then debt, lastly raising equity as a last resort. Hence,
internal financing is used first, when that is depleted, then debt is issued; and when it is no longer sensible to
issue any more debt, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing
sources and prefer internal financing when available, and debt is preferred over equity if external financing is
required.
This model does assume asymmetric information – managers know more than investors, and will only issue
equity, the most expensive form of financing, last in order to avoid transferring wealth from old shareholders
to new shareholders.
Static Trade-Off Theory: Outside the MM construct, this theory views capital structure as a decision that
balances costs and benefits. Under static trade-off, the company should continue to capitalize itself with debt
until the increased costs associated with financial distress exceed the value of the tax shield.
14.6 Summary
Capital Structure of a firm is a combination of different sources of securities raised by a firm as long-term
finance. It is determined by the mix of debt and equity it uses in financing its operations. The capital structure
should aim at maximizing the returns to the shareholders resulting in the increased market value of the firm.
It should be flexible enough that the firm can alter the debt equity ratio at any point of time and need. It is
important for a firm to plan the capital structure, initially and on continuous basis, as it has a considerable
bearing on its profitability.
Capital structure theories developed under some assumptions show sharp differences in the theoretical
relationship between capital structure, cost of capital and value of the firm.
NI Approach at one extreme argues that leverage always affects the cost of capital and the value of a firm.
Increasing the debt portion in debt- equity mix will decreased the overall cost of capital resulting in maximizing
the firm’s value. The NOI Approach, in contrast, is at the other extreme of the spectrum. According to this
Approach, capital structure is totally irrelevant.
The Traditional Approach strikes a balance between these extremes. A firm can increase its value (V) and
reduce its cost of capital (k0) up to a point, but beyond that point, the use of further debt will lead to a rise
in the weighted average cost of capital. At that point the capital structure is optimum.
Although the empirical testing has been only suggestive with respect to the true relationship between leverage
and cost of capital, the Traditional Approach provides a fairly close approximation of the position. The
optimum capital structure would, of course, vary from case to case.
Modigliani and Miller concur with NOI and provide behavioral support to its basic proposition. However,
the basic premises of the MM Approach are of doubtful validity. As a result, the arbitrage process is
impeded.
Modigliani and Miller also agree that with corporate taxes debt has a definite advantage over equity as the
interest is tax-deductible and leverage will lower the overall cost of capital. The value of the levered firm is
equal to the value of the unlevered firm plus the interest tax shield which is tax rate times the debt. The
scenarios presented by MM are not necessarily reflective of business reality and thus additional factors like
financial distress, agency costs are to be considered.
Pecking order theory starts with asymmetric information as managers know more about the firm’s prospects,
risks and value than outside investors. Asymmetric information affects the choice between internal and
external financing and between the issue of debt or equity. Therefore there exists a pecking order for the
financing of new projects.

1. Define Capital Structure and explain its features.
2. Explain the assumptions and implications of NI and NOI theories. Illustrate your answer with
hypothetical examples.
3. Describe the traditional view on optimum capital structure. Compare this view with NI and NOI
approach.
4. Explain the position of M M theory on the issue of an optimum capital structure
a. ignoring corporate income taxes
b. assuming the existence of taxes
5. How does the cost of capital behave with leverage under traditional and M M approach?
6. X Co has a net operating income of Rs 2,00,000 on an investment of Rs 10,00,000 in assets. It can
raise debt at a 16 per cent rate of interest. Assume that taxes do not exist.
(a) Using the NI approach and an equity capitalization of 18 percent, compute the total value of the firm
and the weighted average cost of capital if the firm has (i) no debt, (ii) Rs 3,00,000 debt, (iii) Rs
6,00,000 debt.
(b) Using the NOI approach and an overall capitalization rate of 18 percent, compute the total value of
the firm, value of shares and cost of equity if the firm has (i) no debt, (ii) Rs 3,00,000 debt, (iii) Rs
6,00,000 debt.
Solution:
(a) NI approach
(i) (ii) (iii)

Net Operating income (EBIT) 200,000 200,000 200,000
Debt (D) 300,000 600,000
Debt rate, kd 16% 16% 16%
Total cost of debt, INT = D * kd 48000 96000
Net Income, NI = EBIT - INT 200000 152000 104000
Cost of equity, ke 18% 18% 18%
Market value of equity, E = NI/ke 1,111,111 844,444 577,778
Total value of firm, V = E +D 1,111,111 1,144,444 1,177,778
Weighted cost of capital 18.0% 17.5% 17.0%
(b) NOI approach
(i) (ii) (iii)

Net Operating income (EBIT) 200,000 200,000 200,000
Weighted average cost of capital ko 18% 18% 18%
Total value of firm, V = NOI/ko 1,111,111 1,111,111 1,111,111
Market value of Debt (D) 300,000 600,000
Market value of equity, E = V -D 1,111,111 811,111 511,111
Debt rate, kd 16% 16% 16%
Total cost of debt, INT = D*kd 0 48,000 96,000
Cost of equity, ke = (EBIT - INT)/E 18.0% 18.7% 20.3%
7. Two companies A and B are identical except that company A is unlevered while company B has 6
percent Rs 2,00,000 debt outstanding. As per the NI approach, the valuation of the two firms is as
follows:
Company A Company B
(Unlevered) (Levered)
Net operating income EBIT 60000 60000
Total cost of debt, kd D 0 12000
Net earnings, NI 60000 48000
Equity capitalization, ke 0.100 0.111
Market value of shares, S 600000 432432
Market value of debt, D 200000
Total value of the firm, V 600000 632432
Mr X holds Rs 2,000 worth of Company B shares. Does Mr X have opportunity for arbitrage and
thereby reduce his outlay to earn same return?
Solution:
Mr X can reduce his outlay and earn the same return through arbitrage.
1. He can sell shares in company B for Rs 2,000
2. He can then create a personal leverage equal to the share of debt in company B by
borrowing Rs. 926 (=Rs 2,000 *Rs 2,00,000/ Rs 4,32,000)
3. He can then buy Rs 2,778 (=Rs 6,00,000 * Rs 2,000 / Rs 4,32,000) of company A
shares
Return on Company A shares: Rs 2,778*10% Rs 277.80
Less: Interest on Rs 926 *6% Rs 55.56
Net return Rs 222.24
His return from Company B (Levered company) is Rs 2000 *11.1% = Rs 222.22 which is
same as in Company A (unlevered company). However the funds involved in the unlevered
company are Rs 2778 – Rs 926 = Rs 1852 which is less thatn Rs 2000 cash outlay involved
in the levered company.
8. The following are the costs and values for the firms X and Y according to the traditional approach
X Y
Rs Rs
Total value of firm, V 100,000 120,000
Market value of debt, D 0 60,000
Market value of equity, E 100,000 60,000
Expected net operating income, X 12,000 12,000
Cost of debt, INT = kd D 0 4,800
Net income, X - kdD 10,000 7,200
Cost of equity, K - (X – kdD/E) 10.00% 12.00%
Debt-equity ratio, D/E 0 0.5
Average cost of capital, ka 12.00% 10.00%
Compute the equilibrium value for Firms A and B in accordance with the M-M thesis. Assume that (i) taxes
do not exist and (ii) the equilibrium value of ka is 9.4 per cent.
Solution:
The equilibrium values for Firms X and Y is as below
X Y
Rs Rs
N e t opera tin g inco me (EBIT ) 1 20 0 0 1 2 00 0
C o st o f De bt, INT = k d *D 0 4 80 0
N e t inco me (N I) 1 20 0 0 7 20 0
A vera ge c os t of capital 9. 50 % 9. 50 %
T otal va lu e of firm, V = E BIT/k o 12 63 1 6 12 6 31 6

M a rket va lu e of debt, D 0 6 0 00 0
M a rket va lu e of sh are s, E = V -D 12 63 1 6 6 6 31 6
C o st o f eq uity, ke = N I/E 9 .5 % 10 .9 %
- Chandra, Prasanna.,2007, Fundamentals of Financial Management, Tata McGraw, New delhi.
- Maheshwari, S.N., 2011, Financial Management, Sultan chand & Sons, New Delhi.
- Pandey, I.M.,2010, Financial Management,Vikas Publishing House Pvt Ltd.,New Delhi.
- Khan M.Y and Jain P.K. 2002, Cost Accounting and Financial Management, Tata McGraw Hill,
New Delhi.
- Kulkarni,.P.V. Sathya B.G. 1999. Financial Management, (nineth revised edition), Himalaya
Publishing, Bombay .
- Upadhyaya, K.M., 1985 Financial Management Kalyani Publishers, Ludhiana.
Unit -15 : Capital Structure: Planning
Structure of Unit:
15.0 Objectives
15.1 Introduction
15.2 Meaning of Capital Structure
15.3 Factors Determining Capital Structure
15.4 Approaches to Establish Appropriate Capital Structure
15.4.1 EBIT-EPS Approach
15.4.2 Cost of Capital and Valuation Approach
15.4.3 Cash Flow Approach
15.5 Practical Considerations in Determining Capital Structure
15.6 Summary
15.0 Objectives
After you have studied this unit, you should be able to:
 Appreciate the need for capital structure planning
 Understand the factors determining the capital structure of a firm
 Relate the components of capital structure with risk, return and value of the firm
 Explain and relate the various approaches of capital structure planning
 Critically examine and distinguish between the alternate approaches
 Discuss a number of practical considerations in determining a firm’s capital structure
15.1 Introduction
Capital structure planning is very important for survival of the business in long run. Companies which do
not plan their capital structure may prosper in the short-run, but in a long run they may face considerable
difficulties in raising funds to finance their activities. With unplanned capital structure, these companies may
also fail to economize the use of their funds. Consequently, it is being increasingly realized that a company
should plan its capital structure to maximize the use of the funds and to be able to adapt more easily to the
changing conditions.
Capital structure refers to the mix of long-term sources of funds, such as debentures, long-term debt,
preference share capital and equity share capital including reserves and surpluses (i.e. retained earnings).
Planning the capital structure is one of the most complex areas of financial decision making because of the
inter-relationships among components of the capital structure and also its relationship to risk, return and
value of the firm. Two similar companies can have different capital structures if the decision makers differ in
their judgment of the significance of various factors.
The optimum capital structure is obtained when the market value per share is maximum. Theoretically, a
company needs to plan out an optimum capital structure. But in practice, it is difficult to determine an
optimum capital structure as one needs to go beyond theories. The capital structure should be planned
generally keeping in view the interests of the equity shareholders and the financial requirements of a company.
The equity shareholders, being the owners of the company and the providers of risk capital (equity) would
be concerned about the ways of financing a company’s operations. However, the interests of other groups,
such as employees, customers, creditors, society and government, should also be given reasonable
consideration.
15.2 Meaning of Capital Structure

The capital structure is how a firm finances its overall operations and growth by using different sources of
funds. It refers to how much of each type of funds a company holds as a percentage of its total financing. In
other words, Capital Structure is referred to as the ratio of different kinds of securities raised by a firm as
long-term finance. Therefore, it is a mix of a company’s long-term debt, specific short-term debt, common
equity and preferred equity.
The capital structure involves two decisions-
a. Type of securities to be issued (equity shares, preference shares and long term borrowings)
b. Relative ratio of securities that can be determined by process of capital gearing.
On this basis, the companies are divided into two-
a. Highly Geared Companies- Those companies whose proportion of equity capitalization is small.
A company with high gearing (high leverage) is more vulnerable to downturns in the business cycle
because the company must continue to service its debt regardless of how bad sales are. A greater
proportion of equity provides a cushion and is seen as a measure of financial strength. In high
gearing companies, interest paid on debts reduces profits available to shareholders, and if interest
rates increase, the cost of the business can rapidly increase. But high gearing is not necessarily bad.
It may indicate that a company is adventurous in its expansion plans, and may have taken the
opportunity to invest by borrowing at low rates.
b. Low Geared Companies- Those companies whose equity capital dominates total capitalization. A
company with low gearing is one where the largest proportion of the funding of the business has
come from investment by shareholders. As low gearing will be a result of a low level of borrowings,
this can indicate that the firm is growing through reinvestment of profits, minimizing risk. But low
gearing may indicate that a firm is not aggressive enough to survive, and may not be seeking
opportunities for growth.
Example: There are two companies A and B. Total capitalization amounts to be Rs. 20 lakhs in each case.
The equity capital in the total capitalization of company A is Rs. 5 lakhs, while in company B equity capital
is Rs. 15 lakhs. In company A, equity proportion is 25% and in company B, equity proportion is 75%. In
such cases, company A is considered to be a highly geared company and company B is low geared company.
15.3 Factors Determining Capital Structure

The right capital structure is important for the survival of the business in long run. It enhances the power of
the company to face the losses and changes in financial markets. Decision regarding what type of capital
structure a company should have is of critical importance because of its potential impact on profitability and
solvency.
The factors determining the Capital Structure are highly psychological, complex and qualitative and do not
always follow accepted theory, since capital markets are not perfect and the decision has to be taken under
imperfect knowledge and risk. A theoretical model cannot adequately handle all the factors which affect the
capital structure decision.
The following are the factors determining the capital structure in a business enterprise:
1. Size of the Business Enterprise: The capital structure of a business enterprise is also influenced
by the size of business enterprise. It may be small, medium or large. A large-sized business enterprise
requires much more capital as compared to a small-sized business enterprise. Small size business
firm’s capital structure generally consists of loans from banks and retained profits. While on the
other hand, big companies having goodwill, stability and an established profit can easily go for
issuance of shares and debentures as well as loans and borrowings from financial institutions. The
bigger the size, the wider is total capitalization.
2. Nature of the Business Organization: The capital structure of a business enterprise is also
influenced by nature of business organization. It may be manufacturing, financing, trading or public
utility type.
3. Period of Finance: Period of finance, short, medium or long term is also another factor which
determines the capital structure of a business enterprise. For example, short-term finances are
raised through borrowings as compared to long-term finance which is raised through issue of shares,
stocks etc.
4. The Purpose of Financing: The purpose of financing should also be kept in mind in determining
the capital structure of a business enterprise. The funds may be required either for betterment
expenditure or for some productive purposes. The betterment expenditure, being non-productive,
may be incurred out of funds raised by issue of shares or from retained profits. On the contrary,
funds for productive purposes may be raised through borrowings.
5. Elasticity of Capital Structure: The capital structure of a business enterprise should be quite
elastic so as to meet the future requirements of the capital also. For this purpose the amount of
authorized capital should be fixed at a higher level as compared to present needs.
6. Capital Market Condition: In the lifetime of the company, the market price of the shares has got
an important influence. During the depression period, the company’s capital structure generally
consists of debentures and loans. While in period of boons and inflation, the company’s capital
should consist of share capital generally equity shares.
7. Trading on Equity: Trading on equity means taking advantage of equity share capital to borrow
funds on reasonable basis. It refers to additional profits that equity shareholders earn because of
issuance of debentures and preference shares. It is based on the thought that if the rate of dividend
on preference capital and the rate of interest on borrowed capital is lower than the general rate of
company’s earnings, equity shareholders are at advantage which means a company should go for a
judicious blend of preference shares, equity shares as well as debentures. Trading on equity becomes
more important when expectations of shareholders are high.
8. Degree of Control: In a company, it is the directors who are so called elected representatives of
equity shareholders. These members have got maximum voting rights in a concern as compared to
the preference shareholders and debenture holders. Preference shareholders have reasonably less
voting rights while debenture holders have no voting rights. If the company’s management policies
are such that they want to retain their voting rights in their hands, the capital structure consists of
debenture holders and loans rather than equity shares.
9. Choice of Investors: Generally, the company policy is to have different categories of investors
for securities. Therefore, a capital structure should give enough choice to all kind of investors to
invest. Bold and adventurous investors generally go for equity shares and loans and debentures are
generally raised keeping into mind conscious investors.
10. Cost of Financing: In a capital structure, the company has to look to the factor of cost when
securities are raised. It is seen that debentures at the time of profit earning of company prove to be
a cheaper source of finance as compared to equity shares where equity shareholders demand an
extra share in profits.
11. Stability of Sales: An established business which has a growing market and high sales turnover,
the company is in position to meet fixed commitments. Interest on debentures has to be paid regardless
of profit. Therefore, when sales are high, thereby the profits are high and company is in better
position to meet such fixed commitments like interest on debentures and dividends on preference
shares. If company is having unstable sales, then the company is not in position to meet fixed
obligations. So, equity capital proves to be safe in such cases.
15.4 Approaches to Establish Appropriate Capital Structure

Capital structure is formed initially when a company is incorporated. The initial capital structure should be
designed very carefully. The management of the company should set a target capital structure and the
subsequent financing decisions should be made with a view to achieve the target capital structure. Every
time when funds are needed to finance the activities of the firm, the pros and cons of various sources of
finance should be weighed and the most advantageous sources should be selected, keeping in view the
target capital structure. Thus, the capital structure decision is a continuous one and has to be taken whenever
a firm needs additional finances.
The following are the three most common approaches to decide about a firm’s capital structure:
1. EBIT-EPS approach for analyzing the impact of debt on EPS
2. Valuation approach for determining the impact of debt on the shareholders’ value
3. Cash flow approach for analyzing the firm’s ability to service debt
15.4.1 EBIT-EPS Approach
The EBIT-EPS capital structure approach focuses on finding a capital structure with the highest EPS (earnings
per share) over the expected range of EBIT (earnings before interest and taxes). The reason of finding a
capital structure which will permit maximization of the EPS over the expected range of EBIT is because it
partially helps to achieve the ultimate objective of the enterprise. The ultimate objective of the enterprise is
to maximize shareholders’ wealth by maximizing its stock price. Two key variables that affect stock price
are return (earnings attributed to owners of the enterprise) and risk (which can be measured by required
return). This approach explicitly considers maximization of returns (EPS). However, it is important to note
that this approach ignores risk (does not explicitly consider risk).
Financial leverage is an important consideration in planning the capital structure of a company because of its
effect on the earnings per share. The use of fixed cost sources of funds such as debt and preference share
capital to finance the assets of the company is known as financial leverage or trading on equity. If the assets
are financed using debts and the yield is greater than the cost of debt, the earning per share also increases
without an increase in the owners’ investment. The earnings per share also increase when the preference
share capital is used to acquire assets. But the leverage impact is more pronounced in case of debt because
(i) the cost of debt is usually lower than the cost of preference share capital and (ii) the interest paid on debt
is tax deductible.
One common method of examining the impact of leverage is to analyze the relationship between EPS and
various possible levels of EBIT under alternative methods of financing. The companies with high level of the
earnings before interest and taxes (EBIT) can make profitable use of the high degree of leverage to increase
return on the shareholders’ equity.
Analysis for Risk and Return: The relationship between EBIT and EPS is plotted for different capital
structures, the investor can analyze the graph, focusing on two key challenges. The level of EBIT where
EPS is zero, called the break-even point, and the graph’s slope, which visually represents the company’s
risk. A steeper slope conveys a higher risk — greater loss per share at lower EBIT level. A steeper slope
also means a higher return, and that the company needs to earn less EBIT to produce greater EPS. The
breakeven point is also important because it tells the business how much EBIT there must be to avoid
losses, and varies at different proportions of debt to equity.
Major Shortcoming of the EBIT-EPS Approach: This approach is one of the most widely used measures
of the company’s performance in practice. As a result of this, in choosing between debt and equity in
practice, sometimes too much attention is paid on EPS, which however, has some serious limitations as a
financing-decision criterion. The fact that this approach fails to explicitly consider risk is the major shortcoming
of this method. As firm obtains more debt (its financial leverage increases), the risk also increases and
shareholders will require higher returns to compensate for the increased financial risk. Therefore, this approach
is not completely appropriate because it does not consider one of the key variables (risk), which is necessary
for maximization of shareholders’ wealth.
Illustration: 15.4.1: Suppose that a firm has an all equity capital structure consisting of 100,000 ordinary
shares of Rs.10 per share. The firm wants to raise Rs.250,000 to finance its investments and is considering
three alternative methods of financing –
(i) to issue 25,000 ordinary shares at Rs.10 each,
(ii) to borrow Rs.2,50,000 at 8 per cent rate of interest,
(iii) to issue 2,500 preference shares of Rs.100 each at an 8 per cent rate of dividend.
If the firm’s earnings before interest and taxes after additional investment are Rs.3,12,500 and the tax rate
is 50 per cent, the effect on the earnings per share under the three financing alternatives will be as follows:
Solution: EPS Under Alternative Financing Favorable EBIT:
Equity Financing Debt Preference
Rs. Financing Financing
Rs. Rs.
EBIT 3,12,500 3,12,550 3,12,550
Less: Interest 0 20,000 0
PBT 3,12,500 2,92,500 3,12,500
Less: Taxes 1,56,250 1,46,250 1,56,250
PAT 1,56,250 1,46,250 1,56,250
Less: Preference dividend 0 0 20,000
Earning available to ordinary shareholders 1,56,250 1,46,250 1,36,250
Shares outstanding 1,25,000 1,00,000 1,00,000
EPS 1.25 1.46 1.36
The firm is able to maximize the earnings per share when it uses debt financing. Though the rate ofpreference
dividend is equal to the rate of interest, EPS is high in case of debt financing because interest charges are tax
deductible while preference dividends are not. With increasing levels of EBIT, EPS will increase at a faster
rate with a high degree of leverage. However if a company is not able to earn a rate of return on its assets
that is higher than the interest rate (or the preference dividend rate), debt (or preference financing) will have
an adverse impact on EPS.
Suppose the firm in illustration above has an EBIT of Rs.75,000/- EPS under different methods will be as
follows:
EPS Under Alternative Financing Methods: Unfavorable EBIT:
Equity Financing Debt Financing Preference

Rs. Rs. Financing
Rs.
EBIT 75,000 75,000 75,000
Less: Interest 0 20,000 0
PBT 75,000 55,000 75,000
Less: Taxes 37,000 27,500 37,500
PAT 37,500 1,46,250 1,56,250
Less: Preference dividend 0 0 20,000
Earning available to ordinary shareholders 1,56,250 27,500 17,500
Shares outstanding 1,25,000 1,00,000 1,00,000
EPS 0.30 0.27 0.17
It is obvious that under unfavorable conditions, i.e. when the rate of return on the total assets is less than the
cost of debt, the earnings per share will fall with the degree of leverage.
15.4.2 Cost of Capital and Valuation Approach
A company should have such a mix of debt and equity that its overall cost of capital is minimum. The overall
cost of capital is minimum when the cost of various sources of funds is minimum. Measuring the costs of
various sources of funds is a complex subject and needs a separate treatment. In order to minimize the cost
of capital, cheaper sources of funds should be preferred, other things remaining the same.
The cost of source of finance is the minimum return expected by its suppliers which depends on the degree
of risk assumed by them. A high degree of risk is assumed by shareholders than debt-holders. This is
because the rate of dividends is not fixed for ordinary shareholders and the board of directors has no legal
obligation to pay dividends even if the company has made profits. Besides, the shareholders will have to
share the residue only when the company is wound up. In the case of debt-holders, the rate of interest is
fixed and the company is legally bound to pay interest whether it makes profits or not. The loan of debt-
holders is returned within a prescribed period. This leads to the conclusion that debt is a cheaper source of
funds than equity. This is generally the case even when taxes are not considered; the tax deductibility of
interest charges further reduces the cost of debt.
The preference share capital is also cheaper than equity capital, but not as cheap as debt. Thus, using the
component or specific cost of capital as a criterion for financing decisions and ignoring risk, a firm would
always like to employ debt since it is the cheapest source of funds.
Pecking Order Hypothesis: The cost of equity includes the cost of new issue of shares and the cost of
retained earnings. The cost of debt is cheaper than the cost of both these sources of equity funds. Between
the cost of new issues and retained earnings, the latter is cheaper. The cost of retained earnings is less than
the cost of new issues because the company does not have to pay personal taxes which have to be paid by
shareholders on distributed earnings, and also because, unlike new issues, no floatation costs are incurred if
the earnings are retained. As a result, between these two sources, retained earnings are preferable. It has
been found in practice that the firms prefer internal finance and if they are not sufficient to meet the investment
outlays, firms go for external finance, issuing the safest security first. They start with debt, then possibly
hybrid securities such as convertible debentures and then equity as a last resort. Myers has called it the
pecking order theory since there is not a well defined debt equity target and there are two kinds of equity:
external and internal, one at the top of pecking order and one at the bottom.
Trade Off Theory: It should be realized that a company cannot go on minimizing its overall cost of capital
by employing debt. A point is reached beyond which debt becomes more expensive because of the increased
risk of excessive debt to creditors as well as to shareholders. When the degree of leverage increases, the
risk to creditors also increases. They may demand a higher interest rate and may not further provide loan to
the company at all once the debt has reached a particular level. Furthermore, the excessive amount of debt
makes the shareholders’ position very risky. This has the effect of increasing the cost of equity. Thus, up to
a point the overall cost of capital decreases with debt, but beyond that point the cost of capital would start
increasing and therefore it would not be advantageous to employ debt further. So there is a combination of
debt and equity, which minimizes that firm’s average cost of capital and maximizes the market value per
share. The trade off between cost of capital and EPS set the maximum limit to the use of debt.
Thus, when we consider the leverage and the cost of capital factors, it appears reasonable that a firm should
employ a large amount of debt provided its earnings do not fluctuate very widely. In fact, debt can be used
to the point where the average cost of capital is minimum. These two factors taken together set the maximum
limit to the use of debt. However, other factors should also be evaluated to determine the appropriate
capital structure for a company.
15.4.3 Cash Flow Approach
Cash flow approach hinges on the principle of conservatism which is related to the fixed charge created by
use of debt or preference capital and the firm’s ability to generate cash to meet these fixed charges. A firm
is considered prudently financed if it is able to service its fixed charges under any normally anticipated
adverse conditions.
The fixed charges of a company include payment of interest, preference dividends and principal and they
depend on the amount of loan securities and the terms of payment. If a company employs large amount of
debt, the fixed charges will naturally be high. Whenever a company plans to raise additional debt, it should
analyze the expected future cash flows to meet the fixed charges. Companies expecting larger and stable
cash inflows in the future can employ larger debt in their capital structure. On the other hand, companies
whose cash inflows are unstable are unpredictable will find it risky to employ large debt.
An important parameter to be examined at the time of capital structure planning is debt servicing ratio which
is the ratio of net cash inflows to fixed charges. Greater the ratio, greater is the amount of debt a company
can use. However, it should also be noted that it is not the average cash inflows but the yearly cash inflows
which are important to determine the debt capacity of a company. Hence companies with predictable and
stable cash inflows can take a higher debt that those with varying inflows. Ultimately, it is desirable to do a
full cash flow analysis over a longer term to ensure that fixed financial obligations are met.
Components of Cash Flows: The cash flows should be analyzed over a long period of time, which can
cover the various adverse phases, for determining the firm’s debt policy. The cash flow analysis can be
carried out by preparing proforma cash flow statements to show the firm’s financial conditions under adverse
conditions such as a recession. The expected cash flows can be categorized into three groups.
 Operating Cash Flows refers to the operations of the firm and can be determined from the projected
profit and loss statements. Behavior of sales volume, input and output price over the period of
analysis should be examined and predicted.
 Non-Operating Cash Flows include capital expenditures and working capital changes. During
recession period, the firm may have to specially spend for the promotion of the product and such
expenditures as well as unavoidable capital expenditure during adverse conditions should be included
in non operating cash flows.
 Financial Flows include contractual financial obligations (interest, lease rentals, repayment of debt
etc) and policy financial obligations (dividends etc).
15.5 Practical Considerations in Determining Capital Structure

There are certain considerations in addition to the concerns about EPS, value and cash flow which determine
capital structure decisions. Some of these are listed below:
 Dilution of Control: In designing the capital structure, the existing management is governed by its
desire to continue control over the company. This is particular in case of firms promoted by
entrepreneurs. The existing management team not only wants control and ownership but also to
manage the company without any outside interference.
 Maintain Operating Flexibility: Flexibility means firms ability to adapt its capital structure to the
needs of changing conditions and the company should be able to raise funds without undue delay
and cost whenever needed. It should also be in a position to redeem its preference capital and debt
under warranted situations. The financial plan should be so flexible to change the composition of the
capital structure as required by the firm’s operating strategy and needs. This basically depends on
loan covenance, option to retire loans early and the excess resources at the command of the firm.
 Marketability: Marketability means readiness of investors to purchase security in a given period
of time and to demand reasonable return. Though it does not influence the initial capital structure, it
is an important consideration to decide about the appropriate timing of security issues. The continuous
changes in capital markets is an important input while deciding whether to raise funds with equity or
debt issue. The flotation costs is also considered an important factor influencing the capital structure
when funds are raised externally.
 Economies of Scale: Size of company may influence its capital and availability of funds from
different sources. Small firms may find it difficult to raise long term loans and even if they are able to,
it will be at a higher rate of interest and inconvenient terms. Therefore they depend on share capital
and retained earnings for their long term funds. For those which are able to approach the capital
market, the cost of issuing shares is generally more than the large sized companies.
Large sized company has relative flexibility in designing its capital structure. It can obtain loans with
ease and also sell shares to the public. Because of its large scale its cost of distributing security is
less than that of a small company.
 Agency Costs: There exists a conflict of interest among shareholders, debt holders and management
which may give rise to agency problems involving agency costs. This has an impact on firm’s capital
structure. The conflict between shareholders and debt holders arise because of the possibility of
shareholders transferring the wealth of debt holders in their favor. The debt holders may lend money
in low risk projects while the firm may invest in high risk projects. The conflict between share
holders and managers may arise on two aspects – firstly managers may transfer share holders
wealth to their advantage by increasing their compensation and perquisites, secondly managers may
not act in the best interest of shareholders in order to protect their jobs. So managers may not
undertake risk and thus forego profitable investments.
These problems are handled through monitoring and restrictive covenance which involve costs and
these costs are called agency costs. The implication of the agency cost of capital structure is that
management should use debt to the extent that it maximizes the share holder wealth.
15.6 Summary
Capital structure planning is very important for survival of the business in long run. Planning the capital
structure is highly complex as the components of capital structure are inter-related and also related to risk,
return and value of the firm. There cannot exist a standard capital structure for all firms since there are lots
of factors significantly influencing the determination of the capital structure. Though the primary objective
while framing the capital structure is to maximize the returns to the share holders, the interests of other
groups, such as employees, customers, creditors, society and government, should also be given reasonable
consideration.
There are certain approaches for planning an appropriate Capital structure and each of them have advantages
and limitations too. EBIT- EPS approach focuses on finding a capital structure with the highest EPS over
the expected range of EBIT, thus helping the firm to achieve its ultimate objective of maximizing shareholders’
wealth. This approach fails to explicitly consider risk which is one of the key factors in maximizing the
wealth. In Cost of capital and valuation approach, a company should have such a mix of debt and equity
that its overall cost of capital is minimum. Measuring the cost of various sources of funds is complex and in
order to minimize the cost of capital, cheaper sources of funds should be identified and preferred. Cash flow
analysis clearly reveals that a higher debt equity ratio is not risky if the company has ability to generate
substantial cash inflows in the future to meet its financial obligations. There are factors influencing cash flow
and it is difficult to predict all the possible factors.
In practice, the determination of capital structure involves considerations in addition to the EPS, cash flows,
cost of capital and value. Attitudes of managers with regard to financing decisions are quite often influenced
by their desire to maintain control, to maintain operating flexibility, and to have convenient and cheaper
means of raising funds.
1. What do you mean by an appropriate capital structure? What are the factors influencing it?
2. Explain the features and limitations of the three approaches to the determination of capital structure.
a) EBIT-EPS approach.
b) Valuation approach.
c) Cash flow approach.
3. If debt is cheaper than equity, why do firms not finance their assets with debt?
4. Write notes on
a. Pecking order theory
b. Trade off theory.
5. What are the practical considerations in determining the capital structure?
6. A company is considering a most desirable capital structure. The cost of debt (after tax) and of
equity capital at various levels of debt equity mix are estimated as follows:
Debt as percentage of Cost of debt Cost of equity
total capital employed (%) (%)
0 10 15
20 10 15
40 12 16
50 13 18
60 14 20
Determine the optimal mix of debt and equity for the company by calculating composite cost of capital?
Solution: For determining the optimal debt equity mix, we have to calculate the composite cost of capital
i.e. Ko which is equal to Kdp1+Kep2
Where Kd = Cost of debt
p1 = Relative proportion of debt in the total capital of the firm
Ke = Cost of equity
p2 = Relative proportion of equity in the total capital of the firm
Before we arrive at any conclusion, it would be desirable to prepare a table showing all necessary
information and calculations.
Calculating Cost of capital
Kd % Ke % p1 p2 Kdp1+kep2= Ko
10 15 0.0 1.00 0.0+15.0=15
10 15 0.2 0.8 2.0+12.0=14
12 16 0.4 0.6 4.8+9.6=14.4
13 18 0.6 0.5 7.8+9.0=16.8
14 20 0.6 0.4 8.4+8.0=16.4
The optimal debt equity mix for the company is at a point where the composite cost of capital is minimum.
It is evident that a mix of 20% debt and 80% equity gives the minimum composite cost of capital of 14%.
Any other mix of debt and equity gives a higher overall cost of capital. The closest to the minimum cost
of capital is a mix of 40% debt and 60% equity where Ko is 14.4%. It can therefore be concluded that
a mix of 20% debt and 80%,equity will make the capital structure optimal.

- Chandra, Prasanna.,2007, Fundamentals of Financial Management, Tata McGraw, New delhi.
- Maheshwari, S.N., 2011, Financial Management, Sultan chand & Sons, New Delhi.
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New Delhi.
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Publishing, Bombay .
- Upadhyaya, K.M., 1985 Financial Management Kalyani Publishers, Ludhiana.
Unit - 16 : Sources of Long-term Finance
Structure of Unit:
16.0 Objectives
16.1 Introduction
16.2 Share Capital
16.3 Debentures/Bonds
16.4 Difference Between Shares and Debentures
16.5 Retained Earnings
16.6 Term Loan
16.7 External Commercial Borrowings
16.8 Foreign Loan through Depository Receipts
16.9 Foreign Currency Convertible Bonds
16.10 Euro Bonds and Foreign Bonds
16.11 Leasing and Hire Purchase
16.12 Venture Capital
16.13 Book Building
16.14 Debt Securitisation
16.15 New Instruments
16.16 Summary
16.0 Objectives
 Understand the long term finance and its purpose for raising the fund from the sources of long term.
 Comprehend the share capital and its feature, advantages and disadvantages.
 Differentiate between the shares and debentures/bonds.
 Point out various forms of foreign loans through depository receipts and differentiation between
ADRs and GDRs.
 Know about the different forms of Venture Capital and its growth in India.
 Learn and appreciate the leasing and hire purchase as a source of long term finance.
 Understand the different new long term financial instruments.
16.1 Introduction
The firm has to maintain adequate amount of funds for successful operation of funds. As there should be
adequate blood level in human body, the same is true with finance in business. Long term finance is also
called as long term capital, fixed capital or non-movable capital. The firms require long term fund financing
for purchasing fixed assets, expansion/improvisation, diversification and acquisition & takeovers etc. Long
term finance has two characteristics. I) it is used for fulfilling the long term financial needs ofthe company, II)
they are fixed in nature and these finances can not be encased on will. At the time of inspection of firm fixed
assets like land and building, machines, furniture, fittings, patents are purchased from long term finances.
Long term finance is not liquid. The long term financial sources are Equity shares, preference shares, retained
earnings, debentures and long term debts etc.
16.2 Share Capital
The company has a statutory right to issue shares to raise funds. Funds procured through floatation of
shares are termed as ‘ownership capital’. According to Justice Lindle “Share is the proportional of profit of
which holder is liable to get.” The company can issue two types of shares i.e. Equity shares and Preference
shares.
16.2.1 Equity Shares
Equity shares are owner’s equity having no maturity date. It is known as ordinary shares or common shares,
real owners of the company as they have the voting rights and enjoy decision making authority on important
matters related to the company. Without these shares the company cannot procure debt and preference
share capital from investors. The equity shareholders’ return is in the form of dividend depends on the
profits of the company and capital gain/loss at the time of their sale. According to Indian Company’s Act,
any company which issues the shares for the first time must issue it at its par value. However, subsequent
shares can be issued at a premium.
Features of Equity Shares
 Maturity: They provide permanent capital to the firm and no maturity date is fixed for such funds.
It is only in the event of liquidation that the shareholders get the profits after meeting all debt obligations.
However, the shareholders are free to sell their shares in the secondary market if they require
liquidation their investments.
 Claim on Income: The shareholders are the residual claimant on the income and the assets of the
company. The operating profits are first of all utilized for meeting all the expenses and obligations
and thereafter it is distributed in the form of dividend among the preference shareholders. If the
profit left after meeting all the above then it is distributed among the equity shareholders as dividend.
 Claim on Assets: The equity shareholders are having the residual claim on the assets of the company.
When the company goes for winding up, the assets are used to pay all the expenses and outstanding
liabilities. Thereafter, if any assets are left over, then the equity shareholders can claim on them.
 Right to Control or Voting Rights: The equity shareholders have the right to vote in annual
general meeting on any resolution placed in it. It is in the proportion of the paid up capital of each
shareholder of the company. The boards of directors are selected by the equity shareholders who
appoint the managers who manage the company. The equity shareholders are having the supreme
and ultimate control on the affairs of the company.
 Preemptive Rights: As and when a public limited company wants to issue fresh equity shares,
they are to be offered first to the existing shareholders. This is known as pre-emptive right. The
purpose is to enable the shareholders to continue to have proportionate share of ownership. For
example, if a shareholder has 5% ownership, he has to be offered 5% of the new shares to be
issued.
 Limited Liability: The liabilities of the equity shareholders are limited to the face value of the
shares. In case the shareholder has paid the full amount of the face value, he is no more liability
exists even if the company goes into liquidation and its liabilities are more than its assets.
Merits of Equity Financing
 No Cash Outflow: As the equity financing is a permanent source of capital. The company does
not have the fear of redemption and outflow of cash. The funds are available with the company till
the company goes for liquidation.
 Borrowing Base: lenders feel confident while lending to the company on the basis of its capital.
Generally they lend in proportion of the company’s equity capital.
 No Compulsion for Payment of Dividend: The equity shareholders are the residual claimant
and it is not essential requirement to pay the dividend compulsorily. The company may suspend the
payment of dividend in the case of financial difficulty.
 Real Owners and Gainers: The equity shareholders are having the control on the affairs of the
company hence they are the real owner and in case of profit they are the real gainers by way of
increased dividend as well as appreciation of market price.
Demerits of Equity Financing
 Cost of Equity: The cost of equity financing is the highest as compared to other source of financing
because of dividend is not tax deductable. Floatation cost is also incurred which is comparatively
high than the debt. Floatation costs are incurred incidentally by the company at the time of issue of
share.
 Trading on Equity: It is possible only when debt is issued along with the equity share and it is not
happen when the total requirement of the company is met through equity share capital alone. Trading
on equity enhances the earnings of equity share.
 Risk: The equity is more risky, from the viewpoint of investors, as compared to debt because there
is no certainty of return. Raising the fund through equity is more costly and rather difficult.
 Dilution of Earnings: As company go for additional issue of shares and proportionately the
earnings do not increase in that case the earning per share get diluted.
 Ownership Dilution: The company issues further equity to existing shareholders in order to
maintain the proportionate ownership. In case of financial difficulty, this existing control is likely to
be lost. This is the threat with closely held company.
Activity A:
1. According to you why equity financing is needed in a company? List out any ten companies who
have their financing through equity shares.
16.2.2 Preference Shares
As the very name suggests, preference shares have certain preferences compared to equity shares. Preference
shareholders enjoy the twin preferences in respect of dividend payment and repayment of principal amount,
in the event of liquidation, compared to equity shareholders. In the real sense, preference share capital is a
hybrid form security, as it carries some of the features of equity share as well as debentures.
Preference shares have gained importance after the Finance bill 1997 as dividend become tax exempted in
the hands of the individual investor and are taxable in the hands of the company as tax is imposed on
distributed profits at a flat rate. At present, a domestic company paying dividend will have to pay dividend
distribution tax @ 12.5% plus surcharge of 10% plus an education cess equaling 2% (Total 14.025%)
Features of Preference Shares
 Maturity: Preference shares are perpetual. In the normal course of time, they are not repaid,
similar to equity share. Their money is returned in the event of liquidation, after payment of debenture
holders. But unlike equity it may have a call back arrangement or redemption feature. If it is redeemable
or callable preference shares, then it may be redeemed at the time of maturity.
 Claim on Income and Assets: Preference shares are a senior security compared to equity share.
The preference shareholders are having prior claim on the company’s income and repayment of
dividend then the equity holders. In the event of liquidation, the holders of the preference shares are
prior right then the equity holders on the repayment of the amount of their shares.
 Nature of Preference Dividends: The dividend on the preference shares are fixed and if company
is having extra earning then no extra dividend are paid to preference share holders. In case the
article of association permits then the unpaid amount of dividend in any year due to loss in any
particular year of the company, it will be carried forward for further period and paid when there is
profit.
 Convertibility: Sometimes the preferred stock has the feature of convertibility and if so then the
shareholders get a privilege to convert his preference shares into equity shares. The article of association
provides the conversion price clearly.
 Controlling Power: Preference shareholders have no voting rights in the management of the
company. However, they have a right to vote in respect of those matters that affect them directly. In
case of dividend is in arrears for two consecutive years, preference shareholders can nominate a
member on the board of the company.
 Hybrid form of Security: Preference share capital is a hybrid form security, as it carries some of
the features of equity share as well as debenture. Preference share is similar to equity share, as non-
payment of dividend does not compel the company to go into liquidation. Payment of dividend is
not obligatory. However, dividend paid is not tax deductible. The preference share is similar to
debenture, as fixed rate of dividend is paid, just like a fixed rate of interest. They can not claim a
share in the residual profits of the company.
 Not Tax Deductible: Preference dividends are not tax deductible as they are paid after giving the
tax on the company’s income. Unlike preference dividends Interest paid on debt is deducted before
paying tax, hence tax incident is lowered when interest is paid on debt which is known as interest
tax shield. Thus preferred capital is costlier than debt borrowed by the company.
 Participation: Sometime Company issues participating preference shares and in that case the
preference shareholders get a right to participate in the balance of extraordinary profits in a stipulated
proportion together with equity shareholders. Thus the preference shareholder gets fixed dividend
and flexible dividend which will depend on the extra earnings of the company i.e. extraordinary
profits.
Advantages of Preference Shares
The advantages of Preference shares can be enumerated for both to the company as well as to its investors.
(A) Company’s Point of view: The company has the below explained advantages by issuing preference
shares.
 Absence of Legal Obligation: The dividend to the preference shareholders are paid only if the
company has the distributable profits. Thus it can be connoted that the company does not have any
legal commitment or financial burden.
 Fixed Rate of Dividend: The amount of dividend is specified at the time of issue of preference
shares hence no surplus amount is paid even if the company has handsome profit except in the case
of participating preference shares.
 Cost of Capital: The cost incurred on such type of instrument financing capital is less than the
equity shares.
 Long term Capital: The outflow of cash is negligible as these are treated as permanent source of
capital. But redeemable preference shares are to be redeemed at the end of specified period or
maturity out of the proceeds of fresh issue of shares or accumulated profits of the company.
 Trading on Equity: Raising funds through this source magnifies the earning of the equity shares,
paying fixed rate of dividend to preference shareholders. This is a risk-free leverage advantage with
preference share capital. Even, default in payment of dividend does not force the company into
insolvency.
 Enhances Creditworthiness/ Borrowing Ability: It is regarded as a part of net worth hence it
enhances the creditworthiness of the company. The company has ability to get more borrowing
from outside.
 Absence of Dilution of Control: The preference shareholders do not have the voting power
except in case where their interests are directly affected. So, there is no threat of dilution of control
from preference shareholders.
 Assets are Not Pledged: No specific assets are pledged, while issuing preference shares. So,
company’s mortgage able assets are not disturbed in any manner.
(B) Investors Point of view: The investors enjoy the following benefits
 Fixed Rate of Dividend: The cumulative preference shareholders are paid dividend at fixed rate
but in case the company incurs loss in any year then the dividend at fixed rate is paid in the subsequent
year’s profits. In case of non cumulative preference share, this is not the case. Dividend is not paid
for the year of loss.
 Treated Superior Security Over Equity Share: Preference share enjoys preference over dividend
and repayment of fund on Equity shares. Hence, investors prefer to invest in preference share.
 Right to Vote: Preference shareholder has the right to vote in case when their interest is directly
affected by any resolution.
Disadvantages of Preference Shares: In spite of numerous advantages, it is not free from shortcomings
which is enumerated as below
(A) Company’s Point of View
Cost of Source: The cost of preferred stock & risk is more than the debenture. Hence, from this point, the
debenture is more suitable.
 No Tax Advantages: The dividend on preference share is not tax deductible, while the interest on
debenture enjoys tax shield or advantage.
 Affects Creditworthiness: The Company does not have any legal obligation to pay dividend on
preference shares but in case of non-payment of dividend affects the creditworthiness of the company.
(B) Investor’s Point of View
 At Management Mercy: Normally, the preference shareholders do not have any voting rights,
they remain at the mercy of management for dividend as well as redemption of capital.
 Lower Return: When compared with equity shares, the preference shares are having lower return.
 No Charge on Assets: The charges on assets are not available to the preference shares as available
on debentures. So, preference share rank after debentures, in case of liquidation of the company.
Activity B:
1. Why preference shares are called as hybrid security? Analyze the situation when preference share
are beneficial in general.
16.3 Debentures/Bonds
A debenture is a long term promissory note for raising loan capital. It may be either secured or unsecured.
Debenture or Bond is a creditor ship security, with a fixed rate of interest and fixed maturity period. Debentures
provide low risk capital to the company. Those who invest in debentures are called debenture holders. An
alternative form of debenture is Bond in India. Public sector companies in India mostly issue bonds. The
interest paid is a charge to the profit and loss account. Debentures are normally secured by a floating charge
on the assets of the company. The bond is secured by specific assets of the company. In USA bonds are
either secured or unsecured and debentures are unsecured bonds. As we know debentures are long term
debts of a company which borrows money on a promise to pay at a later date with specified interest, the
interest rate is usually fixed.
According to Indian Companies Act, Section 2(12) “Debenture includes debenture stock, bonds and any
other securities of a company whether constituting a charge on the assets of a company or not”. As Tophan
has defined “Debenture is a document given by a company as evidence of a debt to the holder usually
arising out of a loan and most commonly secured by charge.”
C.W. Gerstenberg has defined “A corporate bond is a written promise under seal to pay a specified sum of
money at a fixed time in future, usually more than ten years after the promise is made with interest at fixed
rate, payable at specified interest dates.”
Public issue of debentures and private placement to mutual funds now require that the issue be rated by a
credit rating agency like CRISIL (Credit Rating and Information Services of India Ltd.). The credit rating is
given after evaluating factors like track record of the company, profitability, debt servicing capacity, credit
worthiness and the perceived risk of lending.
Features of Debentures/Bonds
Maturity: Debentures are issued for a specific period of time and treated as source of long term finance.
Generally, debentures are issued for a period of 7 to 10 years and are redeemed on the specific date.
 Fixed Interest Rate: The interest rate on debenture is fixed and does not change during the tenure
of debenture, irrespective of the profit/loss of the company. Interest is calculated on the face value
of the debenture. Interest is tax deductible and it is the income of the debenture holder and taxable
in the hands of the debenture holders.
 Claim on Income: Interest payment is the obligation on the company even if the company incurs
loss. Default in payment of interest empowers the debenture holder to move a petition in a court of
law for the winding up of the company.
 Claim on Assets: At the time of liquidation, debenture holders are repaid their claim first before
repayment is made to preference and equity shareholders. Debentures may have a specific charge
or floating charge on the assets of the company. In the event, they are secured creditors. The sale
proceeds of the assets pledged to them go towards repayment of principal and interest to them.
 Convertibility: The debentures having a conversion clause are known as convertible debentures.
These debentures can be converted to equity shares after a certain period of time.
 Callable Feature: Call feature enables the company to redeem the debentures before the due
date of redemption. Generally, the company can go for it when the interest rate payable is high then
the current interest rate. In order to save costs, the company redeems the debentures before the
due date. Normally, call price is higher than the issue price. It is noteworthy to mention that the
company is gaining, hence, it is not an issue to share some gain with the debenture holders.
 Indenture or Trust Deed: It is a legal agreement between the company issuing the debentures on
one hand and the trustees representing debenture holders on the other hand. The trust deed provides
the specific terms in respect of the description of debentures, security available, rights of debenture
holders and of the issuing company and responsibilities of the trustees. The responsibility of the
trustees is to protect the rights of the debenture holders by enforcing the responsibilities of the
company that has issued debentures. Normally, a financial institution or insurance company is
appointed as a trustee.
 Controlling Power: A Debenture holder does not have any voting right; therefore, they do not
enjoy the controlling power and can not participate in the management of the company. They have
only prior claim in repayment over equity and preference shareholders.
Benefits of Debentures
 Less Costly: The debenture is less costly source of finance than preference and equity shares as
the interest is tax deductible. From the perspective of investor, it is less risky investment and offers
fixed rate of return.
 Absence of Dilution: Debenture holder do not enjoy any voting rights, hence, there is not any
question of dilution of ownership or control.
 Fixed Interest Rate: The debenture holders are entitled for the fixed rate of interest as specified
in the debenture. They do not have any claim on the extra share in the earnings of the company. So,
cost to the company is fixed.
Beneficial during Inflation: Real interest cost declines during the period of inflation.
 Easy to Raise Funds: At the time of depression or low sentiments in the market, the debenture as
a source of finance is easy and comfortable. The investors appreciate the benefits of certainty of
income, with low risk during those periods.
 Trading on Equity: In case the return on investment is higher than the cost of debt, it is advantageous
to the company to raise fund through debentures as it can trade on equity and enhances the earnings
to the equity holders.
 Flexibility: Debenture provides flexibility in the capital structure of the company as company can
redeem debentures, as and when it has surplus funds and desires to do so. Generally, company
reserves the right in the form of ‘call option’ at the time of issue to take advantage of the falling
interest rates in the market.
Disadvantages of Debentures
 Obligatory Payment: The payment of interest is a legal obligation even in the case of company is
incurring loss in any particular year. Redemption of debentures is to be made at the end of maturity.
Default in payment may force the company to go into liquidation.
 Financial Risk: If a company is having fluctuating sales and earnings than it enhances the financial
leverage and financial risk.
 Stamp Duty: The cost of stamp duty will increases the cost of financing.
 Not for All the Companies: Debenture interest is a fixed commitment. This should be noted that
it not desirable for the companies which do not have stable earnings or who deal in products with
elastic demand to issue debentures. The company that cannot offer assets as security cannot use
this source of financing.
 Cash Outflows: As debentures are to be redeemed at the end of the maturity period. When it is
redeemed, the cash outflow occurs. Even if a sinking fund is created to meet the redemption outflow,
annual cash outflow occurs.
 Restrictive Covenants: The restrictive conditions are contained in the debenture indenture. As a
condition can be incorporated in the indenture that the total borrowing by the company cannot
exceed a specified limit. Hence, the restrictive covenants limit the operating flexibility of the company
in future.
Activity C:
1. How you would able to say that the debenture is cheaper source of finance than the equity or
preference share? Enumerate your view with practical example.
2. “In a period of rising prices, debenture issue is advantageous”. Justify your answer in the context of
above statement.
16.4 Difference Between Shares and Debentures

The debentures carry a fixed rate of interest, which is to be paid by the company, irrespective of profits.
Normally, debentures are secured. Companies offer collateral security to debenture holders to make then
comfortable from the view point of security. Debenture holders are unlikely to suffer from the financial
failure of the company, in case they are secured and enough money is realized at the time of sale.
Equity shares bear the highest risk as it does not give any guarantee of dividend payment. In case of loss, the
equity shareholders do not get any dividend at all. The equity shareholders hardly get back their money
when the company goes for liquidation because most of the money would have disappeared from the
company towards losses by the time. The dissimilarities between shares and debentures are given as under.
Table 16.1 Difference Between Shares and Debentures
Nature of Shares Debentures

Difference
Type of Capital Part of ownership capital Part of borrowed capital
Type of Security Ownership security Creditor ship security or debt
capital
Return The equity shareholder gets the Interest is fixed and depends on the
variable dividend and which contractual term.
depends on the profits of the
company. The preference
shares get the stated rate of
dividend.
Impact on Profit and Appropriation of Profit Treated as Fixed expense and
Loss charge on Profit and Loss Account.
Voting Right The equity shares enjoy voting Debenture holders do not have any
right on all the matters and voting right and they do not
preference shares on the matter participate in the management of
which directly affect their the company.
interest.
Redemption The equity shares are not The debentures are redeemed at the
redeemed during the life of the end of the stated period and as per
company but the redeemable the trust deed.
preference shares are redeemed
at the end of the specified
period.
Priority of At the time of liquidation, first It gets priority in repayment over
Repayment of all outside liabilities are share capital.
repaid. Then preference shares
are paid and if balance left,
then it goes to equity shares.
Activity D:
1. You are required to prepare a comparative chart indicating the risk, return, control and ownership
position in case of equity shares, preference shares and debentures.
16.5 Retained Earnings

Retained earnings are profits retained in the business after distribution of dividends. These are used to
acquire permanent fixed assets required either for expansion or for diversification or for takeover/merger.
This is somewhat wrong perception at certain quarter that the retained earnings of the Company provide a
free source of fund. It is not correct at all. However, cost of funds provided by retained earnings is less than
that of funds obtained by issue of new equity capital. The company must consider the income of the
shareholders could obtain if the earnings has been distributed instead of being retained. It is obvious that if
it cannot earn at least an equivalent amount of income on these funds, it should return them to theshareholders.
There is a belief that all profits of the Company should be distributed as dividend so that the shareholders
can reinvest them wherever they think best. But it may be a costly process to distribute all profits and then
invite equity holders to subscribe for new issues. Thus, the Company should bear in mind that it should only
retain earnings if it can justify doing so, after taking into account the cost differences.
Activity E:
1. “Retained Earning is a free source of finance.” Do you feel that this statement is correct? If yes, then
put your opinion in support of this statement.
16.6 Term Loan

Companies can raise long term finance through term loans, in addition to share capital and debentures. The
term loans are provided by commercial banks, all development financial institutions, State level financial
institutions and investment institutions to the industrial sector to encourage industrial development in India.
They are obtained for financing large expansion, diversification or modernization projects. Term lending
financing is also known as project financing. The major advantage of a term-loan is that it is for a fixed
period. Repayment of installment can be paid back from the profit generations of the company. More so,
interest liability is fixed and cannot be varied so the profitability of the project in not affected for a long term.
Features of Term Loan
Purpose: It is mostly to meet the capital expenditure.
 Maturity: The maturity for long period is granted beyond five year and one to five year is granted
for medium term loan.
 Documentation: In case of term loan, agreement is entered between the company and the financial
institution that sanctions the term loan. The term loan document specifies all conditions of sanction,
security, interest as well as repayment etc.
 Security: term loan are always secured. The assets purchased through the term loan constitute the
security. This is called primary security. The company’s current and future assets also generally
secure term loans. This is called secondary security.
 Schedule for Repayment: Loans are repaid through installment system. Interest is charged on the
outstanding balance. So, interest burden declines over the years. Company has to pay interest as
well as installment amount fixed in the agreement.
 Direct Negotiation: The Company directly negotiates term loan for project finance with the term
lending institution. Thus, term loan is private placement. It saves the company underwriting commission
and floatation costs. The benefits of term loan are ease of negotiation and low cost of raising funds.
 Restrictive Covenants: The lender may like to protect its financial interest apart from the security.
This is done through restrictive covenants, incorporated in the agreement while sanctioning term
loan.
Activity G:
1. You are advised to collect the information about term loan from the related institution and prepare
the list of elements of the same.
16.7 External Commercial Borrowings

Indian promoters can also borrow directly from foreign institutions, foreign development bank, World Bank
etc. It is also known as Foreign Currency Term Loans. Foreign institutions provide foreign currency loans
and financial assistance towards import of plants and equipments. The interest on these loans is payable in
foreign currency. On the payment date, interest amount is converted into domestic currency at the prevailing
foreign exchange rate. The borrowings, repayment and interest payments can be tailor-made in view of the
cash flow position of the project. This is done through restrictive covenants, incorporated in the agreement
while sanctioning term loan.
16.8 Foreign Loan through Depository Receipts

Depository Receipts means any instrument in the form of a depository receipt or certificate created by the
Overseas Depository Bank outside India and issued to the non-resident investors against the issue of ordinary
shares. A Depository Receipt is a negotiable instrument evidencing a fixed number of equity shares of the
issuing company generally denominated in US dollars. DRs are commonly used by those companies which
sell their securities in international market and expand their shareholdings abroad. These securities are listed
and traded in International Stock Exchange. These can be American Depository Receipts (ADRs), European
Depository Receipts (EDRs) and Global Depository Receipts (GDRs)
American Depository Receipts (ADRs) in the USA: ADRs are negotiable receipts issued to investors
by an authorized depository (U.S. bank or depository). In general, ADRs are issued in case the funds are
raised through retail market in United States. ADRs are listed and traded in a U.S. based stock exchange so
it helps in Indian Company going for ADR to be known in the highly liquid U.S. stock exchanges. Indian
companies are not allowed by law to list rupee denominated shares directly in foreign stock markets. Hence
the company issues the shares to a depository which has an office in India. These shares remain in India with
a custodian. Against these shares the depository issues dollar denominated receipts to the foreign investors.
The foreign investors can sell these receipts either in the foreign exchange or to the depository and get the
rupee denominated shares which can be sold in Indian markets. Thus investors gain by playing with the
difference in prices on the U.S. and Indian exchanges. ADRs are instruments that effectively allow non-US
corporate to sell equity to the US investors, by virtue of corporate shares being held by a depository bank
which issues a receipt. These are marketed and sold by coordinated banks like the bank of New York,
Citibank, JP Morgan and bankers trust.
European Depository Receipts (EDRs) in Europe: Unlike ADRs, EDRs are denominated in European
currency and issued in Europe. However, they are not that popular as ADRs as European markets are
dominated by Japanese securities.
Global Depository Receipts (GDRs) in International Market: GDRs are multiple market oriented
i.e. they can raise equity capital anywhere throughout the world. Unlike ADRs & EDRs, GDRs have the
advantage of inter-market trading amongst the different investors in different countries. Through GDRs a
firm can raise capital in more than one country simultaneously through only one security.
ADRs v/s GDRs: ADRs are listed on American Stock Exchange while GDRs are listed in stock exchanges
other than American Stock Exchange; Under ADRs issue the process as governed by American laws and
SEC (Securities & Exchange Commission) whereas such laws are not applicable to GDRs; ADRs issue
involves adhering to very stringent disclosure and accounting norms i.e. U.S. GAAP, it requires a combined
balance sheet of all group companies and not just the single group company going for the issue whereas
disclosure requirements for GDRs are comparatively less strict and ADR market is more liquid compared
to GDR market. Hence company’s going for ADR are able to enhance their shareholders value.
Activity F:
1. What are the reasons that the depository receipts are becoming popular now-a-days? Elaborate
and analyse the situation in the context of LPG (Liberalisation, Privatisation, Globalisation)
16.9 Foreign Currency Convertible Bonds
The FCCB means bonds issued in accordance with the relevant scheme and subscribed by a non-resident
in foreign currency and convertible into ordinary shares of the issuing company in any manner, either in
whole or in part, on the basis of any equity related warrants attached to debt instruments. The FCCBs are
unsecured; carry a fixed rate of interest and an option for conversion into a fixed number of equityshares of
the issuer company. Interest and redemption price (if conversion option is not exercised) is payable in
dollars. Interest rates are very low by Indian domestic standards. FCCBs are denominated in any freely
convertible foreign currency.
FCCBs have been popular with issuers. Local debt markets can be restrictive in nature with comparatively
short maturities and high interest rates. On the other hand, straight equity issue may cause a dilution in
earnings and certainly a dilution in control, which many shareholders, especially major family shareholders
would find unacceptable. Thus, the low coupon security which defers shareholders dilution for several years
can be alternative to an issuer. Foreign investors also prefer FCCBs because of the dollar denominated
servicing, the conversion option and the arbitrage opportunities presented by conversion of the FCCBs into
equity at a discount on prevailing Indian market price.
16.10 Euro Bonds and Foreign Bonds

International/overseas borrowing/debts are termed as ‘euro bonds’. It is issued by international borrowers
and is sold to investors in countries with currencies different from the currency in which the bond is
denominated. The most popular currency in which such bonds are offered and accepted is ‘dollar’
denominated. Plain Euro Bonds are nothing but debt instruments. These are not very attractive for an
investor who desires to have valuable additions to his investment.
Euro Bonds are issued in a single currency in different countries while foreign bonds are issued in different
countries in the respective country’s currency by the foreign borrower e.g. Indian firm issuing foreign bonds
in America will issues in dollar term. In domestic capital markets of various countries the Bonds issues
Foreign Euro Bonds known by different names such as Yankee Bonds in the US, Swiss Frances in
Switzerland, Samurai Bonds in Tokyo and Bulldogs in UK.
16.11 Leasing and Hire Purchase

Leasing has recently emerged as an important source of long term financing of the business enterprises. This
is an arrangement under which a company acquires the right to use the asset without owning it or in other
word it is a right to use an equipment/fixed asset on payment of periodical amount known as lease rental. It
is in the form of written agreement signed by both the owner of the asset and the user for the economic use
of the asset for a definite period of time. Those firms, which do not wish to purchase the asset, instead enter
into leasing arrangement and find it profitable in case of highly expensive assets. In case of hire purchase, the
assets are acquired on credit and payments are made as per terms and conditions. Peculiar feature of hire
purchase is that the person using the asset is the owner of the asset. Full title is transferred to him after he has
paid the agreed installments. The asset is shown balance sheet of user and he is entitled to depreciation and
other allowances on the asset for computation of tax during the tenure of hire purchase agreement and
subsequently.
The growth of leasing business specially equipment leasing is of recent origin (1983) and volume ofbusiness
till today is not that big. By 1985 there has been massive tendency for public issues for operating leasing
business. However, that tendency got subsided by 1987. Apart from many private sectors non-bank financial
companies, some private sector manufacturing companies ICICI, IRBI different subsidiaries of a number of
nationalized bank like SBI Capital Market Ltd, Can Bank Financial services, IFCI, LIC, GIC, HDFC,
Cater Lease Financing in India. For development of leasing business, favorable Tax Policy is essential. The
boom of leasing in 1985 was short-lived because of a) Crowding of so many leasing companies lead to
reduction of lease rental and thus profitability got affected, b) Obtaining of fund by so many leasing Companies
at reasonable rate became difficult.
The hire purchase credit is medium term credit. A down payment is made ranging from 10% to 25%. Hire
purchase financing in commercial vehicle is most popular in India. However, automobiles financing for
domestic purpose has also become popular recently. Normally goods are hypothecated in favour of the
lenders. When there is long payment schedule (period) and the amount is large, guarantee is generally
insisted in addition to hypothecation. In hire purchase financing the peculiarity is that the financier charges
simple interest on total loan and not on diminishing balance. This imposes a heavy burden on the borrower.
Difference Between Leasing and Hire Purchase
1. In leasing the person using the asset is not the owner of the asset whereas in Hire Purchase, the
person using the asset may become the owner of the assets.
2. In case of leasing, after payment of the agreed lease installments the ownership does not get transferred
to the lessor whereas in case of Hire Purchase, after payment of the agreed lease installments the
ownership is transferred to the person using the asset.
3. In leasing, the lessor claims the depreciation and other allowances whereas in Hire Purchase, the
depreciation and other allowances on the asset are claimed by the lessee (user of the asset).
In case of leasing, asset is shown in the balance sheet of the lessor. As the asset is not shown in the balance
sheet of the lessee, hence it is known as ‘off the balance sheet asset’ for the lessee whereas In case of Hire
Purchase, asset is shown in the balance sheet of the lessee.
Activity G:
1. How leasing is different from Hire Purchase? If you have to choose any one source of finance from
the above two for your organization then which is preferred by you and why? Discuss.
16.12 Venture Capital

The venture capital refers to financing of new high risky venture promoted by qualified entrepreneurs who
lack experience and funds to give shape to their ideas. In broad sense, under venture capital financing
venture capitalist make investment to purchase equity or debt securities from inexperienced entrepreneurs
who undertake highly risky ventures with a potential of success. The features of the venture capital can be
enumerated as it is basically a equity finance in new companies, viewed as long term investment in growth
oriented small/medium firm and apart from providing funds, the investor also provides support in form of
sales strategy, business networking and management expertise, enabling the growth of the entrepreneur.
In India venture capital started in 1986 when ICICI set up the first venture fund cell in Bombay. This later on
merged into the Technology Development and Information Company of India Ltd. (TDICI), a Bangalore
based company of ICICI with an equity of 1 crore (contributed equally by ICICI and UTI). Unlike developed
countries, in India venture capital does not finance the risky idea/technology. Indian technological set ups
have usually been of a foreign collaboration type. In India venture capital is usually of nature of financing
small scale enterprises. However, the concept is catching up. Many support institutions are encouraging
venture capital idea. In the year 1988, the Government of India took a policy initiative and announced
guidelines for Venture Capital Fund (VCFs). In the same year, a Technology Development Fund (TDF)
financed by the levy on all payments for technology imports was established. This fund was meant to
facilitate the financing of innovative and high risk technology programmes through the IDBI.
A major development in venture capital financing in India was in the year 1996 when the Securities and
Exchange Board of India (SEBI) issued guidelines for venture capital funds to follow. These guidelines
described a venture capital fund as a fund established in the form of a company or trust, which raises money
through loans, donations, issue of securities or units and makes or proposes to make investments in accordance
with the regulations. This move was instrumental in the entry of various foreign venture capital funds to enter
India. The guidelines were further amended in April 2000 with the objective of fuelling the growth of venture
capital activities in India.
Methods of Venture Capital Financing
Some common methods of venture capital financing can be enumerated as follows:
 Equity Financing: Sometime undertakings require funds for a longer period but they may not be
able to provide returns during the initial period. Therefore, the venture capital finance is generally
provided by way of equity share capital. It is worth mentioning that the equity contribution of
venture capitalist should not exceed 49 % of the total equity capital of venture capital undertakings
so that effective control and ownership remains with the entrepreneurs.
 Conditional Loan: This is repayable in the form of a royalty after the venture is able to generate
sales. The interest is not paid on such loans. The royalty is generally charged between 2 to 15
percent but the actual rate depends on other factors of the venture such as gestation period, cash
flow patterns, risk and other factors of the enterprise.
 Income Notes: This is a hybrid security which includes the features of both conventional loan and
conditional loan. The entrepreneur has to pay both interest and royalty on sales but at substantially
low rates. IDBI’s VCF provides funding equal to 80-87.50% of the projects cost for commercial
application of indigenous technology.
 Participating Debenture: This type of security carries charges in three phases- In the start up
phase no interest is charged, next stage a low rate of interest is charged up to a particular level of
operation, after that, a high rate of interest is required to be paid.
Activity I:
1. What contribution venture capitalists have made towards economic growth? Discuss critically giving
appropriate example.
16.13 Book Building

Book Building is a common practice in developed countries and has recently been making inroads into
emerging markets as well, including India. Book building is essentially a process used by companies for
raising capital through Public offerings- both Initial Public Offers (IPOs) and Follow on Public Offers (FPOs)
to aid price and demand discovery. It is a mechanism where during the period for which the book for the
offers are open, the bids are collected from investors at various prices which are within the price band
specified by the issuer. The process is directed towards both the institutional as well as the retail investors.
The issue price is determined after the bid closure, based on the demand generated in the process.
During the fixed period of time for which the subscription is open, the book runner collects bids from
investors at various prices between the floor price and the cap price. Bids can be revised by the bidder
before the book closes. The process aims at tapping both wholesale and retail investors. The final issue
price is not determined until the end of the process when the book is closed. After the closure of the book
building period, the book runner evaluates the collected bids on the basis of certain evaluation criteria and
sets the final issue price. If demand is high enough, the book can be oversubscribed. In this case, the green
shoe option is triggered.
16.14 Debt Securitisation

Securitization is a process in which illiquid assets are pooled into marketable securities that can be sold to
investors. The process leads to the creation of financial instruments that represents ownership interest in, or
is secured by a segregated income producing asset or pool of assets. These assets are secured by personal
or real property such as automobiles, real estate or equipment loans but in some cases are unsecured.
Process of Securitization: It follows the following process.
Step I – SPV (Special Purpose Vehicle) is created to hold title to assets underlying securities as a repository
of the assets or claims being securitized.
Step II – The originator i.e. the primary financier or the legal holder of assets sells the assets (existing or
future) to the SPV.
Step III – The SPV, with the help of an investment banker, issues securities which are distributed to
investors in form of pass through or pay through certificates.
Step IV – The SPV pays the originator for the assets with the proceeds from the sale of securities.
The process of securitization is generally without recourse i.e. the investor bears the credit risk or risk of
default and the issuer is under an obligation to pay to investors only if the cash flows are received by him
from the collateral. The issuer however, has a right to legal recourse in the event of default. The risk run by
the investor can be further reduced through credit enhancement facilities like insurance, letter of credit and
guarantees.
In India, the Reserve Bank of India had issued draft guidelines on securitization of standard assets in April
2005.These guidelines were applicable to banks, financial institutions and non banking financial companies.
The guidelines were modified and brought into effect from February 2006.
16.15 New Instruments

The new instruments that have been introduced since early 90’s as a source of finance is staggering in their
nature and diversity. These new instruments are as follows:
 Deep Discount Bonds: It is a form of Zero-interest bonds. These bonds are sold at a discounted
value and on maturity face value is paid to the investors. In such bonds, there is no interest payout
during lock in period. IDBI was the first to issue a deep discount bond in India in January, 1992.
The bond of a face value of Rs. 1 lakh was sold for Rs. 2,700 with a maturity period of 25 years.
The investor could hold the bond for 25 years or seek redemption at the end of every five years
with a specified maturity value. The investor can sell the bonds in stock market and realize the
difference between face value (Rs. 2,700) and market price as capital gain.
 Secured Premium Notes: Secured Premium Notes is issued along with a detachable warrant and
is redeemable after a notified period of say 4 to 7 years. The conversion of detachable warrant into
equity shares will have to be done within time period notified by the company.
 Zero Interest Fully Convertible Debentures: There are fully convertible debentures which do
not carry any interest. The debentures are compulsorily and automatically converted after a specified
period of time and holders thereof are entitled to new equity shares of the company at predetermined
price. From the point of view of company this kind of instrument is beneficial in the sense that no
interest is to be paid on it, if the share price of the company in the market is very high than the
investors tends to get equity shares of the company at the lower rate.
 Zero Coupon Bonds: A Zero Coupon Bond does not carry any interest but it is sold by the issuing
company at a discount. The difference between the discounted value and maturing or face value
represents the interest to be earned by the investor on such bonds.
 Double Option Bonds: These have also been recently issued by the IDBI. The face value of each
bond is Rs. 5,000. The bond carries interest at 15% per annum compounded half yearly from the
date of allotment. The bond has maturity period of 10 years. Each bond has two parts in the form
of two separate certificates, one for principal of Rs. 5,000 and other for interest (including redemption
premium) of Rs. 16,500. Both these certificates are listed on all major stock exchanges. The investor
has the facility of selling either one or both parts anytime he likes.
 Option Bonds: These are cumulative and non-cumulative bonds where interest is payable on
maturity or periodically. Redemption premium is also offered to attract investors. These were recently
issued by IDBI, ICICI etc.
 Inflation Bonds: Inflation Bonds are the bonds in which interest rate is adjusted for inflation. Thus,
the investor gets interest which is free from the effects of inflation. For example, if the interest rate is
11 percent and the inflation is 5 percent, the investor will earn 16 percent meaning thereby that the
investor is protected against inflation.
 Floating Rate Bond: This as the name suggests is bond where the interest rate is not fixed and is
allowed to float depending upon the market conditions. This is an ideal instrument which can be
resorted to by the issuer to hedge themselves against the volatility in the interest rates. This has
become more popular as a money market instrument and has been successfully issued by financial
institutions like IDBI, ICICI etc.
Activity J:
1. You are required to list out the benefits of the various new financial instruments from the perspective
of your organization.
16.16 Summary
Long term funds are used for purchasing fixed assets expansion/improvisation programmes, diversification
and acquisition, takeovers & mergers and alliances etc. There are various sources of long term funds like
share capital, debentures, bonds, Retained earnings, foreign loan, Term loans, Venture Capital, leasing etc.
Equity capital is the owners’ capital and remains forever with the company. Preference capital is also
permanent capital but unlike equity shareholders the preference shareholders do not enjoy enough power
and voting rights. Preference shares get a priority to get their share of investment and profits before equity
shareholders. Debentures are long term promissory notes which may be secured or unsecured. The interest
rate is fixed on debentures. Bond holders/Debenture holders have a priority of claim to income over equity
and preference shareholders.
Securitisation is important source of finance and it is a process in which illiquid assets are pooled into
marketable securities that can be sold to investors. Leasing is a very popular source to finance equipments.
It is a contract between the owner and user of the asset over a specified period of time in which the asset is
purchased initially by the lessor (leasing company) and thereafter leased to the user (Lessee Company) who
pays a specified rent at periodical intervals.
Venture capital provides risk capital and skilled to firms which are to invest in ventures of advance technology,
and research and development for commercial production of any item/services.
Every day new creative financial products keep on entering the market. Some of the examples are Deep
Discount Bonds, Option Bonds, and Inflation Bonds etc. To day the businesses are allowed to source funds
from International Market also. Some of important products are ECB, Euro Bonds, American Depository
Receipt etc.

1. What do you understand by long-term finance? Critically examine the importance of instruments of
long-term finance.
2. ‘From the view-point of the investors, debentures are least risky, lesser risky are preference shares
and highest risky are equity shares’. Discuss and bring out the difference between any two different
instruments of long-term finance.
3. What are term loans? What are their features?
4. Explain the different forms of depository receipts.
5. What are ECBs? What are the advantages and disadvantages of ECBs? Why are ECBs becoming
popular these days?
6. What do you mean by venture capital financing and what are the methods of this type of financing?
7. What do you understand by equity shares? What are its features, advantages and disadvantages?
8. What is Debt Securitisation? What are the process of Debt Securitisation?

- Bhalla V. K. (1997); ‘Financial Management and Policy’, First Edition, Anmol Publications Pvt.
Ltd., New Delhi.
- Kapil Sheeba, Kapil Kanwal Nayan (2003); ‘Financial Management: Strategy, Implementation &
Control’, First Edition, Pragati Prakashan, Meerut.
- Gopal C Rama (2011); ‘Financial Management and Management Accounting’, First Edition, New
Age International (P) Limited, Publishers, New Delhi.
- Banerjee Subir Kumar (1997); ‘Financial Management’ First Edition, S. Chand & Company Ltd.
New Delhi.
- Bhalla V.K. (2006); ‘Management of Financial Services’Third Revised and Enlarged Edition, Anmol
Publications Pvt. Ltd., New Delhi.
Unit - 17 : Sources of Short-term Finance
Structure of Unit:
17.0 Objectives
17.1 Introduction
17.2 Characteristic of Short-term Financing
17.3 Trade Credit
17.4 Accrued Expenses, Provisions & Deferred Income
17.5 Bills of Exchange
17.6 Treasury Bills
17.7 Public Deposit
17.8 Commercial Papers
17.9 Inter-Corporate Deposits (ICDs)
17.10 Short-term Unsecured Debentures
17.11 Bank Finance
17.12 Difference between Trade Credit and Bank Credit
17.13 Factoring
17.14 Eurocurrency Loan
17.15 Summary
17.0 Objectives
 Know the short-term finance its characteristic and purpose for raising the fund from the sources of
short-term.
 Portray meaning, benefits and cost of trade credit as a spontaneous source of finance.
 Comprehend the different sources of spontaneous sources such as accrued expenses, provisions
and deferred Incomes.
 Point out commercial paper, bills of exchange, treasury bills, inter-corporate deposit, and short-
term Un-secured debenture as short-term sources of finance.
 Learn about the different negotiated sources from bank to raise short-term funds.
 Put forth the innovative source of short-term fund instrument as factoring and its position in India.
 Differentiate trade credit and bank credit to understand the concept in more lucid manner.
17.1 Introduction
Short term Finance means availability of funds for a period of one year or less than that period. These
include the financial needs up to one year. Short term finance is the source of working capital. Short term
finances are used to purchase the raw materials, to pay salaries, to pay taxes, rent etc. Generally the short
term sources are trade credit, bank credit, indigenous bankers, public deposits, advances from customers,
personal loans, retained earnings, accrued expenses, and provision for taxation and depreciation fund.
Broadly speaking, the short-term finance may be classified between two categories i.e. spontaneous sources
and negotiated sources. Spontaneous sources of finance are those which naturally arise in the course of
business operations. Trade credit, credit from employees, credit from suppliers of services etc. are some of
the examples which may be quoted in this respect. Negotiated sources, as it is clear from name itself, are
those which have to be specifically negotiated with lenders say commercial banks, financial institutions,
general public etc. The finance manager has to be very careful while selecting a particular source, or a
combination thereof for financing of working capital. Generally the following parameters are suggestive to
consider before arriving on any decisions. These are cost, impact of credit rating, feasibility, reliability,
restrictions and hedging or matching approach i.e. raising the same maturity short-term fund as needed in
the business.
17.2 Characteristic of Short-term Financing

The characteristics of the short-term can be enumerated in the below mentioned lines.
Short-term finance tends to be less expensive than long term finance. The principal supplier of the short-
term finance is the banking system and its overdrafts and loans have the additional advantages of being
available quickly and inexpensively. On the contrary, in long term finance, the public issue of shares tends to
be expensive because of the services of issuing houses, merchant banks, lawyers, accountants, and possibly
other experts whose services are almost essential. Bank overdraft negotiations do not require these experts,
although the bank may charge a commission for the overdraft facility offered in addition to the interests on
the overdraft when used.
Short term financing embraces the borrowing or lending of funds for a short period of time, say one year or
less. There is greater tendency for the greater use of short-term financing among small concerns and lesser
use among large concerns is prevalent in practically all type of business. This is probably accounted for by
the fact that a small-sized business finds it quite difficult to raise long-term funds resulting on account of
lower average credit standing and the relative impermanence of many small units.
Short term finance deals with the commercial bank, trade credit and other sources of funds that have to be
repaid within a year or less. Trade credit is the privilege extended by suppliers to their customers for
delaying the payment of goods purchased, sometimes for a month or more. Short-term financing is associated
largely with paying for those business assets that change constantly in form and that are used up or consumed
in the course of operations. Such assets are also called ‘current assets’ or ‘working assets’. Customers may
sometimes provide short-term funds by making advances on contracts. They in essence, make a pre-
payment on goods before receiving delivery. Customers might advance funds, if the order is big enough to
require the manufacturer to tie up in raw materials or goods to process more funds than what the latter can
afford.
Activity A:
1. You are advised to discuss the peculiarities implicit in the problems of short-term financing and its
relevance in modern business business.
17.3 Trade Credit

Trade credit as source of working capital refers to credit facility given by suppliers of goods during the
normal course of trade. In other word, the credit extended in connection with the goods purchased for
resale by a retailer, or for raw materials used by manufacturer in producing its products is called the trade
credit. Thus, trade credit may be defined as the credit available in connection with goods and services
purchased for resale. It is the ‘resale’ which distinguishes trade credit from other sources. It can be clarified
with an example that the fixed assets may be purchased on credit, but since these are to be used in the
production process rather than for resale, such credit purchase of fixed assets is not called trade credit.
When a firm buys goods from another, it may not be required to pay for these goods immediately. During
this period, before the payment becomes due, the purchaser has a debt outstanding to the supplier. This
debt is recorded in the buyer’s balance sheet as creditors; and the corresponding account for the supplier is
that of debtors. Normal business transaction, therefore, provide the firm with a source of short term financing
(trade credit) because of the time gap between the receipts of goods and services and payment thereof. The
amount of such financing depends on the volume of purchases and the payment timing. Small and new firms
are usually more dependent on the trade credit, as they find it difficult to obtain funds from other sources.
There can be an argument that trade credit is a cost free source of finance but it is not, it involves implicit
cost. The supplier extending trade credit incurs cost in the form of opportunity cost of funds invested in
trade receivables. Generally, the supplier passes on these costs to the buyer by increasing the price of the
goods or alternatively by not extending cash discount facility. Trade credit is mostly an informal arrangement
and granted on open account basis, In USA trade creditors are called account payables.
Benefits of Trade Credit:
Trade credit is a spontaneous source of financing. When volume of business grows, amount of credit also
automatically increases. Suppose buyer is in habit of receiving credit for 30 days and his daily purchases are
Rs. 10,000 per day. If his business increases and makes purchases for Rs. 3,00,000 (30 x 10,000) to Rs.
4,50,000 (30 x 15,000). In an informal way, buyer receives extra credit as he has making prompt payment
at the end of 30 days. The major advantages of trade credit are as under:
Easy Availability: Unlike other sources of finance, trade credit is easier to obtain. Market practice in a
particular trade normally determines credit period. On this trade credit, many small firms survive. In many
trades, it is an accepted way of conducting business. Even a new shop gets trade credit after a couple of
transactions. It is not possible to secure borrowing from banks in initial periods. Even for a new company,
trade credit is easier to secure and highly difficult to raise finance in capital market.
Flexibility: Flexibility is a unique feature of trade credit, if business expands, more purchases are made
and with higher purchases, more trade credit is received. In contrast, when business declines automatically
firm makes lower purchases with it, lesser trade credit is received.
Informality: Trade credit is informal. No legal documents are involved. Generally no formal agreement is
entered into while extending trade credit.
Cost of Trade Credit:
The money utilized by the firm as trade credit is simply a postponement of due payments by the firm making
certain trade purchases and delaying certain payments. This does not imply that such capital does not carry
any cost with it. Trade credit has a cost which is equal to the cost of not availing the discount specified in the
credit terms of the suppliers. All suppliers, in order to speed up their collections and to encourage cash
payments, give some cash discount to their buyers. For example the credit term of a supplier is ‘2/15, net
30’ where 2 stands for a cash discount of 2% if the payment is made within 15 days of receiving the invoice.
If the buyer does not wish to avail the discount then the maximum period by when he can make payments is
30 days. If the buyer uses the trade credit as short-term financing it will utilize the money and make the
payments on the last day of credit period extended to him. He will forego this discount. Cost of foregoing
this discount is the cost of trade credit.
Discount % 360
——————————— x ———————————————————————
(1 – Discount %) (Total credit period – cash discount period)
Illustration: Cost of not being able to take discount when credit terms of suppliers are 2/10 net 30 and actual
payment by the firm takes place on 80th day of purchase.
Solution:
.02 360 .02 360 720
Cost = ———— x ————————— = ————— x ———— = ———— = 10.5 %
1 - .02 80 – 10 .98 70 6860
Decision Analysis of Trade Credit:
If the cost of trade credit compared to the opportunity cost of capital is very high then it is advisable to avail
cash discount offered by the supplier. If the cost of trade credit is low compared to the opportunity cost of
capital and it is less, then one should forego cash discount and utilize the cash during the credit period
extended by the supplier. However, in some cases the payment can be delayed beyond the last day of
available credit period. This depends on the buyer supplier relationship. However, the buyer should always
keep in mind the fact that payments can be slowed down only till a point where the credibility and goodwill
of the buyer is not hampered.
Activity B:
1. Cost of not being able to take discount when credit terms of suppliers are 3/12 net 60 and actual
payment by the firm takes place on 90th day of purchase. Calculate the cost of Trade Credit.
17.4 Accrued Expenses, Provisions & Deferred Income

17.4.1 Accrued Expenses
Another source of short-term financing is the accrued expenses or the outstanding expenses liabilities. The
accrued expenses refer to the services availed by the firm, but the payment for which has not yet been
made. The classical example is salaries payable to staff. In case of salaries and wages, employees render
their services and so benefit of services is received by the firm immediately while payments are made at the
end of month. So even employees too provide a source of spontaneous short-term finance to the organization
they work. Electricity and telephone are other examples where services are received first and payments are
made at the end of specified duration normally end of month. In case of corporate taxes, they are paid
quarterly while profits are made as and when sales are made. In this way, even government has provided
credit to business firms in respect of their cash sales. When bill for payment is not received and accounts are
to be finalized, provision for accrued expenses is made in accounts to reflect true and fair profit and financial
position in financial statements. It is built-in and an automatic source of finance as most of the services, are
paid only at the end of a period. Accrued expenses represents spontaneous and interest free source of
financing. There is no explicit or implicit cost associated with the accrued expenses and the firm can save
liquidity by accruing these expenses. The longer the period of payment, higher the benefit firm derives.
However, due to legal constraints and practical difficulties, firm cannot postpone their payment indefinitely.
Till their payment, firm enjoys befit as short term financing.
17.4.2 Provisions and Funds Generated from Operations
From Profit after Tax, the various expenses to be made in future are deducted as estimated expenses of the
future like provision for dividends, provision for bonus etc. As these provisions are not immediate cash
outflow, they provide funds for the firm for its current use. However, the firm has to make these payments in
future from its future earning profits.
Funds generated from operations, during an accounting period, increase working capital by an equivalent
amount. The two main components of funds generated from operations are profit and depreciation. Working
capital will increase by the extent of funds generated from operations.
17.4.3 Deferred Income
Deferred Income represents funds received in advance for services to be rendered in future. The receipts
improve liquidity of firm. However firms that have great demand for their products and services, enjoying
good reputation in market, can only get the benefit of deferred income. Manufacturers and contractors
engaged in producing or constructing costly goods, involving considerable length of time for manufacture or
construction, demand advance money before accepting orders. In turn key projects or where goods are to
be made for a specific requirement, advance payments are insisted. This avoids possibility for cancellation
of sale after commencement of execution of order. Normally, clause remains in those contracts that advance
payment made would be forfeited on cancellation of the contract. These advances are adjusted when goods
and services are supplied. Till supply of services, amount stands as a liability in the books of recipient. This
is a cost free source of finance and really useful in business.
Activity C:
1. Analyse the impact of spontaneous source of short term fund on business decision making taking in
to account accrued expenses, provisions and deferred Income. What plan business should device
to increase this type of source of finance?
17.5 Bills of Exchange

Bills of exchange provide an easy route to extend trade credit. When suppliers of goods is less sure of
receiving payment on due date supplier draws the bill of exchange on the buyer to document transaction
fool proof method and buyer accepts the bill of exchange for payment on due date. In other words, trade
credit is documented in the form of bill of exchange. For wholesaler, the bills of exchange become ‘bills
receivable’ and the same document becomes ‘bills payable’ to retailer. In the accounts of wholesaler, bills
receivable appears in place of sundry debtors. Bills payable take the place of sundry creditors in the accounts
of retailers.
Supplier is also in a position to discount bills receivable with his banker and can raise finance to meet his
working capital needs. Even when there is no doubt of creditworthiness of buyer, seller may adopt this
mode of payment through bill of exchange when he wants to have the option of raising finance through
discounting bills of exchange. In case, bill of exchange is not executed between supplier and buyer, supplier
can raise finance from bank in the form of hypothecation of book debts. In other words, discounting bills of
exchange and hypothecation of book debts are the different routs available for meeting working capital
needs
The greatest advantage with bill of exchange is its self maturing character as due date is certain and buyer
cannot dodge payment unlike book debt. Suppliers are also in a position to discount bills receivable with his
banker and can raise finance to meet his working capital needs.
Credit Terms:
Credit terms refer to those terms under which supplier sell on credit to buyer. There are two important terms
and they are ‘due date’ and ‘cash discount’. Due date is the date on which buyer has to make payment for
goods received. On the due date, suppler can expect payment. Credit terms refer to length of credit period.
Cash discount is granted to customers for early payment, before due date. The typical way of expressing
credit period and cash discount in an invoice is ‘2/15, net 30 days’ This means 2% discount would be given,
if buyers makes payment within 15 days from date of invoice. If buyer does not want to avail cash discount,
he can avail credit period of 30 days. Buyers can make payment at the end of 30 days from date of invoice.
Activity D:
1 How would you analyse the credit term mentioned as ‘3/18, net 40 days’? Think and discuss the
credit term if it becomes ‘2/10, net 30 days’ is beneficial or not to the business.
17.6 Treasury Bills

This represents central government borrowings against a bill or a promissory note. It is a highly liquid, risk
free instrument. At present there are three types of treasury bills but only first and third is generally used.
These are
a) 91 days Treasury Bills issued every week.
b) 182 days Treasury Bills issued every week.
c) 364 days Treasury Bills issued every month.
There are two forms of treasury bills;
a) Ordinary Treasury Bills: These are issued to public and RBI by the Government.
b) Ad-hoc Treasury Bills: These are created only in favour of RBI.
It is the RBI which discounts the treasury bills held by the banks & financial institutions. Rate of interest on
treasury bills is lowest among short-term sources of funds and is fixed by RBI from time to time.
17.7 Public Deposit

A deposit from the public is one of the important source of finance particularly for well established big
companies with huge capital base for short and medium term. The firm may raise short-term funds from the
general public by offering handsome rate of interest. The deposits thus mobilized from public by non-
financial manufacturing companies are known as ‘public deposits’ or ‘fixed deposits’. These are regulated
by regulations of public deposit under the companies’ amendment rules or now company law. However, the
company raising public deposit cannot raise more than 10% of its paid up share capital and free reserves.
The rate of interest on public deposit cannot be more than 15% which is computed on quarterly basis. The
firm seeking funds through public deposit has to issue an advertisement disclosing details about its name,
date of its incorporation, its profits and other relevant information required by the investor in order to invest
with the firm and the same has to be submitted to the registrar of companies before advertising it.
Activity E:
1. You are required to collect the information in detail from your surroundings the case of using short-
term financing as public deposits and reaction of the public in general.
17.8 Commercial Papers

Commercial Paper (CP) is an unsecured promissory note issued by a firm to raise funds for a short period,
generally, varying from a few days to a few months. In India, the maturity period of Commercial Paper
varies between 15 days to 1 year while in some other countries; the maturity period may go up to 270 days.
It is a money market instrument and generally purchased by commercial banks, money market mutual funds
and other financial institutions desirous to invest their funds for a short period. As the Commercial Paper is
unsecured, the firms having good credit rating can only issue the commercial paper.
The firm or the dealers in Commercial Paper sell these to the short-term lenders who use it as interest
earning investment of temporary surplus of operating funds. The nature of these surpluses and motives for
buying the CP suggest that all the holders of the commercial paper expect to be paid in full at maturity. The
maturity term of commercial paper is not extended. This expectation on the part of short term tenders
requires that the borrowing firm must be (i) an established and profitable firm and (ii) consistently maintaining
credit goodwill in the market and having good credit rating. The interest cost of the commercial paper
depends upon the amount involved, maturity period and the prime lending rates of commercial banks. The
main advantage of commercial paper is that cost involved is lower than the prime lending rates. In addition
to this cost, the borrowing firm has to bear another cost in the form of placement fees payable to the dealer
of Commercial Paper who arranges the sale.
The Commercial Paper market has ballooned from Rs. 44,000 crore in March, 2009 to Rs. 67,000 crore
by June end and Rs. 80,000 crore by mid august 2009 as interest rates in the debt market have fallen below
band rates at 4 to 5 percent.
Issue of Commercial Papers in India:
Commercial Paper was introduced as a money market instruments in India in January, 1990 with a view to
enable the companies to borrow for short term. Since the commercial paper represents an unsecured
borrowing in the money market, the regulation of CP comes under the purview of the Reserve Bank of India
which has issued Guidelines in 2000 superseding all earlier Guidelines. These Guidelines are aimed at:
i) Enabling the highly rated corporate borrowers to diversify their sources of short term borrowings,
and
ii) To provide an additional instrument to the short term investors.
These Guidelines have stipulated certain conditions meant primarily to ensure that only financially strong
companies come forward to issue the CP. Commercial Paper should be in the form of usance promissory
note negotiable by endorsement and delivery. It can be issued at such discount to the face value as may be
decided by the issuing company. Commercial Paper is subject to payment of stamp duty. In terms of the
guidelines, the issuer company is not permitted to take recourse to the underwriters for underwriting the
issue of Commercial Paper.
Updated Conditions of CP:
The updated conditions till 1st July 2010 are as under,
a) Eligibility: A corporate would be eligible to issue Commercial Paper provided: i) the tangible net
worth of the company, as per the latest audited balance sheet, is not less than Rs. 4 crores; ii)
company has been sanctioned working capital limit by bank/s or all India financial institution/s; and
iii) the borrowal account of the company is classified as a Standard Assets by the financing banks/
institution.
b) Rating requirements: All eligible participants have to obtain the credit rating from CRISIL, ICRA or
CARE or any other recognized credit rating agency. The minimum credit rating required for issue of
commercial paper is P-2 of CRISIL or any other equivalent rating from other rating agencies.
c) Minimum Investment and Denomination: Amount that can be invested by a single investor cannot be
less than Rs. 5 lakhs (face value). Commercial Paper can be issued in denomination of Rs. 5 lakhs
or multiple there of.
d) Maximum Limit: Commercial Paper can be issued within the overall umbrella limit fixed by the RBI,
i.e., issue of Commercial Paper together with other instruments, viz., term money borrowings, term
deposits, certificate of deposit and inter-corporate deposits, all put together should not exceed 100
percent of its net owned funds, as per the latest audited balance sheet.
e) Aggregate Limit: The aggregate amount of CP from an issuer shall be within the limit as approved by
its Board of Directors or the quantum indicated by the Credit Rating Agency for the specified rating,
whichever is lower. Banks and financial institutions have the flexibility to fix working capital limits
duly taking into account the resource pattern of companies’ financing including CPs. Earlier,
Commercial Bank that sanctioned working capital limit was required to reduce the cash credit limit
of the borrower to the extent of the issuance of commercial paper. Now, there is no need for the
concerned commercial bank to reduce the sanctioned cash credit limit of the concerned company,
automatically, after issuance of commercial paper. Commercial bank has the freedom to fix the
working capitl limits of the borrower.
f) Issuing and Paying Agent (IPA): Only a scheduled bank can act as an IPA for issuance of Commercial
paper.
g) Period of Raising Subscription: Commercial Paper has to be raised within two weeks from the date
of opening the issue for subscription.
a) Maturity: Maturity runs between a minimum of 7 days and maximum of one year from the date of
issue. No grace period is allowed for repayment and if the maturity date falls on a holiday then it
should be paid on the previous working day. Each issue of Commercial Paper is treated as a fresh
issue.
h) Interest: Commercial Paper is issued at a discount to its maturity value. The difference amount
between the issue price and maturity amount is the return to the investor.
i) Credit Enhancement: Commercial Paper is a ‘stand alone’ product. However, banks have the
flexibility to provide credit enhancement by way of stand- by assistance, based on their commercial
judgement. In other words, in case of default in payment by the issuer, responsibility would be cast
on the bank that has provided credit enhancement. This credit enhancement provides the necessary
cushion to the investor’s confidence to invest. It may be made clear that the credit enhancement is
not compulsory for the issue of commercial paper. The issuer normally seeks the credit enhancement
when the credit rating for the commercial paper is not adequate, though enough to issue commercial
paper to attract the investors’ response to raise finance at a cheaper interest rate. This credit
enhancement strengthens the rating of the commercial paper.
These conditions change from time to time and the conditions existing at the time of issue govern the issue of
commercial paper.
Any company proposing to issue commercial paper has to submit an application to the bank which provides
working capital limit to it, along with the credit rating of the firm. The issue has to be privately placed within
two weeks by the company or through a merchant banker. The initial investor pays the discounted value of
the commercial paper to the firm. Thus, Commercial Paper is issued only through the bank that has sanctioned
the working capital limit and it does not increase the working capital resources of the firm.
Recent Importance:
With the recent reduction in interest rates, importance of commercial paper has diminished, of late. However,
corporate sector still finds issue of commercial paper cheap and has again regained its erstwhile importance
to raise finances at a lower interest rate compared to the rates of interest charged on loans by banking
sector. The Indian economy has started witnessing the unprecedented increasing trends on inflation from the
middle of the year 2006. In consequences, bank interest rates have been hardening more significantly from
the year 2007. Increase in interest rates, offered by banks, is also in consequences of different stringent
initiatives taken by RBI. The different measures are increase of credit reserve ratio and statutory liquidity
ratio to contain or control the galloping inflation trends, prevailing more than 6% during the year 2010. So,
commercial paper has regained its importance to work as a potent weapon to raise short-term finances by
highly rated companies to improve their bottom line. In other words, commercial paper has become attractive
way to finance short-term requirements, instead of borrowing from banks.
Annual financing cost of Commercial Paper:
The annual financing cost of Commercial Paper depends upon the discount on issue and the maturity period.
The annualized pre tax cost of commercial paper can be computed as below:
FV - SP 360
Annual Financing Cost = ———————— x ——————
SP MP
Where FV = Face Value of Commercial Paper
SP = Issue Price of Commercial Paper
MP = Maturity period of Commercial Paper
For example, a commercial paper of the face value of Rs. 10,00,000 is issued at Rs. 9,60,000 for a
maturity period of 120 days. The annual financing cost of the commercial paper is:
10,00,000 – 9,60,000 360
Annual Financing Cost = ———————————— x ———— = 12.5%
9,60,000 120
Benefits and limitations of Commercial Paper as a Source of Financing
From the point of the issuing company, Commercial Paper provides the following benefits:
a) Commercial Paper is sold on an unsecured basis and does not contain any restrictive conditions.
b) Maturing commercial paper can be repaid by selling new commercial paper and thus can provide a
continuous source of funds.
c) Maturity of Commercial Paper can be tailored to suit the requirement of the issuing firm.
d) Commercial Paper can be issued as a source of fund even when money market is tight.
e) Generally, the cost of Commercial Paper to the issuing firm is lower than the cost of commercial
bank loans.
However, Commercial Paper as a source of financing has its own limitations.
a) Only highly credit rated firms can use it. New and moderately rated firms generally are not in a
position to issue Commercial Paper.
b) Commercial Paper can neither be redeemed before maturity nor can be extended beyond maturity.
So, Commercial Paper is advantageous both to the issuer as well as to the investor. The issuer can raise
short-term funds at lower costs and the investor as a short term outlet of funds. Commercial Paper provides
liquidity as they can be transferred. However, the issuer must adhere to the RBI guidelines.
Activity F:
1. A commercial paper of the face value of Rs. 20,00,000 is issued at Rs. 19,40,000 for a maturity
period of 140 days. Calculate the annual financing cost of the commercial paper.
17.9 Inter-Corporate Deposits (ICDs)

Sometimes, the companies borrow funds for a short-term period, say up to six months, from other companies
which have surplus liquidity for the time being. The ICDs are generally unsecured and are arranged by a
financier. The ICDs are very common and popular in practice as these are not marred by the legal hassles.
The convenience is the basic virtue of this method of financing. There is no regulation at present in India to
regulate these ICDs. Moreover, these are not covered by the Section 58A of the Companies Act, 1956, as
ICDs are not for long term. The transactions in the ICDs are generally not disclosed as the borrowing under
the ICD simply a liquidity shortage of the borrower. The rate of interest on ICDs varies depending upon the
amount involved and the time period. The entire working of ICDs market is based upon the personal
connections of the lenders, borrowers and the financiers.
Activity G:
1. What is Inter-corporate Deposit? Do you think that it is regulated by any regulation of Company
Act or other? Explain if it is.
17.10 Short-term Unsecured Debentures

Companies have raised short-term funds by the issue of unsecured debentures for periods up to 17 months
and 29 days. The rate of interest on these debentures may be higher than the rate on secured long-term
debentures. It should be noted that no credit rating is required for the issue of these debentures because as
per the SEBI guidelines, the credit ratings required for debentures having maturity period of 18 months or
more. The use of unsecured debentures as a source of short-term financing, however, depends upon the
state of capital market in the economy. During sluggish period, the companies may not be in a position to
issue these debentures. Moreover, only established firms can issue these debentures as new company will
not find favour from the investors. Another drawback of this source is that the company procures funds
from retail investors instead of getting a lump-sum from one source only. Further, that the issue of securities
in capital market is a time consuming process and the issue must be planned in a proper way.
17.11 Bank Finance

Bank offers short term funds for business enterprise in different forms. It may provide funds either directly
or indirectly. In case of indirect finance, the bank covers only the risk and does not provide finance i.e. letter
of credit and in case of direct finance, the bank provide finance plus it covers the risk i.e. cash credit,
overdraft, note lending and discounting of bills. The firm gives an assessment of its working capital requirement
to the bank. On this request the bank provides a credit limit to the firm which the firm can operate accordingly.
The interest is charged on the amount actually utilized by the firm. However, the bank requires the borrowing
firm to maintain a minimum balance in its operating accounts at all times which is known as compensatory
balance.
17.11.1 Nature of Credit
Of all the banking concepts, that of credit is probably the most elusive. It is commonly said that a man ‘has
credit’ – a bank ‘extend credit’ or Credit is based upon the three Cs – of capital, character and capacity’.
However, this does not tell us anything about what credit is or what the function of credit is. First, credit
provides the mechanism whereby a person may acquire real goods without giving an equivalent value of
goods in exchange; secondly, as an indirect consequence, there is a redirection of the flow of real goods,
different from what would otherwise take place. The great importance of the institution which we loosely
call credit finds emphasis in such common expressions as ‘modern industrial society is a credit society,
credit is the heart and core of the industrial system and credit is the life blood of commerce and industry’. In
simple business parlance, credit involves merely getting something now and paying for it later. It is synonymous
with borrowing. The essential element in credit operations always is postponement of payment for something
that has been received.
17.11.2 Cash Credit
Cash credit is the most popular form of credit with borrowers for meeting working capital requirements.
Bank considers firm’s sales and production plans to sanction a particular working capital limit, which is
called sanctioned limit in a cash credit account. In case of seasonal industries, bank sanctions peak credit
limit to meet working capital requirements during season which is always higher in comparison to the limit
sanctioned for non peak period. So, bank sanctions separate limits for peak and non-peak periods as
working capital requirement is maximum during peak season. These cash credit limits are against security of
current assets such as stocks and book debts.
Bank does not finance 100% of current assets. Bank stipulate margin. The drawing power is calculated
after deducting the required margin from value of stocks. Borrower has to submit stock statement monthly
as per terms of sanction, declaring physical stocks and their value on a specified date. If margin requirement
is 30%, bank can lends only up to 70% of value of stock and this is called drawing power of borrower and
borrower is allowed to draw to the extent of the drawing power. Based on value of stock, drawing power
is calculated. Borrower can deposit sale proceeds daily to reduce the outstanding balance in cash credit
account and can draw as and when needed to the maximum extent of drawing power or cash credit limit,
which ever is lower. Borrower is required to pay interest for amount utilized only and not on the total
sanctioned limit. It is sanctioned for one year.
Cash credit facility can be sanctioned either in the form of pledge or hypothecation of goods. In case of
pledge, goods are kept in the godowns under lick and key of bank, so possession of goods and control
thereon is with bank, not borrower. As and when payment is made, goods are released, even proportionately
to borrowers. In case of hypothecation, possession of goods is with borrower and can deal with goods in
the manner he likes, even selling goods without bank’s prior approval. It is extended to such borrowers
whose creditworthiness is well known to bank.
17.11.3 Bank Overdraft
It is short-term borrowing facility made available to the companies in case of urgent need of funds. The bank
will impose limits on the amount they can lend. When the borrowed funds are no longer required they can
quickly and easily be repaid. The bank issue overdrafts with a right to call them in at short notice. Banks
sanction regular overdraft limits normally against security of fixed deposit receipts, shares, life insurance
policy, postal certificates etc. Interest is charged on amount utilized. Cheque facility is made available in
overdraft account. In addition to permanent overdraft limit, bank sanctions temporary overdraft in current
account of customers as and when cheques received are in excess of balance in current account. This is a
temporary arrangement and normally availed by professional for their working capital requirements.
17.11.4 Note Lending
Note lending is very different from Cash Credit and Bank Overdraft account. It is not a running account. It
is sanctioned for a period of about 2-3 months. It is form of loan given to the borrower against promissory
notes/debt instrument. Interest is charged on the complete loan amount sanctioned unlike cash credit/bank
overdraft account where interest is charged only on the utlised (withdrawn) account. However note lending
is not as popular as cash credit/bank overdraft arrangement.
17.11.5 Purchase or Discounting of Bills
Bill discounting is recognized as an important short term financial instrument and it is widely used method of
short-term financing. Supplier can avail the limit for bills drawn on his buyers, covering supply of goods
made. If the bill of exchange is payable on demand, it is purchased by bank. If the bill of exchange is drawn
on acceptance basis bank discounts the bills accepted by buyer of goods. Buyer has to make payment on
the due date. In both the cases, working capital is provided by bank, by purchasing or discounting bills, as
the case may be. This has a self liquidating character with greater control for banks to monitor utilization of
finances for working capital requirements.
17.11.6 Bill Rediscounting
The bill rediscounting Scheme was introduced by Reserve Bank of India with effect from 1st November,
1970 in order to extend the use of the bill of exchange as an instrument for providing credit and the creation
of a bill market in India with a facility for the rediscounting of eligible bills by banks. Under the bills rediscounting
Scheme, all licensed scheduled banks are eligible to offer bills of exchange to the Reserve Bank for rediscount.
17.11.7 Line of Credit
A line of credit is an agreement between a bank and a firm that permits the firm to borrow up to a specified
limit during a particular time period. Once the line of credit is approved at the start of the period, loans taken
out against the line are usually approved by the loan officer with a minimum of delay or additionalinvestigation.
The agreement specifies the terms and conditions of the loans to be made under the line of credit. Although
technically in force for a set time period, usually a year, most credit lines represent an ongoing relationship
with the bank and may be renewed. At renewal the rate, credit limit, or other conditions of the line of credit
may be altered, depending upon the financial performance, condition and needs of the borrower. The line of
credit provides a very flexible source of short-term financing. The borrower has access to a specified
amount of credit, but pays interest only on the actual borrowing. Line of Credit is a commitment by a bank
to lend a certain amount of funds on demand specifying the maximum amount.
The primary purpose of a credit line is to supply funds to meet the short-term, frequently seasonal, cash flow
needs of the borrower. To ensure that the line is used for short-term purposes, credit line sometimes includes
a requirement of a cleanup period, perhaps 30 or 60 days, during which there is no borrowing against the
line. A second purpose of a line of credit is to provide a backup source of cash to pay off maturing commercial
paper. Credit lines used in this way are called backup lines. Most organizations issuing commercial paper
maintained an unused credit line in an amount sufficient to back up their commercial paper. Of course, the
intention is never to have to borrow under this credit line.
17.11.8 Working Capital Loan
It is normally sanctioned by banks for ad-hoc or temporary requirements of customers, not earlier foreseen.
This is additional sanction in excess of cash credit limit sanctioned. Once repayment is made loan account
would be closed. In other words, customer cannot utilize this mode of finance on a continuous basis like
cash credit account. Banks charge higher interest rate for extending this type of facility, compared to normal
cash credit limit extended to same borrower.
Generally, the banks while granting working capital facility to a customer stipulate that a margin of 25%
would be required to be provided by the customer and hence the bank borrowing remains only limited to
75% of the security offered. In other words, against a security of Rs. 100, the bank gives a loan of up to Rs.
75. The short-fall is generally treated as Working Capital Term Loan (WCTL). This WCTL is to be repaid
in a phased manner varying between a periods of two to five years.
17.11.9 Funded Interest Term Loan
Sometimes, a company because of its operations may not be able to pay the interest charge on its working
capital cash credit facility obtained from a commercial bank. Such accumulation of unserviced interest
makes the cash credit account irregular and in excess of the sanctioned limit. It also prevents the firm to
make further operations in the account. Such un-serviced accumulated interest may be transferred by the
bank from cash credit account to Funded Interest Term Loan (FITL). This will enable the firm to operate its
cash credit account. The FITL is considered separately for repayment.
17.11.10 Non-Fund based Facilities
17.11.10.i Letter of Credit
A letter of credit is a guarantee from a bank stating that a loan will be made to the client if specified
conditions are met. It is commonly used to finance international trade. Because an exporter does not know
an importer or because information, language and cultural differences make it difficult to perform an adequate
credit analysis, the exporter is not willing to sell to the importer on open credit. The importer presents a
letter of credit from its bank, stating that the amount necessary for payment of the shipment will be paid on
a specified date if conditions are met. This allows the importer to substitute the bank’s credit rating for its
own credit rating, thereby reducing the risk to the exporter.
The purpose of letter of credit is that payment is assured to supplier of goods or services by bank. Here the
responsibility for payment is assumed by bank and so supplier is not concerned with the creditworthiness of
the buyer. In case payment is not made by customer, bank makes payment to the party in whose favour the
letter of credit is opened. So bank assumes risk for default in payment by the opener of letter of credit.
Simply, creditworthiness of buyer is not relevant to the supplier once letter of credit is opened.
A letter of credit can be either revocable, in which case the bank has the right to cancel the letter, or
irrevocable, in which case the bank is bound to honour the terms if the specified conditions are met. The
maturity of the loan connected to the letter is dictated by the event that evoked the need for the letter. In
most instances, it is of relatively short duration, for example, 30 to 90 days. The loan usually has a fixed rate
based on the prevailing rate at the time the loan is issued. A commitment fee is usually charged for issuing a
letter of credit whether the loan is issued or not.
A banker’s acceptance is generated by a time draft for which a bank is committed to make the payment to
the holder at maturity. Banker’s acceptances most frequently arise from international transactions when the
conditions for a letter of credit have been met. Financing is provided when the bank makes an advance on
the time draft issued. Some banks use the term banker’s acceptance to refer to a loan issued to finance the
purchase of specific goods, whether for an international or a domestic transaction. The loan made under a
banker’s acceptance is usually a discount loan. The discount from face value advanced to the borrower
includes an amount for the interest at prevailing money market rates plus a fee or a commission of approximately
1.5%. Because of the commission, the cost to the borrower is usually above the commercial paper rate, but
because it is based on money market rates, it may be below the prime rate.
17.11.10.ii Bank Guarantees
Bank guarantee is one of the facilities that the commercial banks extend on behalf of their clients in favour of
third parties who will be the beneficiaries of the guarantees. In case of guarantee, it may be categorized as
Performance Bank Guarantee, Bank guarantee against advances received by a supplier and bank guarantee
in liew of security deposit or earnest money as per requirement of tenders of different Governmental or
Corporate bodies be it in private sectors or in public sectors.
In case of performance guarantee, it gives an assurance by bank to the third party about the performance of
project or equipments/machineries upto a certain period which has been executed/ manufactured by the
customers of the bank. In case of bank guarantee for advances received by the customer of the bank from
third party, such guarantee assures the third party that if the project for which advance has been given is not
executed, the bank is liable to refund such advance. Such non-fund facilities by bank are not givenindependently
but are generally considered by them along with the question of sanction of cash credit facilities.
Activity H:
1. ‘There is no guarantee that a borrower utilizes the cash credit limit for short-term Purposes, alone.’
Is it right? Name the alternative form of finance by which bank can better monitor utilization of funds
for short-term by borrower.
17.12 Difference between Trade Credit and Bank Credit

The below enumerated comparison describes the difference between trade credit and bank credit.
Security: Advances by trade creditors are almost invariably unsecured. They may be secured where creditors
constitute a major source of finance for the debtor. Bank advances are commonly secured by a charge over
the real or personal property of the customer, although some bank advances may be made on personal
security only. Initial inquiry into the nature of the security is generally more rigorous in the case of bank
credit.
Purpose: Trade credit arises from a particular purchase of goods. Bank credit is generally undifferentiated
and can, therefore, be used for a wider range of purpose.
Extent: Usually trade creditors’ accounts do not assume large dimensions. For individual clients, on the
other hand, bank advances may be much larger than the amounts those clients owe at any time to the
individual trade creditors
Liquidation: Trade creditors’ accounts are liquidated much more frequently than bank advances.
Cost: Failure to take advantage of cash discounts offered by trade creditors is many times more costly than
borrowing from banks to meet these accounts. Advances on the overdraft cost must be less than the yield
from the prompt settlement of creditor’s accounts.
Competition: There is greater competition among the suppliers of goods than among the suppliers of bank
credit. Long credit terms are frequently extended to retain a customer to whom competitors have offered
longer terms or better discounts or simply to sustain sales in spite of the customer’s reluctance to buy.
Bankers are more cautious, less inclined to encourage borrowing than sales representatives are to promote
sales. Bank credit is thus less conducive to the unwise expansion of stock levels and credit sales than trade
credit.
17.13 Factoring
Factoring is a new concept in financing of account receivables. This refers to outright sale of accounts
receivables to a factor or a financial agency. A factor is a firm that acquires the receivables of other firms.
The factoring lays down the conditions of the sale in a factoring agreement. In factoring, three parties are
involved. The supplier of goods (seller), the receiver of goods (buyer), the undertaker of debt (factor).
When some goods are sold on credit and payable after a specified period, the efforts of seller are always to
collect receivable as quickly as possible. To put it in other way, he is to remain busy significantly for such
receivable management. It involves cost, time and efforts on the part of the seller. Instead of making such
internal management of such receivable, he may delegate such job of receivable management i.e. collection
of debtors to a specialized agency. Such an agency is called factor. To put it in a layman’s language, a factor
is an agent who collects the dues of his client for a certain fee. By factoring the seller assigns his right of
collection of debt from the purchaser to the factor. The buyer is advised with this assignment to pay dues
directly to the factor instead of to the seller. Hereafter, it becomes responsibility of factor to collect receivables.
For such service to the seller and also for bearing the risk of non-collection, the factor obviously charges
some fees. In such cases they charge interest for such financing in addition to fee.
Normally, factoring is the arrangement on a non-recourse basis where in the event of default the loss is
borne by this factor. However, in a factoring arrangement with recourse, in such situation, the accounts
receivables will be turned back to the firm by the factor for resolution. To make operative of such service in
India, RBI constituted a Committee in January, 1988. The Committee submitted its report in January, 1989
and RBI accepted its recommendation in principle. SBI commercial and Factoring Services Ltd. is the first
factoring company which is on verge of starting its operation as factoring.
Factoring Services: The factor manages all the accounts, of all the customers of the said firm to make
collections on time. Factor also interferes in the credit policy of the firm and thus advocates the best credit
policy suitable for the firm. It provides all management and administration support from the stage of deciding
credit extension to the customer to the final stage of debt collection. Factor provides financial assistance to
the business firm by giving it advance cash against book debts. Factoring services provided by factors are
purchasing receivables, sales ledger administration, credit management, credit collection, protection against
default and bad debts, financial accommodation against the assigned book debts, assuming the losses which
may arise from bad debts and providing relevant advisory service to the seller.
Factoring Process: The client firm having book debts enters into an agreement with a factoring agency/
institution. The client firm delivers all orders and invoices and the invoice copy to the factor. The factor pays
80% of the invoice value (depends on the type of factoring agreement), in advance. The balance amount is
paid when factor recovers complete amount of money due on customers (debtors of the client) and against
all these services, the factor charges some amount as service charges.
Cost of Factoring: Cost of factoring is very high about 17-18% of the value of receivables. The high cost
of factoring includes the element of risk present de to the chance of book debts becoming bad debts. But
the cost is overcome by the advantages of factoring like immediate liquidity and 100% risk cover. The cost
of factoring service also depends on various factors like credit worthiness of the client, turnover of the client
and the factor, average size of invoices, various costs borne by the factors etc.
Factoring in India: In India factoring services started very late, around 1991. It is still in the initial stages
and supports only the domestic trade and commerce in India. The nationalized banks have been given the
responsibility of nurturing factoring in India. SBI has floated its subsidiary factoring unit i.e. SBI factors and
Commercial Services Ltd. In the Southern region Canara bank has also floated its subsidiary named as
Canbank Factors Ltd. Factoring is very popular in developed countries like USA, UK etc. In USA the
market for factoring services is around $ 33 billion. In India the total factoring service value was around Rs.
1000 crores in 1996-97. The idea of introducing factoring service in India was first floated by working
group committee headed on money market by Mr. N Vaghul in 1987. RBI then formed a study group,
Kalyansundaram, former managing director of SBI, in January 1988 for examining the introduction of
factoring services in India. But still, till today the factoring service in India has not acquired the status of a
separate industry, instead it has been clubbed with NBFCs.
Advantages of Factoring
a) It enhances the liquidity position of the company.
b) The hazardous job of collection from Debtors gets eliminated.
c) The loss of interest because of late collection of Debtor can be arrested. Obviously, the return of
investment improves.
d) The whole attention and energy of the concerned company can be diverted only on the sales/
marketing aspects.
Disadvantages of Factoring
In spite of many services offered by factoring, following are disadvantages of factoring.
a) High cost of factoring compared to other short-term finance.
b) Firms availing factoring services are viewed as weak.
c) Once a buyer defaults in payment, factor takes a tough stance and may not agree to provide credit
against sales made to the same buyer. This action may force the firm to discontinue sales, resulting
in reduced sales.
Difference Between Factoring and Bill Discounting
The difference between factoring and bill discounting can be enumerated as below.
a) Factoring is called as ‘invoice factoring’ whereas bills discounting is known as ‘invoice discounting’.
b) In factoring the parties are known as client, factor and debtor whereas in bills discounting they are
known as Drawer, Drawee and Payee
c) Factoring is a sort of management of book debts whereas bills discounting is a sort of borrowing
from commercial banks.
d) For factoring there is no specific Act, whereas in the case of bills discounting, the Negotiable
Instrument Act is applicable.
Activity I:
1. ‘Factoring services is related to management of debts arising from credit sales. Factor provides
credit against receivables and in this process firm gets funds immediately for credit sales made.’
What is your opinion on this statement? Discuss.
17.14 Eurocurrency Loan
In international trade short term funding is through Eurocurrency loans. Due to individual government
regulations of different nations, on the interest rate, on domestic banks lending changes as one crosses the
national boundary etc. interest on euro dollar loan would be same as interest on domestic dollar loan if the
world is made free of regulations and taxes imposed by the government.
17.15 Summary
Short-term funds can be collected through many sources such as accrued expenses, provisions, trade
credit, bank finance, public deposit, commercial papers, treasury bills, factory and Eurocurrency etc. Trade
credit is one of the important sources of short-term funds. It arises when firm purchases on credit. However,
the firm should also calculate the cost of foregoing cash discount offered by the supplier, if it takes trade
credit. Accrued expenses or deferred payments arise due to delayed payments and liabilities. This gives rise
to additional funds which the firm can utilize by delaying payments.
Banks are principal sources of short term finance. The different forms of bank borrowings are cash credit,
bank overdraft, discounting of bills, short term loans, letter of credit. However, bank finance is given on the
basis of working capital requirement assessed for a particular firm. There are various regulations of RBI
under which bank finance is offered. Commercial paper is an important instrument of money market. The
highly rated, blue chip company issues commercial paper for short-term finance. In India common commercial
papers are of 91 & 180 days maturity.
Factoring is basically selling receivables to factoring providing firms called factors. These firms monitor and
collect receivables on behalf of the firm. They offer around 70-90% of the receivable amount to the firm
even before the money is recovered. There are various types of factoring. In India factoring is still in its
nascent stage.

1. Explain the importance of trade credit as a source of short-term finance. Whether the provision of
this source involves any cost to the provider and who bears it, finally?
2. What are accrued Expenses? What are the limitations of using accrued expenses?
3. Describe the different types of short-term finance provided by Commercial banks for meeting
short-term needs of the business. Is there a way to utilize non-fund based limit for short-term
purposes?
4. What are Commercial Papers? What are the preconditions required to be fulfilled before floating
commercial papers?
5. What are the advantages and disadvantages of using public deposit as a source of funds?
6. What is factoring? How it is beneficial to a firm? Differentiate between bill discounting and factoring.
7. What is Eurocurrency Loan? Why do firm go for such a loan?

- Bhalla V. K. (1997); ‘Financial Management and Policy’, First Edition, Anmol Publications Pvt.
Ltd., New Delhi.
- Kapil Sheeba, Kapil Kanwal Nayan (2003); ‘Financial Management: Strategy, Implementation &
Control’, First Edition, Pragati Prakashan, Meerut.
- Gopal C Rama (2011); ‘Financial Management and Management Accounting’, First Edition, New
Age International (P) Limited, Publishers, New Delhi.
- Banerjee Subir Kumar (1997); ‘Financial Management’ First Edition, S. Chand & Company Ltd.
New Delhi.
- Bhalla V.K. (2006); ‘Management of Financial Services’Third Revised and Enlarged Edition, Anmol
Publications Pvt. Ltd., New Delhi.
- Kulkarni P.V., Satyaprasad B.G.(2007); ‘Financial Management’, Himalaya Publishing House,
Mumbai.

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Vardhaman Mahaveer Open University, Kota

Vardhaman Mahaveer Open University, Kota

Unit - 1 Financial Management: An Introduction

Unit - 2 Financial Statements

Unit - 3 Techniques of Financial Statement Analysis

Unit - 4 Ratio Analysis

Unit - 5 Funds Flow Statement

Unit - 6 Cash Flow Statement

Unit - 7 Management of Working Capital

Unit - 8 Management of Inventories

Unit - 9 Management of Cash and Marketable Securities

Unit - 10 Cost of Capital

Unit - 11 Capital Budgetings

Unit - 12 Dividend Policy

Unit - 13 Operating and Financial Leverages

Unit - 14 Capital Structure: Theories

Unit - 15 Capital Structure: Planning

Unit - 16 Sources of Long-term Finance

1.1 Meaning and Definition of Financial Management

Financial Decision Investment Decision Dividend Decision

Capital Working capital Capital Current Assets

1.2 Nature or Characteristics of Financial Management

1.3 Objectives of Financial Management

Objectives of Financial Management

Basic Objects Operational Social Objects Research

1.4 Approaches of Financial Management

1.5 Scope or Functions of Financial Management

Functions of Financial Management

Primary or Executive Subsidiary Incidental or Routine

. Financial Planning . Maintaining Liquidity . Maintaining cash receipts and

1.6 Importance of Financial Management

1.7 Limitations of Financial Management

1.8 Functions of Chief Financial Officer

1.9 Changing Role of Financial Manager

1.11 Key Words

1.12 Self Assessment Questions

1.13 Reference Books

Part iculars Amou nt Part iculars Amo unt

To Gen. Reserve … …………. By Bal. b/d ……………..

To Interim Dividend … …………. By Net Profit ……………..

To Prop osed D ividend … ………… . By Transfer fro m …………......

To Balance c/d … …………..

2.2 Objectives of Financial Statements

2.3 Nature of Financial Statements

2.4 Importance of Financial Statements

2.5 Limitations of Financial Statements

2.6 Characteristics of Ideal Financial Statements

Ret ained Profit … …… …… ….

Cas h 2430 0 E quit y Share Capit al (Rs. 10 .00 each) 50 0000

Yo u are required to prepare balance sheet i n st atement fo rm.

Solut ion : M auli Ltd.

Soluti on: Profit and Loss Account

2.9 Key Words

2.10 Self Assessment Questions

3.3 Types of Financial Statement Analysis

According to Material used According to Modus Operandi

Internal Analysis External Analysis Horizontal Analysis Vertical Analysis

3.4 Procedure of Financial Statement Analysis

3.5 Importance of Financial Statement Analysis