Financial

management
Notes
 FINANCIAL MANAGEMENT
Financial management is an academic discipline which is concerned with
decision-making. This decision is concerned with the size and composition of
assets and the level and structure of financing. In order to make right
decision, it is necessary to have a clear understanding of the objectives. Such
an objective provides a framework for right kind of financial decision making.
The objectives are concerned with designing a method of operating the
Internal Investment and financing of a firm. There are two widely applied
approaches, viz.

(a) profit maximization and

(b) wealth maximization.

The term 'objective' is used in the sense of an object, a goal or decision

criterion. The three decisions - Investment decision, financing decision and
dividend policy decision are guided by the objective. Therefore, what is
relevant - is not the over-all objective but an operationally useful criterion: It
should also be noted that the term objective provides a normative framework.
Therefore, a firm should try to achieve and on policies which should be
followed so that certain goals are to be achieved. It should be noted that the
firms do not necessarily follow them.

Profit Maximization as a Decision Criterion

Profit maximization is considered as the goal of financial management. In this
approach, actions that Increase profits should be undertaken and the actions
that decrease the profits are avoided. Thus, the Investment, financing and
dividend also be noted that the term objective provides a normative
framework decisions should be oriented to the maximization of profits. The
term 'profit' is used in two senses. In one sense it is used as an owner-
oriented.
In this concept it refers to the amount and share of national Income that is
paid to the owners of business. The second way is an operational concept i.e.
profitability. This concept signifies economic efficiency. It means profitability
refers to a situation where output exceeds Input. It means, the value created
by the use of resources is greater that the Input resources. Thus in all the
decisions, one test is used I.e. select asset, projects and decisions that are
profitable and reject those which are not profitable.

The profit maximization criterion is criticized on several grounds. Firstly, the

reasons for the opposition that are based on misapprehensions about the
workability and fairness of the private enterprise itself. Secondly, profit
maximization suffers from the difficulty of applying this criterion in the actual
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real-world situations. The term 'objective' refers to an explicit operational
guide for the internal investment and financing of a firm and not the overall
business operations. We shall now discuss the limitations of profit
maximization objective of financial management.
1) Ambiguity:
The term 'profit maximization' as a criterion for financial decision is vague and
ambiguous concept. It lacks precise connotation. The term 'profit' is amenable
to different interpretations by different people. For example, profit may be
long-term or short-term. It may be total profit or rate of profit. It may be net
profit before tax or net profit after tax. It may be return on total capital
employed or total assets or shareholders equity and so on.

2) Timing of Benefits:
Another technical objection to the profit maximization criterion is that It
Ignores the differences in the time pattern of the benefits received from
Investment proposals or courses of action. When the profitability is worked
out the bigger the better principle is adopted as the decision is based on
the total benefits received over the working life of the asset, Irrespective of
when they were received. The following table can be considered to explain this
limitation.

3) Quality of Benefits
Another Important technical limitation of profit maximization criterion is that
it ignores the quality aspects of benefits which are associated with the
financial course of action. The term 'quality' means the degree of certainty
associated with which benefits can be expected. Therefore, the more certain
the expected return, the higher the quality of benefits. As against this, the
more uncertain or fluctuating the expected benefits, the lower the quality of
benefits.

The profit maximization criterion is not appropriate and suitable as an

operational objective. It is unsuitable and inappropriate as an operational
objective of Investment financing and dividend decisions of a firm. It is vague
and ambiguous. It ignores important dimensions of financial analysis viz. risk
and time value of money.
An appropriate operational decision criterion for financial management
should possess the following quality.
a) It should be precise and exact.
b) It should be based on bigger the better principle.
c) It should consider both quantity and quality dimensions of benefits.
d) It should recognize time value of money.

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Wealth Maximization Decision Criterion

Wealth maximization decision criterion is also known as Value Maximization or

Net Present-Worth maximization. In the current academic literature value
maximization is widely accepted as an appropriate operational decision
criterion for financial management decision. It removes the technical
limitations of the profit maximization criterion. It posses the three
requirements of a suitable operational objective of financial courses of action.
These three features are exactness, quality of benefits and the time value of
money.

i) Exactness: The value of an asset should be determined In terms of returns

it can produce. Thus, the worth of a course of action should be valued In
terms of the returns less the cost of undertaking the particular course of
action. Important element in computing the value of a financial course of
action is the exactness in computing the benefits associated with the course of
action. The wealth maximization criterion is based on cash flows generated
and not on accounting profit. The computation of cash inflows and cash
outflows is precise. As against this the computation of accounting is not exact.

ii) Quality and Quantity and Benefit and Time Value of Money:

The second feature of wealth maximization criterion is that. It considers both

the quality and quantity dimensions of benefits. Moreover, it also incorporates
the time value of money. As stated earlier the quality of benefits refers to
certainty with which benefits are received In future.

The more certain the expected cash in flows the better the quality of benefits
and higher the value. On the contrary the less certain the flows the lower the
quality and hence, value of benefits. It should also be noted that money has
time value. It should also be noted that benefits received in earlier years
should be valued highly than benefits received later.

The operational implication of the uncertainty and timing dimensions of the

benefits associated with a financial decision is that adjustments need to be
made in the cash flow pattern. It should be made to incorporate risk and to
make an allowance for differences in the timing of benefits. Net present value
maximization is superior to the profit maximization as an operational
objective.

It involves a comparison of value of cost. The action that has a discounted

value reflecting both time and risk that exceeds cost is said to create value.
Such actions are to be undertaken. Contrary to this actions with less value
than cost, reduce wealth should be rejected. It is for these reasons that the
Net Present Value Maximization is superior to the profit maximization as an
operational objective.
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PROFIT MAXIMIZATION VS WEALTH MAXIMIZATION

PROFIT MAXIMISATION - It is one of the basic objectives of financial

management. Profit maximization aims at improving profitability,
maintaining the stability and reducing losses and inefficiencies.
Profit in this context can be seen in 2 senses.

1. Profit maximization for the owner.

2. Profit maximization is for others.

Normally profit is linked with efficiency and so it is the test of efficiency.

However this concept has certain limitations like ambiguity i.e. the term is not
clear as it is nowhere defined, it changes from person to person.
2. Quality of profit - normally profit is counted in terms of rupees. Normally
amt earned is called as profit but it ignores certain basic ideas like wastage,
efficiency, employee skill, employee’s turnover, product mix, manufacturing
process, administrative setup.
3. Timing of benefit / time value of profit - in inflationary conditions the value
of profit will decrease and hence the profits may not be comparable over a
longer period span.
4. Some economists argue that profit maximization is sometimes leads to
unhealthy trends and is harmful to the society and may result into
exploitation, unhealthy competition and taking undue advantage of the
position.

WEALTH MAXIMISATION - One of the traditional

approaches of financial management , by wealth maximization we mean the

accumulation and creation of wealth , property and assets over a period of
time thus if profit maximization is aimed after taking care , of its limitations it
will lead to wealth maximization in real sense, it is a long term concept based
on the cash flows rather than profits an hence there can be a situation
where a business makes losses every year but there are cash profits because
of heavy depreciation which indirectly suggests heavy investment in fixed
assets and that is the real wealth and it takes into account the time value of
money and so is universally accepted.

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IMPORTANT FUNCTIONS OF THE FINANCIAL MANAGER:
The important function of the financial manager in a modern business consists
of the following:
1. Provision of capital: To establish and execute programmes for the
provision of capital required by the business.
2. Investor relations: to establish and maintain an adequate market for the
company securities and to maintain adequate liaison with investment
bankers, financial analysis and share holders.
3. Short term financing: To maintain adequate sources for company’s
current borrowing from commercial banks and other lending institutions.
4. Banking and Custody: To maintain banking arrangement, to receive, has
custody of accounts.
5. Credit and collections: to direct the granting of credit and the collection
of accounts due to the company including the supervision of required
arrangements for financing sales such as time payment and leasing
plans.
6. Investments: to achieve the company’s funds as required and to
establish and co-ordinate policies for investment in pension and other
similar trusts.
7. Insurance: to provide insurance coverage as required.
8. Planning for control: To establish, co-ordinate and administer an
adequate plan for the control of operations.
9. Reporting and interpreting: To compare information with operating
plans and standards and to report and interpret the results of operations
to all levels of management and to the owners of the business.
10. Evaluating and consulting: To consult with all the segments of
management responsible for policy or action concerning any phase of
the operation of the business as it relates to the attainment of
objectives and the effectiveness of policies, organization structure and
procedures.
11. Tax administration: to establish and administer tax policies and
procedures.
12. Government reporting: To supervise or co-ordinate the preparation of
reports to government agencies.
13. Protection of assets: To ensure protection of assets for the business
through internal control, internal auditing and proper insurance
coverage.

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 WHAT IS WEIGHTED AVERAGE COST OF CAPITAL?

The term cost of capital means the overall composite cost of capital defined as
“weighted average of the cost of each specific type of fund. The use of
weighted average and not the simple average is warranted by the fact that
proportions of various sources of funds in the capital structure of a firm are
different.

Therefore the overall cost of capital should take into account the weighted
average. The weighted cost of capital based on historical weights takes into
account a long-term view.

The term cost of capital, as the acceptance criterion or investment proposals,

is used in the sense of the combined cot of all sources of financing. This is
mainly because focus is on the valuation of the firm as a whole. It is related to
the firm’s objective of wealth maximization.

Thus, the weighted average cost of funds of a company is based on the mix of
equity and loan capital and their respective costs. A distinction is usually
drawn between the average cost of all funds in an existing balance sheet and
the marginal cost of raising new funds.

WHAT IS OPERATING CYCLE FOR WORKING CAPITAL?

The operating cycle is the length of time between the company’s outlay on
raw materials, wages and other expenditures and the inflow of cash from the
sale of the goods. In a manufacturing business, operating cycle is the average
time that raw materials remain in stock less the period of credit taken from
suppliers, plus the time taken for producing the goods, plus the time goods
remain in finished inventory, plus the time taken by customers to pay for the
goods.

Operating cycle concept is important for management of cash and

management of working capital because the longer the operating cycle the
more financial resources the company needs. Therefore, the management has
to remain cautious that the operating cycle should not become too long.

The stages of operating cycle could be depicted through the figure given:
CASH (Ultimate Stage).

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Sundry Debtors Raw materials
(Period of credit Stage I (Period of Turnover
taken by customers) of raw material stock)

Stage
Stage IV

II
Stage III
Finished goods Work-in-progress
(Period of turnover (Period in production)
of finished goods)

The above figure would reveal that operating cycle is the time that elapses
between the cash outlay and the cash realization by the sale of finished goods
and realization of sundry debtors. Thus cash used in productive activity, often
some times comes back from the operating cycle of the activity. The length of
operating cycle of an enterprise is the sum of these four individual stages i.e.
components of time.

CASH BUDGETING

1. Cash Budget shows the policy and programme of cash inflows and
outflows to be followed in a future period under planned condition.

2. Cash Budget usually of 2 parts gives detailed estimate of cash receipts

and cash distribution. Estimate of cash receipts budget on cash
incoming. Estimate of cash distribution based on cash outgoing.

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 3. Cash Budget is a tool of control since it represents actions which can be
shaped to will so that it can be suited in the conditioning which may or
may not happen.

4. Cash Budget begins when Cash Forecasting ends. Cash Forecasting is

convince in Cash Budget.

5. Cash Budget has a limited scope.

6. Cash Budget denotes a definite target.

CASH FORECASTING:

1. Cash Forecast is a main estimate of cash balance likely to happen under

anticipated conditions using a specified period of time.

2. Cash Forecasting is an estimate showing amt of cash which would be

available in future period.

3. Cash forecast being statement of future event does not connote any
sense of control.

4. Cash Forecasting is a preliminary step for Cash Budgeting. It ends with

the forecast of likely cash balances.

5. Cash Forecast is a wider scope.

6. Cash Forecasting denotes some degree of flexibility.

LEVERAGES

The employment of an asset or source of funds for which the firm has to pay a
fixed cost or fixed return maybe termed as leverage.

OPERATING LEVERAGE – Operating Leverage may be defined as the firm’s

ability to use fixed operating costs to magnify the effects of changes in sales
on its earnings before interest and taxes.

FINANCIAL LEVERAGE – Financial Leverage can be defined as the ability of

a firm to use fixed financial charges to magnify the effects of changes in EBIT
on the earnings per share.

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i). Operating Leverage results from the existence of fixed operating expenses
in the firm’s income stream whereas Financial Leverage results from the
presence of fixed financial charges in the firm’s income stream.

ii). Operating Leverage is determined by the relationship between a firm’s

sales revenues and its earnings before interest and taxes. (EBIT)Financial
Leverage is determined by the relationship between a firm’s earnings before
interest and tax and after subtracting the interest component.

iii). Operating Leverage = Contribution

EBIT
Financial Leverage = EBIT
EBT
iv). Operational Leverage relates to the Assets side of the Balance Sheet,
whereas Financial Leverage relates to the Liability side of the Balance Sheet.

v). Operational Leverage affects profit before interest and tax, whereas
Financial Leverage affects profit after interest and tax.
vi). Operational Leverage involves operating risk of being unable to cover
fixed operating cost, whereas Financial Leverage involves financial risk of
being unable to cover fixed financial cost.

vii). Operational Leverage is concerned with investment decisions, whereas

Financial Leverage is concerned with financing decisions.

viii). Operating Leverage is described as a first stage leverage, whereas

Financial Leverage is described as a second stage leverage.

TOOLS USED FOR FINANCIAL ANALYSIS

The various tools used for financial analysis are:

 Fund flow Statement
 Ratio Analysis
 Common Size Statements
 Comparative Financial Statements
 Trend Analysis
 Cash Budget
 Working Capital
 Leverages

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Fund Flow Statement

Fund flow statement also referred to as statement of “source and application

of funds” provides insight into the movement of funds and helps to
understand the changes in the structure of assets, liabilities and equity
capital. The information required for the preparation of funds flow statement
is drawn from the basic financial statements such as the Balance Sheet and
Profit and loss account. “Funds Flow Statement” can be prepared on total
resource basis, working capital basis and cash basis. The most commonly
accepted form of fund flow is the one prepared on working capital basis.

Ratio Analysis

Ratio analysis is the method or process by which the relationship of items or

groups of items in the financial statements are computed, determined and
presented. Ratio analysis is an attempt to derive quantitative measures or
guides concerning the financial health and profitability of the business
enterprise. Ratio analysis can be used both in trend and static analysis. There
are several ratios at the disposal of the analyst but the group of ratios he
would prefer depends on the purpose and the objectives of the analysis.

Accounting ratios are effective tools of analysis. They are indicators of

managerial and overall operational efficiency. Ratios, when properly used are
capable of providing useful information. Ratio analysis is defined as the
systematic use of ratios to interpret the financial statements so that the
strengths and weaknesses of a firm as well as its historical performance and
current financial condition can be determined the term ratio refers to the
numerical or quantitative relationship between items/ variables. This
relationship can be expressed as:

1. Fraction
2. Percentages
3. Proportion of numbers

These alternative methods of expressing items which are related to each other
are, for purposes of financial analysis, referred to as ratio analysis. It should
be noted that computing the ratio does not add any information in the figures
of profit or sales. What the ratios do is that they reveal the relationship in a
more meaningful way so as to enable us to draw conclusions from them.

Common Size Statements

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It facilitates the comparison of two or more business entities with a common
base. In case of balance sheet, Total assets or liabilities or capital can be
taken as a common base. These statements are called “Common
Measurement” or “Component Percentage” or “100 percent” statements. Since
each statement is reduced to the total of 100 and each individual component
of the statement is represented as a % of the total of 100 which invariably
serves as the base.

Thus the statement prepared to bring out the ratio of each asset of liability to
the total of the balance sheet and the ratio of each item of expense or
revenues to net sales known as the Common Size statements.

Comparative Financial Statements

Comparative financial statements is statement of the financial position of a

business so designed as to facilitate comparison of different accounting
variables for drawing useful inferences.

Financial statements of two or more business enterprises may be compared

over period of years. This is known as “inter-firm comparison”
Financial statements of particular business enterprise maybe compared over
two periods of years. This is known as “inter-period comparison”.

Trend Analysis

Trend analysis is employed when it is required to analyze the trend of data

shown in a series of financial statements of several successive years. The
trend obtained by such an analysis is expressed as percentages. Trend
percentage analysis moves in one direction either upwards or downwards,
progression or regression. This method involves the calculation of percentages
relationship that each statement bears to the same item in the base year.

The base year maybe any one of the periods involved in the analysis but the
earliest period id mostly taken as the base year. The trend percentage
statement is an “analytical device for condensing the absolutely rupee data”
by comparative statements.

Cash Budget

Cash budget is a forecast or expected cash receipts and payments for a future
period. It consists of estimates of cash receipts, estimate of cash
disbursements and cash balance over various time intervals. Seasonal factors

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must be taken into account while preparing cash budget. It is generally
prepared for 1 year and then divided into monthly cash budgets.

Working Capital

Working capital is the amount of funds held in the business or incurring day to
day expenses. It is also termed as short term funds held in the business. It is
ascertained by finding out the differences between total current assets and
total current liabilities. Working capital is a must for every organization. It is
like a life blood in the body. It must be of sufficient amount and should be
kept circulated in the different forms of current assets and current liabilities.
The success of organization depends upon how successfully the circulation of
short term fund is maintained smoothly and speedily. Working capital is also
compared with the water flowing in the river as the water is always flowing it
is pure water similarly working capital should be kept circulated in different
short term assets.

Leverages

The employment of an asset or source of funds for which the first firm has to
pay a fixed cost or fixed return may be termed as leverage.

Operating leverages: is determined by the relationship between firms, sales

revenue and its earnings before interest and taxes (EBIT) which are generally
called as Operating profits. Operating leverage results from the existence of
fixed operating expenses in the firm’s income stream. the operating leverage
may be defined as the firm’s ability to use fixed operating cost to magnify the
affects of charges In sales on its earnings before interest and taxes.

Financial leverages: it relates to the financing activities of a firm. Financial

leverage results from the presence of fixed financial charges in the firm’s
income stream. Financial leverages concerned with the effects or changes
in the EBIT in the earnings available to equity shareholders. It is defined
as the ability of a firm to use fixed financial charges to magnify the effects
or changes in EBIT on the earnings per share.

SOURCES OF FINANCE

Sources of Short term and long term finance

The business requires two types of finance namely:

1. Short term finance
2. Long term finance
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Short term finance is concerned with decisions relating to current assets and
current liabilities and is also called as working capital finance.
Short term financial decisions typically involve cash flows within a year or
within the operating cycle of the firm. Normally short term finance is for a
period up to 3 years.

The main sources of short term finance are:

1. Cash credit
2. Short term loans from financial institutions
3. Bill Discounting
4. Letter of credit
5. Inter-corporate deposits
6. Commercial papers
7. Factoring
8. Working capital advance by commercial banks

1. Cash Credit:
Cash Credit facility is taken basically for financing the working capital
requirements of the organization. Interest is charged the moment cash credit
is credited to the Bank A/C irrespective of the usage of the Cash Credit.

2. Short term loans from financial institutions: Bank overdraft

3. Bill Discounting:
Bill Discounting is a short term source of finance, whereby Bills Receivable
received from debtors is in cashed from the bank at a discounted rate.

4. Letter of credit
Letter of credit is an indirect form of working capital financing and banks
assume only the risk, the credit being provided by the supplier himself.
A letter of credit is issued by a bank on behalf of its customer to the seller. As
per this document, the bank agrees to honor drafts drawn on it for the
supplies made to the customer. I f the seller fulfills the condition laid down in
the letter of credit.

5.Inter- corporate Deposits

A deposit made by one company with another, normally for a period of six
months is referred to as an ICD ie. Short-term deposits with other companies
are a fairly attractive form of investment of short term funds in terms of rate
of return.
These deposits are usually of three types:
a. Call deposits: A call deposit is withdraw able by the lender on a given
days notice.

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 b. Three-months Deposits: These deposits are taken by the borrowers to
tied over a short term cash inadequacy
c. Six-month Deposits: Normally lending companies do not extend
deposits beyond this time frame. Such deposits are usually made with
first-class borrowers.

6. Commercial papers
A company can use commercial papers to raise funds. It is a promissory note
carrying the undertaking to repay the amount or/ on after a particular date.

7. Factoring
A factor is a financial institution which offers services relating to management
and financing of debts arising form credit sales. Factoring provides resources
to finance receivables as well as facilitates the collection of receivables.
There are 2 banks, sponsored organizations which provide such services:

a. SBI factors and commercial services LTD

b. Canbank factors LTD, started operations since the beginning of 1997.

8. Working capital advance by commercial banks

Since the above sources do not permit the use of funds, for a longer period of
time, the business has to seek further sources, if the need is for a longer
period of time, i.e. This extends up to 3 years and above.

When a firm wants to invest in long term assets, it must find the needs to
finance them. The firm can rely to some extent on funds generated internally.
However, in most cases internal resources are not enough to support
investment plans. When that happens the firm may have to curtail investment
plan or seek external funding. Most firms choose to take external funding.
They supplement internal funding with external funding raise from a variety of
sources.
The main sources of long term finance can broadly divided into:

Internal sources include:

a. Share capital (Equity shares and preference shares)
b. Reserves and Surplus
c. Personal loans and advances from owners called as ‘Quasi Capital’
External sources include:

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 a. Term loan from banks, financial institutions and international bodies
like International Monetary Funds, World Bank, Asian Development
Bank.
b. Debentures
c. Loans and advances from friends and relatives
d. Inter- Corporate Deposits
e. Asian Depository Receipts / Global Depository Receipts
f. Commercial Papers.
The short term or long term finance is a function of financial management.
The good and efficient management is that which can raise the funds
whenever required and at the most competitive terms and conditions.
Raising of funds either internally or externally requires a professional
approach and also complying with so many legal, technical and statutory
requirements prescribed by the Companies Act, Securities Exchange Board
Of India, Stock Exchanges Authorities and also allied laws like Income Tax,
Foreign Exchange Management Act, Banking Regulations Act, etc.

CONTENTS OF THE CAPITAL STRUCTURE

The capital structure includes Funds received from the owners of the business
i.e. the Shareholders and therefore called as:

• Share holders fund

• Proprietor fund
• Owners fund
The share holders fund are further classified into

 Share Capital: Equity and Preference

 Reserves and Surplus: General reserve, etc

 Fictitious assets: Preliminary expenses etc

The capital structure also includes Borrowed Funds which are further divided
into:

 Secured Loans (Bank loans, debentures, etc)

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  Unsecured loans ( loans from friends and relatives)

The Result of which is: The Capital employed i.e. the total long term funds
supplied by the creditors and owners of the firm. It can be computed in 2
ways. First as mentioned above – the non-current liabilities plus owner’s
equity. Alternatively its is equal to net working capital plus fixed assets.

Kd( before tax) = R The format of the capital structure will

further illustrate the meaning.
Kd ( After tax) = R ( 1-t)
(Refer to choudhari and chopde book
for the format)
Ke = Dividend * 100
Net proceeds

Trading on Equity
Trading on Equity refers to the practice of using borrowed funds, carrying a
fixed charge, to obtain a higher return to the Equity Shareholders.
With a larger proportion of the debt in the financial structure, the earnings,
available to the owners would increase more than the proportionately with an
increase in the operating profits of the firm.

This is because the debt carries a fixed rate of return and if the firm is able to
earn, on the borrowed funds, a rate higher than the fixed charges on loans,
the benefit will go the shareholders. This is referred to as “Trading on Equity”

The concept of trading on equity is the financial process of using debt to

produce gain for the residual owners or the equity shareholders. The term
owes its name also to the fact that the equity supplied by the owners, when
the amount of borrowing is relatively large in relation to capital stock, a
company is said to be trading on equity, but where borrowing is comparatively
small in relation to capital stock, the company is said to be trading on thick
equity. Capital gearing ration can be used to judge as to whether the
company is trading on thin or thick equity.

Illustration
PARTICULARS A B C A B C
EQUITY 200 200 200 800 600 200
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 DEBT@15% 800 800 800 200 400 800
TOTAL 1000 1000 1000 1000 1000 1000
EBIT 300 400 200 300 300 300
LESS:INTERSET@15% 120 120 120 30 60 120
NPBT 180 280 80 270 240 180
LESS:TAX@35% 63 98 28 94.50 84 63
NPAT 117 182 52 175.50 156 117
RETURN ON
EQUTIY 58.50 91 26 21.94 26 58.50
%INC/DEC IN EBIT - 33.33 (33.33)
%INC/DEC IN ROE - 55.56 (55.56)

RECEIVABLES MANAGEMENT
The management of accounts receivables management deals with viable
credit and collection policies. A very liberal credit policy will increase sales and
also bad debt losses. On the other hand a conservative credit policy will
reduce bad debt losses but also reduce sales. A good credit policy should seek
to strike a reasonable balance between sales and bad debt losses.

The objective of receivables management is to promote sales and profits until

that point is reached where the returns that the firm gels from funding of
receivables is less than the cost that the firm has to incur in order to fund
these receivables. This, the purpose of receivables is directly connected with
the firms objective of making credit sales.

The following aspects of receivables management are important:

(A) Credit Policy: Credit policy means the decisions with regard to the credit
standards, i.e. who gets credit and up to what amount and on what specific
terms. The firms credit policy influences the sales level, the investment .level,
in cash, inventories, accounts receivables and physical equipments, bad debt
losses and collection costs. The various factors associated with credit policy
are:

(i) Credit Standards

(ii) Credit Period
(iii) Cash Discount
(iv) Collection Programme.

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Credit Standard means classification of customers to whom credit can not
be expended or can be extended. A firm can take the help of credit rating
agencies for this purpose.

Credit Period means the length of time customers are allowed to pay for
their purchases. It may vary from 15 days to 60 days.

Cash Discount is generally offered to induce prompt payment by the

customers, credit terms provide the percentage of discount and the period
during which it may be available, for example, credit terms of 2/10 net 30
means that a discount of 2 percent is offered if the payment is made by the
10th day otherwise the full payment is due by the 30th day.

The Collection Programme means the collection effort of a firm as decided

by the credit policy. The objective of the collection policy is to collect the
receivables in time. The collection programme consists of the following
details:

(1) Monitoring the state of receivables,

(2) Dispatch the letters to customers, whose due date is approaching,
(3) communicate the customers by telephone at about the due date,
(4) Threat of legal action to overdue accounts,
(5) Actual legal action against overdue accounts.

(B) Credit Evaluation: Credit evaluation means a review of a prospective

customer by obtaining the information to judge the customers willingness and
ability to pay his debt. In judging the credit worthiness of an applicant the
three basic factors which should be considered are, character, capacity and
collateral. The character refers to the willingness of the customer to honour
his obligations. The capacity ' refers to the ability of a customers to pay on
time and the collateral represents the security offered by him in the form of
mortgages. A firm can use different ways to judge the creditworthiness of an
applicant. Some of the ways are as follows:

- Analysis of financial statements

- obtaining of bank certificate
- Analysis of past experience
- Numerical credit scoring.
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(C) Credit Granting Decision: Credit evaluation helps to judge the credit
worthiness of a prospective customer. Credit granting decision is a procedure
of final decision whether to grant credit to the prospective customer or not.
The decision to grant credit or not depends upon the (cost benefit analysis.
The manager can form a subjective opinion based on credit evaluation about
the chance of getting payment and the chance of not getting payment. The
relative chances of getting the payment or not getting the payment are at the
back of his mind while taking such a decision.

CONCEPTUALS QUESTIONS:

Net worth: Net worth means total equity including reserves and surplus less
intangible assets like goodwill.

(FA+CA) – (CL & Borrowed funds).

Capital employed: Capital employed is total shareholders fund and borrowed
fund. In other words, it means total sources. The formula for capital employed
is:

Capital employed=Share capital + reserves & surplus + P&L a/c (cr) +

loans (borrowed funds).

Return on capital employed: Return on capital employed is the return on

total resources or profitability on the overall investment viz total resources
utilized by the business. Total resources employed or total capital employed
means the total funds at the disposal of the business.
Common size statement: The determination of trends and comparisons of
amounts are facilitated by use of percentage of figures instead of rupee
amount. The amounts and accounts in financial statements are reduced to %
and these % are presented for comparison purpose. Such statements are
called common size statements.
Ratio analysis: Ratio analysis is the process of computing, determining and
presenting the relationships between items or group of items in the financial
statements through accounting ratios. An analysis is normally undertaken for
the purpose of projecting financial position or profitability, knowledge of
trends is usually more significant than knowledge of present status only. An
analysis of trends through ratio analysis helps in appraisal of financial
conditions, efficiency and profitability of a business. Ratio analysis helps to
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relate information in the financial data in a meaningful manner. It facilitates
comparison.

Q) The following financial results indicate a mismatch between sales

and profit, an increase in sales is followed by decrease in profit or vice
versa. Discuss various possible results.
Ans) An increase in sales is followed by a decrease in profit or vice versa. It
indicates that although sales might have increased, the cost of sales has
increased much more that is why the profits have decreased. It could be
possible that the operating expenses, administrative expenses and other
expenses might have increased at a higher rate than the increase in sales so,
the profit will definitely decrease. Another reason could be an increase in the
cost of production which decreases the profit. It can be also that the sales
might decrease and the profit increase. This may be decrease in operating
cost or decrease in the cost of raw materials.
Q) State any 3 reasons for the changes in:
1) Expense ratio.
2) Current ratio.

A) a) Expense ratio is a profitability ratio, related to sales which can be

computed by dividing expenses by sales.
Here the term expenses includes:-
i) Cost of goods sold
ii) Administrative expenses
iii) Selling and distribution expenses
iv) Financial expenses

The expenses ratio is closely profit margin, gross as well as net. It is very
important for analyzing the profitability of a firm. A low expenses ratio is
favourable whereas a high expenses ratio is unfavourable. The implications
of a high expenses ratio is that only a relatively small percentage share of
sales is available for meeting financial liabilities like interest, tax &
dividends and so on.

Thus, an increase in a company’s expenses ratio would leave the company

in a financial crunch.

An analysis of the factors responsible for a low ratio may reveal changes in
the selling price on the operating expenses. It is likely that individual items
may behave differently.

While some operating expenses may show a rising trend, others may
record a fall. The specific expenses ratio for each of the item of operating
may be calculated. These ratios would identify the specific cause.

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 To, illustrate, an increase in selling expenses may be due to a number of
reasons like:
i) General rise in selling expenses.
ii) Inefficiency of the Marketing department leading to
uncontrolled promotional and other expenses.
iii) Growing competition.
iv) Ineffective advertising.
v) Inefficient utilization of resources.
b) Current ratio:

The current ratio is the ratio of total current assets to total current
liabilities. The calculation is done by using the formula:

Current assets
Current ratio=
Current liabilities
The current assets are those can be converted into cash within a short period
of time during the ordinary course of business of a firm, whereas the current
liabilities include liabilities which are short term obligations to be met within a
year. Thus any change in the composition of current assets &/or liabilities will
lead to a change in the current ratio.

The current ratio of a firm its short term solvency i.e. the ability to meet short
term obligations. The higher the larger is the amount of rupees available per
rupee of current liability, the more is the firm’s ability to meet current
obligations & assures greater safety of funds of short term creditors.

The flow of funds through current assets and liabilities account is quite
inevitably uneven. Current assets might shrink due to reasons like: - i) bad
debts, ii) inventories becoming obsolete or unsaleable, iii) occurrence of
unexpected losses in marketable securities etc.

A firm should have a satisfactory and a reasonable current ratio [2:1 is

considered to be satisfactory]. A satisfactory ratio depends upon the
development of the capital market & the availability of long term funds to
finance current assets, the nature of industry and so on. Thus the current
ratio varies with variations in such factors.

The nature of the industry is one of the major cases for difference in the
current ratio. For instance, public utility companies generally have a very little
need for current assets. The wholesale dealers, on the other hand, purchasing
goods on a cash/credit basis for a very short period but selling to retailers on
credit basis, require a higher current ratio.

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Q) As a creditor or investor or finance manager suggest any 3 ratios
to be used for analysis with reasons.
Ans) Ratio analysis is a tool of financial analysis used to interpret the financial
statements so that the strengths & weaknesses of a firm as well as its
historical performance & current financial condition can be determined. Ratios
are used for comparison with related facts. Comparison involves i) trends
ratio, comparison of ratios of a firm over time. ii) inter-firm comparison, iii)
comparison of items within a single year’s financial statement of a firm & iv)
comparison with standards or plans.
Ratios e classified into 4 broad groups:-
i) Liquidity ratio
ii) Capital structure/leverage ratio
iii) Profitability ratios &
iv) Activity ratios.

The use of following ratios is suggested:-

Firstly, the liquidity ratio as adequate liquidity is quite important since it

indicates the firm’s ability to meet current/short term obligations. Creditors
are interested in the short term solvency of a firm.

Current ratio is one important component/type or liquidity ratio. It measures

firm’s short term solvency i.e. its ability to meet short term obligations by
comparing the current assets and current liabilities. The higher the current
ratio, the larger the amount of rupees available per rupee of current liability,
the more is the firm’s ability to meet current obligations & assures greater
safety of funds of short term creditors.

Secondly the leverage/capital structure ratio. These ratios throw light on the
long term solvency of a firm. It judges the soundness of a firm in terms of its
ability to pay the interests regularly to long term creditors & repayment of
principal on maturity.

Among the leverage ratios, the debt-equity is one of the important ones. It
shows the relationships between borrowed bunds and owner’s capital to
measure the long term financial solvency of the firm. This ratio reflects the
relative claims of the creditors & shareholders against the assets of the firm.
Alternatively, it includes the relative proportions of debt & equity in financing
the assets of the firm. It can be expressed as follows:

Debt-Equity ratio= Long term debt

Shareholder’s equity
Or
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 Total debt

Shareholder’s equity.

The D/E ratio is thus, the ratio of the amount invested by outsiders to the
amount invested by the owners of the business.

It is an important tool of financial analysis to appraise the financial structure

of a firm. It has important implications from the view point of creditors,
owners & the firm itself.

A high ratio shows a large share of financing by the creditors of the firm while
a lower ratio implies smaller claim by creditors. It indicates the margin of
safety to creditors.

For ex: If the D/E ratio is 2:1, it implies for every rupee of outside liability, the
firm has two rupees of the owner’s capital. Hence there is a safety of margin
of 66.67% available to the creditors of the firm. Conversely if the D/E ratio is
1:2, it implies low safety of margin for the creditors.

A high D/E ratio has equally serious implications from the firm’s point of view.
It would affect the flexibility of operations of the firm, restrict the borrowings
etc. the shareholders would however gain in 2 ways:-
i) with a limited stake they would be able to retain control of the firm.
ii) The returns would be magnified.
A low D/E ratio would have just the opposite implications.

Thirdly, the profitability ratios. The creditors (long term/short term), the
owners & the management of the company. The management is eager to
measure its operations efficiently. Similarly, owners invest their in the
expectation of reasonable returns. Both these factors depend ultimately on
the profits earned by it which can be measured by its profitability ratios.

Profitability ratios can be determined on the basis of either sales or

investments.

1) Related to sales:
a) Profit margin [gross & net]:- It measures the relationship between
profit & sales of a firm.
b) Expenses ratio: - It measures the relationship between expenses
like administration, selling & distribution, financial etc & the sales
of the firm.

2) Related to investments:-
a) Return on investments
i) Return on assets [compare net profits & assets].
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 ii) Return on capital employed [compare profits & capital
employed]
ii) Return on shareholder’s equity [measure the returns on
owner’s funds]

Q. What is the effect of the following on the funds flow statement?

Ans. Transfer to reserve: Transfer of profits to general reserve the journal

entry is
Profit and loss appropriation a/c Dr
To general reserve a/c

This transaction affects

i) profit and loss appropriation a/c
ii) general reserve a/c

Both the accounts belong to the non current category and hence there is no
flow of fund. Increase in any of the reserves on account of transfer from P&L
a/c is to be added back to the profits to ascertain funds from operations. If
increase is on account of adjustment of profits on non current accounts it
would not affect the fund. Similarly if the decrease in reserves is on account of
adjustment of loss on non current assets, it would not affect the funds.

a) Depreciation: It means decrease in the value of asset due to wear and

tear, lapse of time, obsolescence. Depreciation is taken as an operating
expense. While calculating funds from operations the accounting entries
are

i) Depreciation a/c Dr.

To fixed assets a/c

ii) Profit and loss a/c Dr.

To depreciation a/c

Thus effectively the P&L a/c is debited while the fixed asset a/c is credited
with the amount of depreciation. Since both P&L a/c and the fixed asset
a/c are non current accounts depreciation is a non fund item. It is neither
a source nor an application of funds. It is added back to operating profit to
find out funds from operation. Since it has already been charged to profit
but it does not decrease funds from operations. Depreciation should not,
therefore be taken as a source of funds.

However depreciation can be taken as a source of funds in a limited sense.

This is mainly because it helps to consumer funds by reducing the profits
available for dividends and also by reducing the tax liability. Depreciation
charge unlike other expense is paid by the company to itself. Therefore
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depreciation is reduced as a non cash item and it does not affect the funds
from operations of an accounting period.

b) Proposed dividend: It may be taken as a current liability. In such a case

it will appear as one of the items decreasing working capital in the schedule
of changes in working capital. It will not be shown as an application of
funds when dividend is paid later on.

Proposed dividend may simply be taken as an appropriation of profit. In

such a case proposed dividend for the current year will be added it to
current year’s profit in order to find out the funds from operation if such
amount of dividend has already been charged to profits. Proposed dividend
will be shown as an application of funds.

c) Interim dividend: Payment of dividend is an application of funds. In the

case of interim dividend the following entry is passed

Interim dividend a/c Dr

To bank a/c

Interim dividend is transferred to P&L a/c by the following entry

P&L a/c Dr
To interim dividend a/c

The composite entry is

P&L a/c Dr
To bank a/c

As the transaction affects the P&L a/c (a non current item). Payment of
interim dividend results in application of funds.

d) Provision of tax: It is an application of funds and as such it appears in

the funds flow statement. Provision for tax may be treated as a current
liability. When tax provision is treated as a current liability, it forms a
part of the working capital calculations. In that case tax paid will not be
treated as an application of funds.

The second alternative is to treat provision for tax as a non current

liability. In that case the following entries are passed
P&L a/c Dr
To provision for tax a/c

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 When the assessment is completed and tax is paid the amount of tax
paid is debited to provision for tax and is treated as an application and
the following entry is passed
Provision for tax a/c Dr.
To bank a/c

Q. What are the precautions to be taken during trend analysis?

Ans. During the calculation of trend analysis the following precautions

should be taken:

i) There should be consistency in the principles and practices followed

by the organizations through out the period for which analysis is
made.
ii) The base year should be normal i.e. representative of the items
shown in the statement.
iii) It should be calculated only for the items which are having logical
relationship with each other.
iv) It should be studied after considering the absolute figures on which
they are based.
v) Figures of the current year should be adjusted in the light of price
level changes as compared to the base year before calculating trend
analysis.
vi) The changes in financial data can understood clearly when the % of
change interpreted concurrently with the absolute change.
vii) The changes in incomes should always be studied in the light of
changes in expect items.
viii) Changes should be interpreted with some reservations.
ix) The interpretation of the statements should be done in the light of all
possible factors which might have brought about such changes.

Thus the above precautions have to be taken during the calculations of trend
analysis.

Q. Give any three objectives of financial analysis?

Ans. Financial management analysis is an integral part of interpretations of

results disclosed
by financial statements. It supplies to decision makers crucial financial
information and points out the problem areas which can be investigated
financial statement analysis involves regrouping of the data suitably by
arithmetic operations. Financial statements may be analyzed with a view to
achieve the following purposes:

-27-
 1) Profitability analysis: Users of financial statements may analyze financial
statements to decide past and present profitability of the business.
Prospective investors may do profitability analysis before taking a
decision to invest in the shares of the company.

2) Liquidity analysis: Suppliers of goods moneylenders and financial

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

3) Solvency analysis: It refers to analysis of long term financial position of

a company. This analysis helps to the ability of a company to repay its
debts. For this purpose, financial structure, interest coverage is
analyzed.

Q. Differentiate between static and dynamic analysis.

Ans.

SR.NO Dynamic analysis Static analysis

1. It requires financial It requires financial statements
statements of 2 or more of one year.
years.
2. It gives information in It gives information in
absolute as well as percentage form only.
percentage form.
3. It deals with same item of Ti deals with different items of
different years. the same year.
4. It is used for times series It is used for cross section
analysis. analysis.

Q. State any 3 uses of common size statement, comparative

statement, trend analysis and ratio analysis?

Ans.Use of common size statement:

1. Common size analysis reveals the sources of capital and all other
sources of funds and the distribution or use or application of the
total funds in the assets of a business enterprise.
2. Comparison of common size statements over a number of years
will clearly indicate the changing proportions of the various
components of assets, liabilities, costs, net sales and profits.

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 3. Comparison of common size statements of 2 or more enterprises
in the same industry or that of an enterprise with the industry as
a whole will assist corporate evaluation and ranking.

Uses of comparative statement:

1. These statements are very useful to the financial analysts because they
indicate the direction of the movement of the financial position and
performance over the years.

2. These statements can also be used to compare the position of the firm
every month or every quarter. They can be prepared to facilitate
comparison with the financial position of other firms in the same
industry or with the average performance of the entire industry. Such
comparisons facilitate identification of ‘trouble spots’ in a company’s
working and taking corrective measures.

3. Comparative statements present a review of the past activities and their

cumulative effect on the financial position of the concern.

Uses of trend analysis:

1. Trend analysis indicate the increase or decrease in an accounted item
along with the magnitude of change in percentage which is more
effective than absolute data.

2. The trend analysis facilitates an efficient comparative study of the

financial performance of a business enterprise over a period of time.

Uses of ratio analysis:

1. The relation between 2 or more financial data brought out by an
accounting ratio is not an end in itself. They are means to get to know
the financial position of an organization.

2. Industrial ratios may provide valuable information only when they are
studied and compared with several other related ratios.

3. Ratio analysis will tend to be more meaningful when certain standards

and norms are laid down so that what the ratios indicate can be
compared with the said standards.

Q. Difference between fund flow and cash flow statement.

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 Cash flow statement Fund flow statement
1. It shows net change in the position It shows change in the position of working
of cash and cash equivalents. capital.
2. Cash flow statement is based on Fund flow statement is based on broader
narrower concept of funds i.e. cash concept of funds i.e. working capital.
and cash equivalent.
3. It is now mandatory for all the It is not mandatory and it is not being used
listed companies and is more by the companies.
widely used in India or abroad.
4. Cash flow statement classifies and Whereas such a meaningful classification
highlights the cash flows into 3 is not used in fund flow statement.
categories ‘operating activities’,
‘investing activities’, and ‘financing
activities’.
5. In cash flow statement of changes In fund flow statement of changes in
in working capital is not prepared working capital is prepared.
as the changes in working capital
are adjusted for ascertaining cash
generated from operations.
6. In cash flow statement decrease in In fund flow statement decrease in current
current liability or increase in liability or increase in current asset brings
current asset results in decrease in increase in working capital and vice-versa.
cash and vice-versa.

TREASURY BILLS:
Treasury bills are obligations of the government. They are sold on a discount
basis for that reason. The investor does not receive an actual interest
payment. The return is the difference between the purchase price and the face
(par) value of the bill.

The treasury bills are issued only in bearer form. They are purchased,
therefore, without the investor’s name upon them. This attribute makes them
easily transferable from one investor to the next. A very active secondary
market exists for these bills. The secondary market for bills not only makes
them highly liquid but also allows purchase of bills with very short maturities.
As the bills have the full financial backing of the government, they are, for full
practical purposes, risk free. This negligible financial risk and the high degree
of liquidity make their yield lower than on marketable securities. Due their
virtually risk-free nature and because of active secondary market for them,
treasury bills are one of the most popular marketable securities even though
the yield on them is lower.

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 What are inter- corporate deposits?

A deposit made by one company to another normally for a period up to 6

months is referred to as an inter-corporate deposit. Such deposits are usually
of three types:

1. Called deposits: In theory a called deposit is withdraw able by the

lender on a day’s notice. In practice, however the lender has to wait for
at least three days. The interest rate on such deposits may be around
16% p.a.

2. 3 months deposits: More popular in practice, these deposits are taken

by borrower to tide over a short term cash inadequately that may be
caused by one or more of the following factors, disruption in production,
excessive imports of raw materials, tax payments, delay in collection,
dividend payable and planned capital expenditure. The interest rate on
such deposit is around 80% p.a.

3. 6 months deposits: Normally, lending companies do not extend

deposits beyond this time frame. Such deposits usually made with first
class borrowers carry an interest rate of around 20%p.a.

Characteristics of inter-corporate deposits market:

It may be interest to note the following characteristics of the inter-corporate
deposit market:

Lack of regulation: The lack of legal hassles and bureaucratic red tape
makes and inter-corporate transaction very convenient. In a business
environment otherwise characterized by a plethora of rules and regulations,
the evolution of the inter-corporate market is an example of the ability of the
corporate sector to organize itself in the reasonably orderly manner.

Secrecy: The inter-corporate deposit market is shrouded in secrecy. The

brokers regard their lists of borrowers and lenders as guarded secrets.
Tightlipped and circumspect, they are some what reluctant to talk about their
business. Such disclosures, apprehend would result in unwelcome competition
and undercutting of rates.

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Importance of personal contracts: Brokers and lenders argue that they
are guided by reasonably objective analysis of the financial situation of the
borrowers. However the truth is that lending decisions in the inter-corporate
deposits market are based on personal contacts and market information which
may lack reliability. Given the secrecy that shrouded this operation and the
non-ability of hard data can it be otherwise?

Discount of bills:

A bill arises out of a trade transaction. The seller of goods draws the bill on
the purchaser. The bill may be either clean or documentary (a documentary
bill is supported by a document of title to goods like a railway receipt or a bill
of lading) & may be payable on demand or after a usance period which does
not exceed 90 days. On acceptance of the bill by the purchaser the seller
offers it to the bank for discount/ purchase. When the bank discounts/
purchases the bill it releases the funds to the seller. The bank presents the bill
to the purchaser (the acceptor of the bill) on the due date& gets its payment.

The reserve bank of India launched the new bill market scheme in 1970 to
encourage the use of bills as an instrument of credit. The objective was to
reduce the reliance on the cash credit arrangement because of its amenability
to abuse. The new bill market scheme sought to promote an active market for
bills as a negotiable instrument so that the lending activities of a bank could
be shared by the other banks. It was envisaged that the bank, when short of
funds, would sell or rediscount the bills that it has purchased or discounted.
Likewise, a bank which has surplus funds would invest in bills. Obviously for
such a system to work there has to be lender of last resort who can come to
the succour of the banking system as a whole.
This role naturally has been assumed by the reserve bank of India, which
rediscounts bills of commercial banks upto a certain limit. Despite the
blessings & support of the reserve bank of India, the new bill market scheme
has not functioned very successfully in practice.

Objectives of cash management

Motives for holding cash

1. Transaction motive

Firms need cash to meet their transaction needs. The collection of cash
(from sale of goods and services, sale of assets, and additional financing) is
not perfectly synchronized with the disbursement of cash (for purchase of
goods and services, acquisition, of capital assets, and meeting other
obligations. Hence, some cash balance is required as a buffer.

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 2. Precautionary motive

There may be some uncertainty about the magnitude and timing of cash
inflow from sale of goods and services, sale of assets, insurance of
securities. Like wise, there may be uncertainty about cash inflow on
account of purchases and other obligations. To protect itself against such
uncertainties a firm may require some cash balance.

3. Speculative motive

Firms would like to tap profit making opportunities arising from

fluctuations in commodity prices, securing prices, & interest rates. Cash-
rich firms is better prepared to exploit such bargains may carry additional
equity. However for most firms their reserve borrowing capacity &
marketable securities would suffice to meet their speculative needs.

What is cash operating cycle?

The operating cycle can be shortened by the following means.

1. Raw materials procurement:

One should have a good supply network. This means that he should have
a supplier who can provide him with his raw material requirement at the
right time, place and in the required quantity at minimum amount of
time. Thus this also implies that he should be in possession of automated
machines in case the raw materials are large and bulky .this helps in
reducing the time required for the transport and movement of the goods
from one place to another.

2. Production process:
In the production process there should not be any time lag from the time
of actually receiving the raw materials and the starting of production
process. This means as soon as the materials arrive they should be
introduced in the production process. This therefore meant that the
company will be following the just in time policy(JIT) which simply means
that the requirements of the company will be fulfilled at the time required
thus reducing the work in progress and thus increasing the efficiency of
the company.

3. Finished goods:
The goods once produced should be held in the company’s possession as
the company’s capital would be locked up in these goods. Thus it is
essential that the company sell all these finished goods as soon as
possible so as to allow the company reacquires its capital employed in the
operating cycle.
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4. Receipt of sales:
The receipts of the money from the debtors as soon as possible so as to
regain the money along with the profits.

This is how the operating cycle operates along with how it can be improved so
as to enable the company to regain the money invested in the production of
the goods being produced.
Marketable investments: - Marketable investments are those investments
which are acquired by the company by the employing its surplus funds or cash
temporarily. These investments are short term in nature. These investments
can be disposed off by the company at its free will and thus convert it into
cash as and when the need arises. Hence, these investments are considered
as good as cash, and are often called ‘secondary cash resources’. such
investments are grouped under “current assets”.

Options for investing surplus funds

 Shares and debentures: - the company invests its surplus funds in

the outside corporate securities. i.e. shares and debentures of other
companies. The company gets dividend and interest from these idle
investments.

 Government bonds: - The company can invest its surplus funds in the
various government bonds which will earn them some returns. These
bonds not only beneficial to the government but also to the corporate
business people.

 Intercorporate deposits: - The company can also invest its surplus

funds with another company via deposits these sorts of deposits are
called imtercorporate deposits, the company earns interest on these
investments.

 Expansion: - the company can also utilize its surplus funds by

employing it in it the same business for further expansion of the
business. Expansion of these businesses leads directly or indirectly
through their surplus.

Types of Marketable Securities

Commercial paper:

Commercial paper consists of short term unsecured promissory notes issued

by finance companies and certain industrial concerns. Commercial paper can

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be sold either directly or through dealers. Many large scale companies have
found it profitable because of the volume, to sell their papers directly to
investors, thus bypassing dealers. Among companies selling papers on this
basis are General Electric Credit Corporation and the Ford Motor Credit
Company. Paper sold through dealers is issued by industrial companies and
smaller finance companies. Dealers very carefully screen the creditworthiness
of potential issuers. In a sense, dealers stand behind the paper they place
with investors.
Rates on commercial paper are somewhat higher than rates on treasury bills
of the maturity and about the same as the rates available on banker’s
acceptance. Paper sold directly generally commands a lower yield than a
paper sold through dealers. Usually, commercial papers are sold on discount
basis, and maturity generally ranges from 30 -270 days. Most paper is held to
maturity, for there is essentially no secondary market.0ften direct sellers of
commercial papers will repurchase the paper on request… arrangements may
also be made through dealers for repurchase of paper sold through them.
Commercial paper is sold only in large denominations, usually $100,000.

Negotiable certificate of deposit:

A short term investment, the certificate (CD) is evidence of the deposit of

funds at a commercial bank for a specified period of time and at a specified
rate of interest. The most common denomination is $100,000, so its appeal is
limited to large investors. Money market banks quote rates on CDs; these
rates are changed periodically in keeping with changes in money market
rates. Yields on CDs are greater than those on treasury bills and repose and
about the same as those on banker’s acceptances and commercial paper.
Original maturities of CDs generally range from 30-360 days. A good
secondary market has developed for the CDs of the large money market
banks; default risk is that of the bank rating. Like bankers acceptances,
corporations buy domestic as well as CDs of large foreign banks. The latter is
known as “YANKEE” CDs, and they typically carry a higher expected return.

Eurodollars:

Although most Eurodollars are deposited in Europe, the term applies to any
dollar deposit in foreign banks or in foreign branches of U.S banks. There
exists a substantial, very active market for deposit and leading of Eurodollars.
This market is a wholesale one in that the amounts involved are at least $
100000. Moreover the market is free of government regulations, as it is truly
international scope.

The rates quoted on deposits vary according to the maturity of the deposit,
while the rates on loans depend on maturity and default risk. For a given
maturity, the leading rate always exceeds the deposit rate. The bank makes it
money on the spread. The benchmark rate in this market is 6-month London
-35-
interbrain offer rate. (LIBOR). This is the rate at which banks make loan to
each other. All others borrowers are quoted rates in excess of this rate, such
as LIBOR + 1\2 PERCENT.

As a marketable security, the Eurodollar time deposit is like a negotiable

certificate of deposit. Most deposit have a maturity of, less than a year, and
they can be sold in the market prior to maturity. Call money deposits are
available, allowing investors to get their money back on demand, and there
are 1-day (overnight) deposits. For the large corporation with ready contact
with international money centers, the Eurodollar deposit usually is an
important investment.

Short term municipals:

State and local governments are increasingly providing securities tailored to

the short term investors. One is a commercial paper type of instrument,
where the interest rates reset every week. That is, the security is essentially
floating rate where the weekly reset ensures that market value ill vary
scarcely at all. Some corporations invest in longer term municipal securities,
but the maturity usually is kept within one or two years. A problem with
longer term instruments designed for the corporate treasurer and for
municipal market mutual funds have much better marketability and price
stability.

Factors Determining Cash Needs:

The working capital needs of a firm are influenced by numerous factors. The
important ones are:

• Nature of business.

• Seasonality of operations.

• Production policy.

• Market conditions.

• Conditions of supply.

Nature of business:

The working capital requirement of a firm is closely related to the nature of its
business. A service firm, like an electricity undertaking or a transport
corporation which has a short operating cycle and which sells predominantly
on cash basis, has a modest working capital requirement. On the other hand,
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a manufacturing concern likes a machine tools unit, which has a long
operating cycle and which sells largely on credit, has a very substantial
working capital requirement.

Seasonality of operations:

Firms which have marked seasonality in their operations usually have highly
fluctuating working capital requirements. To illustrate, consider a firm
manufacturing ceiling fans. The sale of ceiling fans reaches a peak during the
summer months and drops sharply during the winter period. The working
capital need of such firm is likely to increase considerably in summer months
and decrease significantly during the winter period. On the other hand, a firm
manufacturing product like lamps, which have even sales round the year,
tends to have stable working capital needs.

Production policy:

A firm marked by pronounced seasonal fluctuation in its sales may pursue a

production policy which may reduce the sharp variations in working capital
requirements. For example, a manufacturer of ceiling fans may maintain a
steady production throughout the year rather than intensify the production
activity during the peak business season. Such a production policy may
dampen the fluctuations in working capital requirements.

Market conditions:

The degree of competition prevailing in the market has an important bearing

on working capital needs. When competition is keen, a larger inventory of
finished is required to promptly serve customers who may not be inclined to
wait because other manufacturers are ready to meet their needs.

Further, generous credit terms may have to be offered to attract customers in

a highly competitive market. Thus, working capital needs tend to be high
because of greater investment in finished goods inventory and accounts
receivable.

If the market is strong and competition weak, a firm can manage with a
smaller inventory of finished goods because customers can be served with
some delay. Further, in such a situation the firm can insist on cash payment
and avoid lock-ups of funds in accounts receivable –it can even ask for
advance payment, partial or total.

Conditions of supply:

The inventory of raw materials, spares, and stores on the conditions of supply.
If the supply is prompt and adequate, the firm can manage with small
inventory. However, if the supply is unpredictable and scant, then the firm, to
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ensure continuity of production, would have to acquire stocks as and when
they are available and carry large inventory on an average. A similar policy
may have to be followed when the raw material is available only seasonally
and production operations are carried out round the year.

Floating-rate preferred stock:

Straight preferred stock is a perpetual security where the dividend can be

omitted by the issuer when its financial conditions deteriorate. For these
reasons, usually we do not think of it as being suitable for marketable security
portfolio of a corporation. However, the corporate investor gains a
considerable tax advantage, in that 70 percent of the preferred stock dividend
is exempt from federal taxation (in U.S.A.). (The full dividend is subject to
state income taxation).

Floating-rate preferred stock, as the name implies, provides a yield which

goes up or down with money market values. It also permits the corporate
investor to reap the advantage of the 70 percent dividend is exempt from
federal tax purposes. One product in this vein is money market preferred
stock (MMP). How does it work?

With MMP, an auction is held every 49 days. This provides the investor with
liquidity and relative price stability as far as interest rate risk goes. It does not
perfect the investor against default risk. The new auction rate is set by the
forces of supply and demand in keeping with interest rates in the money
market. A typical rate might be 0.75 times the commercial rate, with more
creditworthy issuers commanding an even greater discount.

As long as enough investors bid at each auction, the effective maturity date is
49 days. As a result, there is little variation in the market price of the
instrument over time. The auction where there are insufficient bidders, there
is default rate for one period that is frequently 110 percent of the commercial
paper rate. In addition, the holder has the option to redeem the instrument at
its face value.

These provisions are attractive to the investor as long as the company is able
to meet the conditions. If the company should altogether default, however the
investor loses. There have been only a few instances of failed auctions and
default.

Portfolio Management:

The decision to invest excess cash in marketable securities involves not only
the amount to invest but also the type security in which to invest, to some

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extent, the two decisions are interdependent. Both should be based on
evaluation of expected net cash flows and the uncertainty associated with
these cash flows. If future cash –flow patterns are known with reasonable
certainty and the yield curve is upward sloping in the sense of longer term
securities yielding more than shorter term ones, a company may wish to
arrange its portfolio so that securities will mature approximately when the
funds will be needed. Such a cash flow pattern gives portfolio, for it is unlikely
that significant amounts of securities will have to be sold unexpectedly.

What are the benefits of holding cash?

These are various reasons that a company may want to hold cash. Some of
the important reasons for holding cash would be to meet immediate and
unexpected expenses that may arise during the course of the running of the
business. Some of these expenses may be attributed to the spending on
stationery or may be on other such miscellaneous such as purchase of
beverages of refreshments for any of the company’s guests.

Q. Explain the implementation of an improvement in the current

ratio from 1 in 1999 to 2.5 in 2000.

Ans) The current ratio is the ratio of current assets to current liabilities. The
current ratio of a firm measures its short-term solvency, that is, its ability to
meet short-term obligations. As a measure of short term/current financial
liquidity, it indicates the rupees of current assets available for each rupee of
current liability/obligation.

The higher the current ratio, the larger is the amount of rupees available per
rupee of current liability, the more is the firms ability to meet current
obligations and greater is the safety of funds of short term creditors.

So, the increase in current ratio from 1 in 1999 to 2.5 in 2000 indicates good
liquidity position of the firm. It indicates that firm has greater working capital
to meet its day to day requirements. The firm can meet its short-term
obligations effectively.

Increase in current ratio means increase in current assets, which may be

either stock or cash or debtors. Increase in stock or any other current asset
indicates good short-term solvency of the firm.

The standard current ratio is 1.33:1 and the firm’s current ratio has increased
from 1 in 1999 to 2.5 in 2000. It indicates that the firm is improving its
current ratio. The firm had current ratio of 1:1 i.e. for every one rupee of
current liabilities current assets of one rupee are available to meet them. But
the firm’s current ratio of 2.5:1 in the year 2000 indicates that for every one
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rupee of current liability, the firm has two and a half times current asset to
meet them, which means more working capital.

This will improve short-term solvency of the firm. The increase in the current
ratio may also due to decrease in current liabilities i.e. creditors, bills payable,
etc.

Q. Which of the financial ratios of a company would you most likely,

refer to in each of the following situations? Give reasons.

a) The company asks you to sell material on credit

In this situation, the short-term solvency position of the company should

be determined. The short-term solvency position is determined by current
ratio. The current ratio is a test of the credit strength and solvency of an
organization. It indicates the company’s ability to meet its day to day
financial obligations. Also the liquid ratio should be considered to know the
immediate solvency position of the company. This ratio shows the firms
ability to meet its immediate obligations promptly. It is necessary to know
the immediate solvency position, as these are possibilities of becoming
cash-insolvent in a very short time, if major parts of the current assets are
locked in inventories.

* Debtors turnover is very important.

b) You are thinking of investing Rs. 25000 in the company’s

debenture

In the above situation, the long-term solvency position of the company

should be determined. The proprietary ratio and debt equity ratio
determines the long-term solvency position of the company. The two points
which should be considered in the given condition

i) Interest to be paid on time.

ii) Investments to be secured (assured return)

The proprietary ratio is a test of the financial and credit strength of the
business. It relates shareholders funds to total assets i.e. total funds. This
ratio determines the long term or ultimate solvency of the company. In
other words, proprietary ratio determines as to what extent the owner’s
interests and expectations are fulfilled from the total investments made in

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 the business operation. The debt service ratio will also be considered. This
ratio is also called as interest coverage ratio.

The purpose of this ratio is to find out the number of times the fined
financial charges are covered by income before interest and tax. It
indicates whether the company will earn sufficient profits to pay
periodically the interests charges. Higher the ratio it is favorable. It shows
that the company will be able to pay interest regularly.

c) You are thinking of investing Rs.25000 in the company’s share.

In this situation, the company should refer to earning per share ratio and
price earning ratio. The 2 main points to be considered under this content
are

1) Payment of dividend

2) Appreciation of investment

Earnings per share represent earnings of the company whether or not

dividends are declared. If there is only one class of shares, the earnings
per share are determined by dividing net profit by the number of equity
shares. If there are both equity and preference shares the net profit
should be reduced by the amount necessary to pay preference dividend.
It indicates the possibility of issue of bonus share in future. In short, the
ratio is used by the investors for evaluating the investment opportunities.
It shows effective utilization of equity capital.

Price earning ratio should also be referred to as it shows whether the

shares of a company are under or over valued. The ratio helps the
investors in deciding about the purchase of shares of a company at a
particular market price. Higher ratio indicates that the investors are
satisfied that the future earnings per share will increase.

*Return on shareholders fund.

*Debt equity ratio.

Q. Explain the solvency and profitability ratios.

Ans.

I. SOLVENCY RATIOS: These ratios analyze short term and immediate

financial position of a business organization and indicate the ability of the
firm to meet its short term commitments (Current Liabilities) out of its

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 short term resources (Current Assets) also known as Liquidity or Credit
Ratios. Solvency Ratios includes:

1) Long Term Solvency ratios:-

a) Proprietary Ratios ⇒ Proprietary Ratio is a test of financial and credit
strength of the business. It relates shareholders funds to total assets i.e.
Total funds. This ratio determines the long term or ultimate solvency of the
company.
Proprietary Ratio = Proprietors Funds
Total Funds
b) Debt Equity ⇒ it expresses the relation between the external equities and
internal equities or the relationship between borrowed capital and owners
capital.
Debt Equity Ratio = Debt
Debt + Equity

c) Capital Gearing Ratio ⇒ Capital Gearing Ratio brings out the relationship
between two types of capital i.e. capital carrying fixed ratio of interest or
fixed dividend and capital that does not carry fixed rate of interest or fixed
dividend.

Capital Gearing Ratio = Securities bearing fixed rate of interest

Shareholders fund

2) Short Term Solvency ratios: -

a) Current Ratio ⇒ Current Ratio is also known as the ‘Working Capital

Ratio’, ‘Solvency Ratio’ or ‘2 in 1 Ratio’. This ratio expresses the
relationship between current assets and current liabilities.

Current Ratio = Current Assets

Current Liabilities
b) Quick Ratio ⇒ Quick ratio is also known as ‘Liquid Ratio’ or ‘Quick Assets
Ratio’ or ‘Acid Test Ratio’ or ‘Near Money Ratio’ or ‘1 to 1 Ratio’. This ratio
is designed to indicate the liquid financial position of an enterprise. Thus,
the ratio shows the firms ability to meet its immediate obligations
promptly. It measures the relationship between quick assets and quick
liabilities.

Quick Ratio = Quick Assets

Quick Liabilities

II. PROFITABILITY RATIOS:

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 These ratios are intended to reflect the overall efficiency of the organization,
its ability to earn a reasonable return on capital employed or on shares issued
and the effectiveness of its investment policies. Profitability Ratios includes:
1) Product
a) Gross Profit Ratio ⇒ Gross profit brings out the relationship between
gross profit and net sales. It is also known as ‘Turnover Ratio’ or ‘Margin’
or ‘Gross Margin Ratio’ or ‘Rate of Gross Profit’. It is expressed as % of net
sales.
Gross profit = Gross Profit × 100
Sales
b) Net Profit Ratio ⇒ Net Profit Ratio indicates the relationship between net
profit and net sales. Net profit can be either operating net profit or net
profit after tax or net profit before tax. This ratio is known as ‘Margin or
Sales Ratio’.

Net Profit can be calculates as:-

Net Profit After Tax × 100

Net Sales

Net Profit Before Tax × 100

Net Sales

c) Operating Ratio ⇒ Operating Ratio is the relationship between cost of

activities and net sales. This ratio brings out the relationship between total
costs of goods sold to net sales.

Operating Ratio = Operating Cost × 100

Net Sales
2) Investment

a) Return on Capital Employed ⇒ This ratio explains the relationship

between total profits earned by the business and total investments made
or total assets employed. This ratio thus measures the overall efficiency
of business operations. This ratio is alternatively known as ‘Return on
Total Sources’.

Return on capital employed = Net profit before interest and tax

× 100
Capital employed

b) Return on Proprietors Fund ⇒ This ratio is alternatively known as

‘Return on Proprietors Equity’ or ‘Return on shareholders investment’ or

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 ‘Investors Ratio’. The ratio indicates the relationship between net profit
earned and total proprietors funds.

Return on Proprietors Fund = Net Profit After Tax × 100

Proprietors Funds

c) Return on Equity Share Capital ⇒ This ratio indicates the rate of earning
on the equity or ordinary share capital. This is expressed as a % or in
absolute monetary terms. Alternatively, this may be expressed as an
amount of return per equity share but as a % of the equity capital, it is
easily understood. This ratio is also known as ‘The Rate of Return on Equity
Capital’.

Return on Equity Share Capital = NPAT – Preference Dividend

Equity Shares Capital
d) Earning per share ⇒ Earning peer share is calculated to find out overall
profitability of the organization. Earnings per share represent earnings of
the company whether or not dividends are declared. If there is only one
class of shares, then EPS are determined by dividing net profit by the no.
of equity shares. If there are both equity and preference shares the net
profit should be reduced by the amount necessary to pay preference
dividend.

Earnings per share = NPAT – Preference Dividend

No. of Equity shares
e) Dividend Payout Ratio ⇒ The purpose of this ratio is to find out the
proportion of earning used for payment of dividend and the proportion of
earning retained. The ratio is the relationship between earning per equity
share and dividend per equity share.

Dividend Payout Ratio = Dividend per equity share

Earning per equity share
Q. Importance of cash flow statement.

Ans.1) An enterprise should prepare a cash flow statement and should

present it for each period for which financial statements are presented.

2) Users of an enterprise’s financial statements are interested in how

the enterprise generates and uses cash and cash equivalents. This is
the case regardless of the nature of the enterprise's activities and
irrespective of whether cash can be viewed as the product of the
enterprise, as may be the case with a financial enterprise. Enterprises
need cash for essentially the same reasons, however, different their
principal revenue-producing activities might be. They need cash to

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 conduct their operations, to pay their obligations, and to provide
returns to their investors.
Q. Funds from operation:
A. It is working capital flow arising out of operating activities. Incase of
non-cash items it is decided without considering the effect of non-cash
operating items as these items represent only book entries. Incase of
non-operating items it is decided without considering the effect of non-
operating items, as these items are not relating to operating activities.

Name any 5 sources of funds & classify them into short-term & long
-term funds?
Ans.)
Issue of equity share & preference shares = Long- term funds.
 Issue of debentures = Long- term fund.
 Receipt of public deposits & other unsecured loans = Short- term
fund.
 Receipt of securities premium = Short- term fund.
 Income from long-term investments = Long-term funds.

Q) Name 3 short-term & 3 long-term applications of funds?

Ans.)

Short term application of funds

1. Premium paid on redemption of preference shares & debentures.

2. Extra ordinary payments & non-recurring losses.
3. Repayment of temporary loan secured & unsecured.

Long term application of funds

1. Redemption of preference shares & debentures.

2. Purchase of fixed assets.
3. Purchase of investments.

Q) Uses of fund flow statements:

Ans.)

 Fund flow statements are prepared for internal & external uses.

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  They are designed to assess the funds available, forecast cash
requirements & to evaluate the investments & financial decisions of a
business entity.

 There are many parties who are interested in the funds flow
statements. Shareholders, investors, bankers, creditors & the
management are among them.

 Primarily, the funds flow statements is to identify the sources &

applications of funds.

Q) Importance & short comings of fund flow statement:

Ans.)
Funds flow statement is a financial statement, which shows as to how a
business entity has obtained its funds & how it has applied or employed
its funds between the opening & closing balance sheet dates(during the
particular year/period.

Importance of funds flow statement:

Funds flow statement is an important analytical tool for external as well

as internal uses of financial statements. The users of funds flow
statement can be listed as under:

1. Managements of various companies are able to review cash

budgets with the aid of funds flow statements. They are extensively used
by the management in the evaluation of alternative finance & investments.
In the evaluation of alternative finance & investment plans, funds flow
statement helps the management in the assessment of long-range
forecasts of cash requirements & availability of liquid resources. The
management can judge the quality of management decisions.
2. Investors are able to measure as how the company has utilized the funds
supplied by them & its financial strength with the aid of funds statements.
They gauge can the company capacity to generate funds from operations.
On the basis of comparative study of the past with the present, investors
can locate & identify possible drains on funds in the near future.

3. Funds statement serve as effective tools to the management for

economic analysis as it supplies additional information, which cannot be
provided by financial statements, based on historical data.

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4. Fund statement explains the relationship between changes in working
capital & net profits. Funds statement clearly shows the quantum of
funds generated from operations.

5. Funds statement helps in the planning process of a company. They are

useful in assessing the resources available and the manner of utilization of
resources.

6. Funds statement explains the financial consequences of business

activities. They provide explicit & clear awareness to questions regarding
liquid & solvency positions of the company, distribution of dividend &
whether the working capital has been effective or otherwise.

7. Management of companies can forecast in advance the requirements of

additional capital & can plan its capital issue accordingly.

8. Fund statement provides clues to the creditors & financial institutions

as to the ability of a company to use funds effectively in the best interest
of the investors, creditors & the owners of the company.

9. Funds statement indicates the adequacy or inadequacy of working

capital.

10. The information contained in fund flow statement is more reliable,

dependable & consistent as it is prepared to include funds generated
from operations & not net profit after depreciation.

11. Funds flow statement clearly indicate how profits have been invested,
whether investments in fixed assets or inventories or ploughed back.

Q) The liquidity of a business is explained by cash flow statement.

Discuss.
Ans.)

In making plans for the more immediate future (short-range financial

planning) the management is vitally concerned with a statement of cash
flows which provides more detailed information. Such a statement is useful
for the management to assess its ability to meet obligations, to trade
creditors, to pay bank loans, to pay interest to debenture holders & dividend
to its shareholders.

Furthermore the projected cash flow statements prepared month-wise or so

can be useful in presenting information of excess in some months & shortage
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of cash in others . By making available such information in advance, the
statement of cash flows enables the management to revise its plans. Cash
flow statements summarizes sources of cash inflows & uses of cash outflows
of the firm during a particular period of time.

In the preparation of cash flow statement all the item that increase/decrease
cash are included but all those items that donot have any effect on cash are
excluded. Hence, it is essentially a tool of short term financial planning. Cash
flow information is useful in assessing the ability of company.

Q) What do you mean by liquidity funds. How can the liquidity of a

firm be assessed?
Ans.) Liquidity of funds means the availability of liquid cash to meet the
immediate commitments. It helps in analyzing the liquidity position of the firm
.Furthermore; we can assess the liquidity of the firm by liquidity ratios. These
ratio analyses short term immediate financial position of a business
organization & immediate ability the firm to meet its short term
commitments. The (current liability) out of its short term resource (current
assets). That is also known as solvency ratio which helps the firm to meet
its immediate obligations promptly.

It measures the relationship between the Quick assets & Quick liabilities.

The quick ratio or liquid ratio is calculated by dividing Quick assets by Quick
liabilities.

Quick Ratio = Quick Assets &

Quick liabilities

C.R. = C.A.
C.L.

It is more of qualitative concept. This ratio is the true test of business or firms
solvency & liquidity position & this will indicate the inventory hold-ups when
studied along with the current ratio.

Q) The liquidity of a business is explained by cash flow statement.

Discuss.
Ans.)
In making plans for the more immediate future (short-range financial
planning), the management is vitally concerned with a statement of cash
flows, which provides more detailed information. Such a statement is useful
for the management to assess its ability to meet obligations to trade creditors,
to pay bank loans, to pay interest to debenture holders & dividend to its
shareholders. Furthermore the projected cash flow statements prepared
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month-wise or so can be useful in presenting information of excess in some
month & shortage of cash in others. By making available such information in
advance, the statement of cash flows enables the management to revise its
plans. Cash flow statements summarize sources of cash inflows & uses of cash
outflows of the firm during a particular period of time. In the preparation of
cash flow statement all the item that increase /decrease cash are included but
all those items which have no effect on cash are excluded. Hence, it is
essentially a tool of short term financial planning. Cash flow information is
useful in assessing the ability of the enterprise to generate cash & cash
equivalent & enables users to develop models to assess & compare the
present value of the future cash flows of different enterprises.

Q) What is short-term solvency & long-term solvency ? How do they

differ? As a shareholder/debenture holder which will you be
concerned about.

Ans.) The short-term solvency position of company indicates the ability of

the company to meet its short-term abilities like payment to creditors,
payment of wages & salaries etc.

Short term solvency position is studied by taking into consideration current

ratio accompanied by liquid ratio.

Long-term solvency position of a company indicates the ability to meet its

long-term liabilities like redemption of debentures, payment of long term
loans etc.

Long-term solvency position is indicated by the proprietary ratio & debt

equity ratio.

As a shareholder/debenture holder one will be concerned about the long-

term solvency position of the company this is because the
shareholders/debenture holders invest their money in long-term funds.
Q) Differentiate between static and dynamic analysis

Dynamic Analysis: (Also Called as Horizontal Analysis):

Financial statements for a number of years are reviewed and analyzed. The
current years’ figures are compared with the standard bases year. The
analysis statement usually contains figures for two or more years and
changes are shown regarding each item, from the base year, usually in the
form of percentage. Such an analysis gives considerable insight into levels
and areas of strength and weaknesses. E.g. Trend Analysis.

Static Analysis: (Also Called as Vertical Analysis):

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Study of quantitative relationship of the various items in the financial
statement on a particular date. For example, the ratios of different items of
costs for a particular period may be calculated with the sales for that
period. Such an analysis is useful in comparing the performance of several
companies in the same group, or divisions or departments in the same
company. Since this analysis depends on the data for one period, this is
not very conducive to proper analysis of the company’s financial position.
E.g. Comparative statements
It may be noted that these two types of analysis are not mutually
exclusive. They can be done simultaneously also.

1. What is opportunity cost of capital?

Opportunity cost of capital is “the rate of return associated with the best
investment opportunity for the firm and its shareholders the will be
foregone if the project presently under consideration by the firm were
accepted.” Its is also called as ‘Implicit Cost’. In case of retained earnings,
it is the income, which the shareholders could have earned if such earnings
would have been distributed and invested by them.

2. Distinguish between cash budget and cash forecast

Cash Budget Cash forecast

Cash Budget is usually prepared Cash forecast is for longer terms
for short periods ranging upto exceeding one year such as 3
one year. years, 5 years, etc.

Objective is to ensure short term Objective is to study sources of

liquidity and avoid default in funds for various future
timely discharge of current requirements.
liabilities.

Thrust is on current assets and Capital receipts and capital

liabilities and maintaining cash expenditure, investments dominate
cushion for safety. this number game.

Usually prepared by junior Usually prepared by senior

management team for perusal of management for perusal of
senior managers. Directors, Owners.

It is working capital It is more of investment planning

management activity. activity.

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3. Distinguish between Cash Flow Statement and Cash Budget:

Cash Flow Statement Cash Budget

Cash flow statement is Cash Budget is prepared based on
prepared based on past estimates of collection and outgo of
data of Income Statement cash.
and Balance sheet.
Is historical in nature. Is futuristic in nature.
Analytical tool. Planning tool.
Is based on real data. Is based on estimates.

4. What are marketable securities?

Marketable securities are short-term investment instruments to obtain a
return on temporarily idle funds. They are securities, which can be
converted into cash in a short period of time, typically few days. To be
liquid, it should have two basic characteristics.

Basic Characteristics of Marketable securities:

Ready market: Ready market reduces amount of time required to convert a
security into cash. Ready market should have breadth (large number of
participants scattered over large geographical area) and depth (ability to
absorb purchase/ sale of large number of securities.)
Safety of principal amount: There should not be any loss of principal
amount invested in the security. Then only it is worth investing in such
securities. Otherwise, the investing firm is anyway better off maintaining
idle cash/ bank balance.
Examples of Marketable securities are: Treasury Bills, Commercial Paper,
Banker’s Acceptance, Repurchase agreements, Inter-corporate Deposits,
Bill Discounting, call market, etc.

5. Lease and hire purchase

Lease: A contract of lease may be defined as “A contract whereby the owner

of an asset (lessor) grants to another party (lessee) the exclusive right to use
the asset usually for an agreed period of time in return for the payment of
rent.”
Important features here are:
1. Owner and User are different
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 2. Depreciation claim is not with the user (lessee) as he is not the owner.
Lessor (owner) claims the depreciation.
3. Lease (rent) payment is a tax-deductible expense.
4. In most transactions, asset is delivered directly to the lessee by the
manufacturer/ supplier. Lessor makes payment to the supplier and
receives rent from lessee in future periods.
5. Lease funded assets do not alter Debt: Equity ratio.

Hire Purchase: In case of Hire Purchase transaction, the goods are delivered
by the owner to another person on the agreement that such person pays the
agreed amount in periodical installment.

Important features here are:

1. Ownership of the asset is transferred to the buyer only on payment of
last installment.
2. Buyer claims depreciation on the asset.

Lease Hire Purchase

Lessor claims depreciation Buyer claims depreciation

On completion of contract On completion of contract

residual (salvage) value goes residual (salvage) value goes
to Lessor to Buyer

In absence of specific Asset is conclusively

agreement otherwise, asset is purchased by the buyer at
to be returned to the lessor the end of the agreement
after the lease period. period.

Lease payment is fully Only interest portion of EMI/

deductible for tax. Hire value is tax deductible.

6. ADR, GDR, ECB

ADR: American depository receipt is a negotiable certificate that

represents a company's publicly traded equity or debt. They are created when
a broker purchases the company's shares on the home stock market and
delivers those to the depository's local custodian bank, which then instructs
the depository bank, to issue Depository Receipts. Depository receipts could

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be traded freely just like any other security, either by exchange or in the
over-the-counter market and could be used to raise capital.

GDR -Global 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 non-resident investors against the issue of
ordinary shares or Foreign Currency Convertible Bonds of issuing company.
A GDR issued in America is an American Depository Receipt (ADR).

ECB: External Commercial Borrowing: It is a term loan denominated in

foreign currency (eg. $, £). Firms having significant exports to foreign
countries earn the respective foreign currency inflow. Hence, it may be
beneficial for them to borrow in that currency, especially when interest rates
are much lower there. In absence of exports, however, cost of hedging almost
nullifies the advantage of lower interest rates.

Points to remember:

Leverages:
• Business Risk is risk due to fixed operating costs (operating leverage)
• Financial Risk is risk due to fixed financial costs (interest, preference
dividend) i.e. due to financial leverage.
• Financial Leverage is also called as ‘Trading on Equity’

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• Direct Costs usually would mean variable costs

Ratio Analysis:

• P/V Ratio is contribution /Sales

• Just ‘Turnover Ratio’ is ‘Capital Turnover Ratio’ i.e. Sales/ Capital Employed
• Net Assets = Fixed Assets + (Current Assets – Current Liabilities) = Capital
Employed
• Return on Investment (RoI) is
Return on Capital Employed = Return on Net Assets = PBIT / Capital
Employed
If specified as ‘post tax RoI’: RoI = [PBIT (1- T)]/ Capital Employed
{Sometimes RoI is also signified as Return on Total Assets : Use this only if specified this way}
• Debtors Velocity = Debtors Collection Period = ACP
Debtors Turnover = Sales / Debtors = 12 / ACPmonths = 360 / ACPdaysM

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