Financial Management (202)

Semester II 202 – FM 3 Credits LTP: 2:1:1 Compulsory Generic Core Course

Course Outcomes: On successful completion of the course the learner will be able to
CO# COGNITIVE COURSE OUTCOMES
ABILITIES
CO202.1 Remembering DESCRIBE the basic concepts related to Financial Management,
Various techniques of Financial Statement Analysis, Working Capital,
Capital Structure, Leverages and Capital Budgeting.
CO202.2 Understanding EXPLAIN in detail all theoretical concepts throughout the syllabus
CO202.3 Applying PERFORM all the required calculations through relevant numerical
problems.
CO202.4 Analysing ANALYZE the situation and a. comment on financial position of the
firm b. estimate working capital required c. decide ideal capital
structured d. evaluate various project proposals
CO202.5 Evaluating EVALUATE impact of business decisions on Financial Statements,
Working Capital, Capital Structure and Capital Budgeting of the firm
CO202.6 Creating CREATE Common Size Comparative Statements, Comparative
Financial Statements using Ratio Analysis (Year-wise, Industry – wise),
Comparative Proposals using Capital Budgeting Techniques
Unit Contents No. of
Number Sessions
Introduction: Introduction to Finance, Meaning and Definition of Financial
Management, Objectives of Financial Management- (Profit Maximization and
Unit – 1 Wealth Maximization), Modern Approach to Financial Management- (3+2)
(Investment Decision, Financing Decision,
Techniques of Financial Statement Analysis: Introduction, Objectives of
Unit – 2 financial statement analysis, various techniques of analysis viz Common Size (10+2)
Statements, Comparative Statements, Trend Analysis, Ratio Analysis
Working Capital Management:Meaning of Working Capital, its components
Unit – 3 & types, Operating Cycle, Factors affecting working capital, Estimation of (8+2)
working capital requirement. (Total Cost Method & Cash Cost Method)
Capital Structure: Meaning and Factors affecting Capital Structure, Different
sources of finance. Concept and measurement of Cost of Capital
Unit – 4 (measurement of Specific Cost and WACC), Trading on Equity, Concept of (7+2)
Leverages and its types.
Capital Budgeting: Capital Budgeting: Meaning, Definition of Capital
Budgeting, Time value of money. Tools of evaluation of the project based on
Unit – 5 traditional techniques and modern techniques - ARR, Payback Period, (7+2)
Discounted Payback Period, NPV, PI & IRR
Note:
1. Theory 40% and Numerical Problems 60%.
Very 2. Numerical Problems will be asked on following topics only –
Important Common Size Statements, Comparative Statements, Ratio Analysis
Instructions (Calculation of ratios plus its interpretation), Estimation of working capital
for
Problems
requirement (Total Cost Method & Cash Cost Method), Measurement of
Specific Cost (Cost of Equity, Preference, Retained Earnings and Debt) and
WACC, Capital Structure, Leverages, Capital Budgeting (ARR, Payback
Period, Discounted Payback Period, NPV, PI & IRR)

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 M.B.A. - I
202 : GC - 08 : FINANCIAL MANAGEMENT
(2024 Pattern) (Semester - II)
[Time : 2½ Hours] [Max. Marks : 50]
Instructions to the candidates:-
1) All questions are compulsory. 2) Figures to the right indicate full marks. 3) Use of simple
calculator is allowed.
Paper Pattern
Q.1 MCQ, Fill in the Blanks, Match the pairs & True or False

(based on whole syllabus) solve any 5 out of 8 Que. 10Marks

Q.2 Write a Short Notes (Any 2 out of 4) (based on whole syllabus) 10Marks

Q.3 Solving (Problem) on Ratio Analysis 10Marks

or

Q.3 Solving (Problem) on Interpretation of Ratio

Q.4 Solving (Problem) on Capital Budgeting (PBP, NPV, ARR, PI, etc) 10Marks

or

Q.4 a. Solving (Problem) on Capital structure (WACC) 05 Marks

Q.4 b. Solving (Problem) on Leverage 05Marks

Q.5 Solving (Problem) on Working Capital requirement (Cash cost Approach)10Marks

or

Q.5 Solving (Problem) on Working Capital requirement (Total Cost Approach) 10Marks

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Finance:- Generally Meaning of Finance is Money(Cash), Funds & Money equivalent Like
Negotiable Instruments such as Cheques, Bills of Exchange etc. Finance is life blood of any business
or organization, without finance business can’t survive, even unable to came into exist.
In short Finance is related to money and money management.
According to P.G. Husings “Finance is the management of monetary affairs of a company
which includes determining what has to be paid for & when it has to be paid, raising the money on the
best terms available and devoting the available funds to the best uses”

It is the process of organizing the flow of funds so that business can carry out its objectives in the most
efficient manner and meets its obligations as they fall due.

The word finance gives itself characteristics which is explain as bellow

F - Funds Owned & Borrowed(Loan)

I - Investment Investment Management

N - Negotiation Negotiable Instruments like B/R, B/P, Cheques, BOE etc..

A - Accounting All Accounting Stream

N - Numerical Information Figures & Budgets

C - Costing Standard Costing, Marginal Costing, Process Costing etc

E - Estimation Forecasting & Budgeting

Finance May be Define as art & Science of managing money. The major area of finance are
1. Financial Services
2. Financial Management / Finance Functions

 Financial Services:- is concerned with the design & delivery of advice & Financial
Products to individuals, business & Government within the area of Banking & related
institutions, Personal Financial Planning, Investments, Real Estate, Insurance etc.

 Financial Management :- Financial Management deals with how the firm obtains the
funds and how it uses within the firm. Financial Management involves the application of
general management principles to a particular financial operation. It may be considered to
be the management of the finance function.

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Definitions:-
1 According to Archer & Ambrosio,
“ Financial Management is the application of the planning & control functions to the Finance
Functions”
2 According to Weston & Brigham,
“ Financial Management is an area of Financial decision making, harmonizing individuals
motives and enterprises goals”
3 According to Prather & Wert,
“ Financial Management deals with the raising, administering & disbursing funds by privately
owned business units operating in non financial field of industry”
4 According to Joseph & Massie,
“ Financial Management is the operation activity of business that is responsible for obtaining &
effectively utilizing the funds necessary for the efficient operation”
5 According to Fathman & Dougall,
“ Financial Management can be broadly define as the activity concerned with planning, raising,
controlling & administering of funds used in the business”

With reference of above definition we can conclude that, Financial management deals
with procurement of funds and effective utilization of funds within business. The two basic aspects of
Financial Management are – (1) Procurement of Funds and (2) Effective Utilization of Funds, to
achieve business objectives.

1. Procurement of Funds:

(a) Funds can be obtained form various sources like Equity, Preference Capital, Debentures, Term
Loans etc. funds procured from various sources have different characteristics in terms of risk, cost
and control.
(b) The objective is to minimize the cost of funds obtained. Hence, a proper balancing of risk and
control factors becomes essential.
Thus, procurement of funds involves the following:-
 Identification of Sources of Finance.
 Determination of Finance mix.
 Raising of Funds.
 Division of Profits between dividends and retention of profits i.e. internal fund generation.

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2. Effective utilization of funds:

(a) Funds are procured at a cost. Hence it is crucial to employ them properly and profitable.
(b) The finance Manager identifies the areas where funds remain idle and why they are not used
properly.
(c)He analyses the financial implication of each decision – to invest in Fixed Assets, the need for
adequate Working Capital etc.

OBJECTIVE OF FINANCIAL MANAGEMENT

There are basically two objectives of Financial management –

(1) Profit Maximization,
(2) Wealth / Value Maximization.

I) Profit Maximization :-
The basic motive of any business is Profitability. So the Finance Manager has to take
his decision is order to maximize the profits of the business. Profit Maximization is a basic and long-
term objective, but has a short-term measurement focus (say a financial year).

Profit Maximization, as an objective has the following advantages and limitations

Advantages –
(a) Profit Maximization must for survival of business, else. Capital is lost.
(b) Essential for growth and development of business.
(c) Impact on society through factor payments.
(d) Profit-making firms only pursue social obligations.

Disadvantages / Limitations –
(a) The term “Profit” is vague.
(b) Higher the profits, higher the risks involved
(c) It ignores time pattern of returns.
(d) It ignores social and moral obligation of the business
Hence, Profit Maximization is viewed as a limited objective, i.e. essential but not sufficient.

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II) Wealth Maximization:-
The second objective of Finance Management is to maximize the Value or Wealth
of the Firm. Wealth or Value of a Firm is represented by the market price of its Capital (i.e. Shares and
Debentures). This value depends upon-
(a) likely rate of earnings of the Company (EBIT); and
(b) Capitalization rate.

1) Earnings: It takes into account, the present and prospective earnings, the timings and risk of these
earnings, the dividend polices of the Firm and other factors governing revenues.

2) Capitalization Rate: - It is the cumulative result of the assessment of the various stock-holders
(Equity and Debt) regarding the risk and other qualitative factors of a Company. This rate reflects
the liking of the investors for a company.

Limitation of Wealth or Value Maximization Objective:-

a) Timing: The timing or duration of expected returns is not specified. So one cannot be sure
whether an investment fetching Rs. 10 Lakhs return 5 years is more or lese valuable than an
investment fetching Rs. 1.50 Lakhs per year for the next five years.
b) Risk: The risk factor of projects to be undertaken is not considered properly. A Firm with a
higher Debt Capital may have the same EPS as a Firm having a lesser Debt Capital in the
capital structure. However, the Market Price per Share of the two Companies shall be different.
c) Dividends: The effect of dividend policy on Market Price per Share is not fully considered. To
maximize Share may go down due to adverse reactions from the Shareholders.
However for routine decision-making purposes. The Finance Manager views Profit
Maximization as a short-term objective and Value Maximization as a Medium/Long-Term
Objective.

Scope of Financial Management:-

1) Forecasting :- Anticipation of Financial Need
2) Financing :- Acquisition of Capital
3) Co-ordination & Control :- Allocation of Funds
4) Costing :- Measuring Cost of Capital & Controlling
5) Decision Making :- Financial Investment Decisions, Working Capital Mgt decision
6) Miscellaneous :- Tax Management, Insurance, Credit Collection etc.

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 TYPES OF FINANCE FUNCTION
1. Fund Requirement Estimation:
i) The Finance Manager has to carefully estimate the Firm’s requirements of Funds.
ii) The purpose of fund (investment in Fixed Assets or Working Capital) and timing of funds (i.e.
when it is required) should be determined, using techniques like budgetary control and long
range planning.
This calls for forecasting all physical activities of the organization and translating them into monetary
terms.

2. Capital Structure / Financing Decisions:

i) The Finance Manager has to determine the proper mix / combination of procuring funds.
Funds can be procured from various sources for short term and ling-term purposes.
ii) Decisions regarding capital Structure (called Financing Decision) should be taken to provide
proper balance between –
(1) Long-Term and Short-Term funds and also
(2) Loan Funds and Own Funds.
iii) Long Term funds are required to finance fixed Assets and long-term Investments and provide
for permanent needs of working capital. Short Term is required for Working Capital purposes.
Fund Types Risk Cost Tax Benefit Returns Control
Own Fund Low Risk Most Expensive No Only if profit is Dilution of Control
(Equity & Pref. Share) there
Owner of The firm
Loan Fund High Risk Comparatively Available Profit or Loss No Dilution
(Loan, Debenture & (Principal & Cheaper Interest should be
Bonds) Int.) paid

3. Capital Budgeting / Investment Decision:

i) Funds procured should be invested / utilized effectively. The Finance Manager should prescribe
the asset management policies for Fixed Assets and Current Assets.
ii) Long Term Funds should be invested – (1) in Fixed Assets / Projects after Capital budgeting
and (2) in Permanent Working Capital after estimating the requirements carefully.

4. Cash Management Decision:

i) The Finance Manager has to ensure that all sections / branches / factories / department and
units of the Firm have adequate funds (cash), to facilitate smooth flow of business operation.
ii) He should also ensure that there is no excessive cash (idle fund) in any division at any point
of time. For this purpose, cash management and cash disbursement / transfer policies should
be laid down.

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5. Financial Analysis / Performance Evaluation:
i)Financial Analysis helps in assessing how effectively the funds been utilized and in identifying
methods of improvement. So, the Finance Manager has to evaluate financial performance of
various units of the Firm.
ii) There are various tools of Financial Analysis like Budgetary Control, Ratio Analysis, Cash
Flow and Fund Flow Analysis, Common Size Statement analysis, Intra-Firm Comparison etc.

6. Dividend Decisions:
i)The Finance Manager should assist the top management in deciding the dividend – payout and
retention money i.e. – (1) what amount of dividend should be paid to shareholder shareholders
and (2) what amount should be retained in the business itself.
iii) Dividend decision depend upon factors like – (1) trend of earning; (2) requirement of funds
for future growth; (3) cash flow situation; (4) trend of share market price, and (5) tax
liability of Firm/Shareholder.

7. Financial Negotiations / Liaison with Lenders:

The Finance Manager is required to interact and carry out negotiations with financial
institutions, banks, and public depositors. Negotiations especially with outside financiers
require specialized skills.

8. Market Impact Analysis:

i) The Finance Manger has to monitor the stock exchange quotations and behavior of share
prices. This involves analysis of major trends in the stock market and judging their impact on
the share price of the Firm.
ii)Value Maximization Objective is achieved through this analysis and action.

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The Relationship between Finance Function and Other Function

Finance is the life and blood of an organization. It is the common thread that binds all organizational
functions. Each function in an organization has financial implications. The relationship between finance
and other function can be described as follows –

Function Investment aspect Decision – making aspect

Finance and This includes decision on Decision such as Make or Buy
investment in Production Components, Retain or Replace
Production
inventories, stock levels, Machinery etc. are taken after
purchase policies etc. analyzing financial implication
thereof.
Finance and This includes decision on Marketing decision and
investment in Marketing strategies such as Credit
Marketing
finished goods inventories. Granting, Change in Sale price
to sell additional quantities,
acceptance of additional order
etc. is taken after analyzing
their financial impact.
Finance and This includes decision on Investment in HRD is bound to
capital costs Personnel increase in future. Restructuring
Personnel
associated with personnel with of pay package, drafting or
personnel policies and voluntary retirement schemes,
substantial training expenditure, issue of sweat equity etc. are
if any. some major decision in Human
Resource Management.

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OVERVIEW OF FINANCIAL MANAGEMENT – ASPECTS, OBJECTIVE AND FUNCTIONS

FINANCE MANAGEMENT

PROCUREMENT OF FUND Profit & Wealth UTILISATION OF FUNDS

(i..e. Sources of Funds) Maximization (i.e. Application of Funds)

Objective: To minimize Cost Objective: To Maximize Returns

Long Term Sources Short Term Sources Short Term Long Term
Investment Investments

Own Loan Current Liabilities Current Assets Fixed Asset &

Projects
Funds Funds e.g. Creditors, e.g. Stock,
(Equity) (Debt) Payables etc. Debtors, Cash

Capital Structure Decisions Working Capital management Decision Investment

Or Decision
Financing Decisions or
Capital Budgeting

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 Working Capital Management
Introduction :-

Working Capital can be defined in simple words as, that part of the total capital which required
to recover day-to-day expenses of the business. For example purchase of raw material or consumable
stores, payments of expenses like wages, salary, rent, freight etc…
Working capital also known as circulating capital, revolving capital or fluctuating capital
because its starts with cash and ultimately results in cash after the completing operational (Working
capital) cycle.
Definition :- According to Shubin “Working Capital is the amount of Funds necessary to cover
the cost of operating the enterprises.”

This concept of working capital is useful to know whether the Current Assets are sufficient or not to
meet the current Liabilities. i.e. the short term Solvency of the business is sound or questionable.

Working Capital Calculated as –

Working Capital = Current Assets – Current Liabilities
It means Working Capital is “Excess of Current assets over current liabilities.”

 Components of Working Capital

1. Current Assets
2. Current Liabilities

1 Current Assets :- Current Assets are those assets which can be easily convertible into Cash
within a Year. Examples – Inventories, Cash & Bank Balance, Debtors, Prepaid Exp., Short term
Investments etc

2 Current Liabilities – Current Liabilities are those liabilities which fall due for payment or
settlement within a year. Examples – Creditors, Tax Liability, Outstanding Exp., Short term Loans,
Bank Overdraft, Cash credit etc.

Classification of Working Capital.

Based on Cost Factor Based on Time Factor

Gross Working Capital Net Working Capital Permanent Temporary

(Current Assets only) (CA – CL) Working Capital Working Capital
(Fixed or Hard Core) (Fluctuating or Variable)

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1. Gross Working Capital :- Gross Working Capital refers to the firms investments in
Current Assets only. The concept of Gross working Capital is advocated for the following
reasons-
a. Profit of the firm are earned by making investment of its funds in fixed and current assets. This
suggest the part of the earning relates to investment in current assets, therefore aggregate of
current assets should be taken to mean the working capital.
b. The management is more concerned with the total current assets as they constitute the total
funds available for operating purpose than with the sources from the total fund came.
c. An increases in the overall investment in the firm brings an increase in working capital.

2. Net Working Capital :- Net Working Capital means difference between current assets and
current liabilities. It’s an qualitative concept which indicates liquidity of firm, because liquidity
is measured in ability to satisfy short term obligation which suggest Net working capital.

Amount Rs
In this View The amount of Permanent
Working Capital remains the same over all
Temporary periods of times.

Permanent e.g. :- Rs. 10 Lacks at all times, irrespective

of the amount of sales, Activity etc.

1. Remaining Constant At All Times

Amount Rs Temporary
Permanent The mere logical second View is that the
Permanent Working Capital increase in
amount (Rupee Value) based on the activity
levels of the firm.

e.g. :- Working Capital of Rs. 10 Lacks may be

sufficient for a turnover level of Rs. 50 lacks. But
when turnover increases to Rs 100 crore after a
2. Increasing along with Times certain time period, the amount of Working capital
should raise & hence should be an amount higher
than 10 lacks.

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Importance of working Capital:-
1. Working Capital is required to use fixed assets profitability. For example. A machine cannot
be used productively without raw materials.
2. Funds are required for day-to day operations and transactions. These are provided cash and
cash equivalents forming parts of current assets.
3. Adequate working capital determines the short term solvency of the firm. Inadequate working
capital means that the firm will enable to meet its immediate payment commitments.
4. Increase in activity levels and sales should be backed up by suitable investment in working
capital.
5. The aspects of liquidity and profitability should be suitably analyzed by the finance manger.
To much emphasis on profitability may affect liquidity and vice versa.

Determinant Factors of Working Capitals

Sr. Low or Moderate Working
Factor High Working Capital
No. Capital
High Production during peak
1 Production Policies season Uniform Production over the year
e.g. Dairies, calendars etc
2 Production Process Labour Intensive process Capital Intensive Process
3 Nature of Business Manufacturing Firm Trading Firm
Liberal Credit policy & Low efforts Strict Credit policy & efficient credit
4 Credit Policy
for debtors follow-up collection Mechanism
Newly establish Firm- Credit sales Reputed & Established firm- better
5 Market Condition are made but purchases settled in & efficient credit terms with Debtor
cash & Creditor
High Storage Period or JIT Inventory policy & moderate
6 Inventory Policy
Stockholding period stockholding period
Sellers Market- quick disposal of
7 Type of Market Buyers Market stocks & immediate collection of
receivable
Inflationary In case of highly inflationary For moderate & mild inflationary
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Conditions conditions conditions
9 Business Cycle During Peak or boom Conditions During moderately active conditions

 Approaches to estimating Working Capital Requirement :-Working Capital requirement

can be forecast in two ways –
a. By reference to the operating cycle
b. By estimation of each component of current assets & current Liabilities
The second method is more popularly used in practice. There are two approaches of working capital
requirements-
1. Total Approach:- All Expenses & profit margin are considered.
2. Cash Cost Approach:- only cash expenses (Excluding depreciation & Profit) are considered.
The second approach is to be used in to solve working capital requirement problem or assignment.

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  Various Sources for financing Working Capitals:-

Sources of Working Capital

Negotiated
Spontaneous Sources
Sources

Non-Fund
Sources Trade Credits

Bank Guarantee Sundry Creditor

Letter of Credit Bills Payable

Short Term Sources Long Term Sources

External Sources Internal Sources Internal Sources External

Sources

Bank Overdraft Provision of Tax Retention Profit Share

Capital
Cash Credit Provision For Reserve & Surplus Debenture
Trade Deposits Dividend Long
Short term Loan Term Loan
Public Deposits
Bills Discounting
Commercial Paper

 Factoring :-
Factoring is an arrangement under which a firm (called borrower) receives advances against in
receivables, from financial institutions (called Factor). The Factor also provides certain allied services
like Debtors follow-up, Maintenance of Debtors Ledger etc on behalf of the Borrower.

Types of Factors:-
a. Disclosed Vs Undisclosed Factoring: - In disclosed factoring, all parties factor,
borrower/Seller and the Buyer, is aware of the other’s presence in the arrangement. However, in
undisclosed factoring, the factoring arrangement is not known to the Buyer of goods.

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 b. Recourse Vs Non- Recourse Factoring: - In Recourse Factoring, in case of default by the
customer, the risk of bad debts is born by the borrower and not the Factor. In Non-Recourse
Factoring, the risk of bad debts is born by the borrower.
In India, Factoring is always “Disclosed” and “With Recourse”.
c. Bulk / Agency Factoring: - In Such types credit administration is done by client himself
(Borrower) and only advance received from factor according to total bills receivable. Usually
this method of Factoring used as financing “Book- Debts”.

Procedure:-
a) The borrower sells his accounts receivable (i.e. Book debts) to the Factor.
b) The Factor purchases the receivable and provides advances against them, after deducting and
retaining - i) a suitable margin/ reserve, ii) Factor’s commission/ Fees & iii) Interest on
Advance.
c) The borrower forwards collections from his customers /Buyers, to the Factor and thus settle the
advances received by him.
d) The Factor may also provide allied services like credit investigation, sales ledger management,
collection of Debts, credit protection and Risk bearing.

FACTORING ARRANGEMENT

Client/ 1 Customer/
Seller 3 Buyer
2
6
5
8
Factor 7
4
Financing Institution

1. Place Purchase Order

2. Fixes Customer Limit
3. Supplies goods & Invoice; Invoice carries instruction to send Payments to Factor
directly
4. Sends Invoice Copy
5. Gives advance
6. Follows Up for Debt Collection
7. Pays amount due
8. Pays/Settles balance upon realization of dues.
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  Working Capital during Inflation

Inflation means increase in prices of stock, Raw materials, & debtors without increasing quantity of
sales. E.g. suppose currently we required of Rs. 50,000/- to produce 10 units of product A but due to
inflation to produce same quantity we required Rs. 65,000/- therefore while calculating or determining
working capital we should consider inflation to maintain optimum level of investment in current assets
for increasing in returns on capital employed.
Due to high inflation business is face a condition known as ‘Technical Insolvency’ which is explain as
under-
a) Due to inflation the amount of sundry debtors & stocks is to be higher but sales quantity
remains constant.
b) Firm require huge amount or extra fund to maintain same stock level.
c) Increase in stock value shows higher amount of profit but it’s not realize in to cash. Which is
directly affect on payment of tax, payment of dividend & bonus.
d) Increase in investment in current assets require increase in working capital but due to inflation
sales are not increases (in quantity) or not increases in profitability.

Hence finance manager should be very careful about impact of inflation in assessment of working
capital requirement & it’s management. For that purpose we may consider following points-
1. Using substitute raw material without affecting quality.
2. Reduce production cost by using time & motion study & intensive schemes.
3. Reduce inventory level or stock levels by using JIT technique
4. Change or revised credit policies of creditors & debtors.
5. Reducing various floats like billing floats, mailing floats & Cheque processing floats.

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  Management receivable :-

The three aspects of management of receivables are-

1. Credit Policy: - Decisions on credit period to be allowed, early payment discount rates etc.
2. Credit Analysis: - Decisions on whether credit can be extended to particular customer.
3. Control over Receivable: - Steps for debtor’s follow-up, faster collection of debtors.

Importance of Management receivable:-

a. High Investment: - if large amounts are tied up in sundry debtors, working capital
requirements and consequently interest charges will be high. Also bad debts and cost of
collection would be high.
b. Low Investment: - If the investment in sundry debtors is low, the sales may be restricted, since
the competitors may offer more liberal credit terms.
Hence management of sundry debtors is an important issue and requires proper policies and efficient
execution of such policies.

Meaning of Credit Policy:-

This involves decisions relating on the following aspects of credits
a) Length of the credit period
b) Discount policy and c) other special items, wherever applicable.
Role: - the credit policy determines the investment in sundry debtors average collection period and bad
debts losses. Hence credit policy of a firm should enable it to achieve the following objectives-
1. Increasing sales & market share
2. Increasing Profits due to higher sales & higher margins on credit sales and
3. Meeting Compaction.

Credit Period:- Credit period denotes the period allowed for payment by customers, in the normal
course of business.

Discount Policy: - In the context Debtors management discount policy involves decisions relating to –
1. Percentage of cash discount to be offered as incentive for early settlements of invoice and
2. Period within which cash discount can be availed.

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 Financial Statements
A Statement which shows the financial position or condition of the Firm known as Financial statement.
Financial Statement reveals financial information (Data) which is useful in decision making. It consist
of Trading A/c, Profit & Loss A/C, Balance sheet, cash flow statement, Fund Flow Statement, Income
Statement, Working Capital Statement etc. Financial Statement helps to Management in financial
decision making.
The users of Financial Statement
1. Management – For day to day decision making & also for performance evaluation.
2. Proprietor / Shareholders- for analyzing performance, profitability & financial
positions prospective investors require track records of performance.
3. Lenders – Banks & financial Institutions for determining financial positions of the
company.
4. Suppliers- To determine the credit worthiness of company in order to grant credit.
5. Customers – To know the financial position before entering long term contracts.
6. Government – To ensure prompt collection of direct & indirect revenue (Tax), To
formulate various policies like EXIM Policy, Monetary Policy, Fiscal Policy etc.
7. Research Scholars– For study, research & analysis purposes
8. Companies in same Industry – For the purpose of Inter firm Comparison, to study
trend in the Industry.

Management Shareholders/ Proprietors Lenders

Users
Suppliers Of Customers
Financial Statement

Government Companies in Same Industry Research Scholars

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  Preparations of Financial Statements-

Business Transactions Cash Transactions

Credit Transactions
Bartter Exchange

Accounting Entry Made

Record in Primary Books (Journal) Daily Book/Dairy

Posted in Secondary Books (Ledger)

Trial Balance

Financial Statement

Trading A/c Profit & Loss A/c Balance Sheet Income Statement Fund/CashFlow Statements Budgets

The above flow chart shows process of Preparation of Financial Statements is explain briefly. In
the organization various transactions taken place it may be Cash, Credit or Barter Exchange
Transactions.
All of them first recorded in primary books with the help of types of accounts. Primary books (Daily
Dairy) known in accounting sense Journal Book. then after such transactions are posted in the various
Secondary books called as Ledgers. Sales book, Purchase book, Cash book, Purchases returns book,
Sales returns book, Bank book, Assets A/c, Expenses A/c, etc are the few examples of Secondary
books.
Such Ledgers (Secondary books) are balanced at specific time period say at the Year End, and
those balances are compiling together in Trail Balance. Lastly with the help of Trail balance various
Financial Statements are prepared. Few examples of Financial Statements are shown in above chart.

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 Format of Financial Statement

As per Companies Act 1956, Section 211

Schedule VI Part – I

Horizontal Form

Balance Sheet of ABC Ltd. Pune

As on 31 Mar 2009
31.03.08 Liabilities 31.03.09 31.03.08 Assets 31.03.09
Share Capital Fixed Assets

 Authorized share  Goodwill

capital  Land & Building
 Subscribed Share  Furniture
capital  Plant & Machinery
 Paid up share capital  Patents, Copyrights &
trade marks
 Vehicles
Reserve & Surplus
Investments
 Share premium  In Govt. Securities
 Other Reserve  In Other companies
 Surplus
 Sinking Funds Current Assets, Loans &
 Capital Redemption Advances
reserves
 Capital Reserves  Current Assets
like Stock ,Dr,
Secured Loans B/R, Cash, Bank
 Loans &Advances to
 Debentures employees & supplier
 Loans & Advances
(Long Term) Miscellaneous Expenses
 Preliminary Exp.
Unsecured Loans  Discount to share
 Fixed Deposits holders
 Short term Loans  Development Exp.

Current Liabilities & Profit& Loss Accounts

Provisions Debit Balance (loss)
 Liabilities-
o B/P
o Sundry
Creditors
o Outstanding
 Provisions for
Taxations, dividend, PF
etc.

Total Total

20
 As per Companies Act 1956, Section 211
Schedule VI Part – I

Vertical Form

Balance Sheet of ABC Ltd. Pune

As on 31 Mar 2009

Particulars Schedule 31.3.2009 31.3.2008

No.
1 Sources of Funds

a. Share holders’
Funds
- Capital
- Reserves & Surplus
b. Loan Funds
- Secured Loan
- Unsecured Loan
Total
2 Application of Funds

a. Fixed Assets
Gross Block
Less- Depreciation

b. Investments

c. Current Assets, Loans &

Advances
Less- Current Liability & Provisions

d. Net Current Assets

Miscellaneous Expenses
Profit & Loss A/c (Debit Balance)
Total

21
 Financial Statement Analysis
Financial Statement Analysis consists of breaking down a complex set of facts or figures in to simple
elements and arranging them in such a manner that they can be easily understood.
Example – In Profit & Loss to calculate Gross Profit, Net Profit, Cost of Goods sold, Gross Margin,
EBIT etc & In Balance Sheet Own Fund, Loan Fund, Fixed Assets etc.

Objectives of Financial Statement Analysis:-

i. To judge the Financial Health of Firm.
ii. To Evaluate Profitability of the Company
iii. To Gauge the Debt Servicing Capacity of the Firm
iv. To Understand the long term & short term Solvency of the Enterprise
v. To know the return on the Capital employed or Invested
vi. To determine the Productivity of the Company
vii. To Calculate Liquidity of the Firm

Types of Financial Statement Analysis

Inter Firm Analysis Vertical Analysis Short Term Analysis

Types
External Analysis of Horizontal Analysis
Financial Statement
Analysis

Long Term Analysis Intra-Firm Analysis

Internal Analysis

1. External Analysis:- This analysis done by external entity for their private purpose like analysis
done by Banks, Financial Institutions, Lenders, Creditors etc. The detailed records & accounting
information is not available to the outsiders and they rely mostly in published financial
statement & information for analysis.

22
2. Internal Analysis:- It is done within Finance Department because it needed detailed record of
Financial Information. Generally management is interested in this sort of analysis for decision
making & performance evaluation. Sometimes, officers appointed by court or government
under statute will conduct Internal Analysis, Like Internal Audit.

3. Inter Firm Analysis:- Comparison of Financial Statement of One Firm with other Firm, in
same Industry known as Inter Firm Analysis. Example- Analysis of Financial Statement of
Bajaj Co. Compare with Yamaha Co.

4. Intra-Firm Analysis:- It involves comparison of Financial Statement of One Firm for different
time period or different divisions/different departments of Firm for the same Year. Example- In
Bharat Ltd. Analysis of Balance Sheet of Last Year compare with Current year or Comparison
of Marketing dept. Statement with Admin. Dept’s Statement.

5. Long Term Analysis:- It is done to evaluate long term Solvency, Profitability, Liquidity,
Financial Health, Earning Capacity of the Firm. The objective of long term analysis is to
determine whether the earning capacity of the Firm sufficient to meet the targeted rate of returns
on investment, and is adequate for future growth and expansion of business.

6. Short Term Analysis:-This analysis had done to calculate short term profitability, Solvency,
Liquidity & Financial Condition of the Firm. The main objective of this analysis is to carry out
all management function Effectively & Efficiently through proper decision makings.

7. Horizontal Analysis:- It’s just like to Intra-Firm Analysis. In this analysis items are compared
on a one-to-one basis, e.g. sales increases, comparative net profit for 2 years etc.

8. Vertical Analysis:- It involves analysis of relationship between various items in the Financial
Statements of one year. Relationship between items i.e. ratios or percentages are considered
under this analysis.
 Various techniques of Financial Statement Analysis
1. Common size Statement
2. Comparative Analysis
3. Trend Analysis
4. Ratio Analysis
5. Fund Flow Analysis
6. Cash Flow Analysis

23
 1. Common Size Statement:- In this technique some factor treat as Common base and
other factors are co-relate with that for Analysis purpose. E.g. in the Balance Sheet Total of balance
sheet taken as base 100% and remaining items co-relate with it, In the Profit & Loss A/c Sales treat
as 100% and all items of expenditure are shown as a percentage of sales.

Common size statements for profit & loss A/c indicate the expenditure pattern of the company. In case
of the balance sheet, it shows the pattern Assets holding and the extent of liabilities.
Common size Statements are also prepared over a number of years in order to analyses the trend or
pattern or movement of various items over the years. It also helps in Inter-Firm comparison.
Illustrative Common Size Statements (Rs. in Lakshs)
Common Size Profit & Loss A/c Common Size Balance Sheet
Particulars Amount Percentage Particulars Amount Percentage
Sales 1000 100% Fixed Assets 100 50%
Less- Material 400 40% Investments 20 10%
Labour 250 25% Current Assets 120 60%
Gross Profit 350 35% Less Current Liab. (40) 20%
Less-Fixed Cost 50 5% Total Funds Employed 200 100%
EBIT 300 30% Share holders Funds 50 25%
Less Interest 100 10% Loan Fund 150 75%
EBT 200 20% Total Fund obtained 200 100%
Less Tax 80 8%
EAT 120 12%
Less Dividend 60 6%
Retained Earning 60 6%

2. Comparative Analysis:- In this analysis financial statements are compare with same of last year
statements or compare with other firms statements in same industry. Hence comparison may be
Inter-Firm or Intra-Firm.
Comparative analysis is to be used to for
1. determining absolute data(Money Value or Rupee Value)
2. calculate Increase or Decrease in absolute data in terms of Money value
3. calculate Increase or Decrease in absolute data in terms of Percentage
4. Comparison in terms of Ratios
5. Percentage of totals
Advantages: - The comparative financial statements are useful for analysis of the followings
1. Comparative statements indicate trends in sales, cost of production,
Profits etc. and helps analyst to evaluate the performance of the Company.

24
 2. Comparative statements can also be used to compare the performance of
the firm with the average performance of the industry or inter firm Comparison. This helps to in
identification of the weaknesses of the firm and remedial measures can be taken accordingly.

Disadvantages: - The Comparative Financial statements suffers from the following weakness.
1. Inter-firm Comparison can be misleading if the firms are not
identical in size and age and when they follow different accounting procedures with regard to
depreciation, inventory valuation etc.
2. Inter Period comparison may also be misleading, if the period has
witnessed changes in accounting policies, inflation, recession etc.

3. Trend Analysis:- Trend Analysis involves compilation of Comparative financial statements over a
period of time, say 10 to 12 years. It has the following advantages-
1. Analysis of effect of price changes
2. Analysis of pattern of movements in revenues and assets.
3. Analysis of the firm’s performance or growth over a time period.
4. Fund flow Statement & Cash Flow Statement:-
Fund flow Statement Cash Flow Statement
This statement indicates Flow of Funds It shows Flow of cash within organization for
1
within organization for Specific Period Specific Period (Say one Financial year)
2 It used to ascertains the changes in the It ascertains the changes in balance of cash in
financial position between two hand and cash at bank between two dates
accounting period
3 This statement analyses the reasons for This statement analyses the reasons for
changes in Financial position between changes in cash & bank balances on a
two balance sheet particular date
4 It Reveals Sources & Applications of I t indicates the Inflow & Outflow of Cash
Funds
5 It helps to test whether working capital It is an important tool for short term analysis.
has been effectively used or not. The two significant areas of analysis are cash
generating efficiency & free cash inflow.

Steps to slow Fund flow statement problem:-

1. Prepare 3 Compulsory A/c i.e. a) Fund flow statement, b) Profit & Loss Appropriation A/c &
c) Statement showing Changes in working capital.
2. Draw all Adjustment A/c’s 3. Write down opening & Closing balances in accounts only
4.Find out changes in working capital if increases it application and if decreases its Sources
5. Solve the adjustments Which are having two or more effects,
6. Solve Hidden adjustments
7. Find out Funds for Operation or Funds from operations
8. Fund flow must be tallied
25
5. RATIO ANALYSIS –
The ratio is used to describe significant relationship between two different figures. One Numerical
figure express in another known as Ratio, which may be express in Percentage, Times or Proportions,
which helps for financial performance analysis of the firm
Need of ratio-
An absolute or single figure does not convey much more meaning, Suppose only profit of the
firm is to be provided, that time we can’t say firm is profitable, solvent, liquidate or insolvent but if that
profit correlates with Sales, we can find out the profitability and came to know exact financial
condition of the firm hence, one figure must be correlates with another to provide meaningful
expression. Therefore ratio is to be needed.

Signification of Ratio Analysis:-

1. Evaluation of Liquidity – The ability of a firm to meet its short term payment
commitments is called Liquidity. Current ratio & quick Ratio helps to assess the short term
solvency (Liquidity) of the firm.
2. Evaluation of Profitability- Profitability ratio i.e. Gross Profit Ratio, Operating Profit
Ratio & Net Profit Ratio are basic indicators of the firm. In addition, various profitability
indicators like returns on capital Employed (ROCE), Earning Per Shares (EPS), Returns on
Assets (ROA), etc. are used to assess the financial performance.
3. Evaluation of Operating Efficiency - These ratios throw light on the degree of efficiency
in the management and utilization of assets and resources. These are indicated by activity of
Performance of Turnover ratios e.g. Stock Turnover ratio, Debtors Turnover Ratio, Fixed Assets
Turnover Ratio etc. these indicate the ability of the firm to generate revenue (sales) per rupee of
investment in its Assets.
4. Evaluation of Financial Strength- Long term solvency or financial strength is indicated
by Capital structure ratio like debt equity ratio, Gearing Ratio, Leverage ratio. These ratio
signify the effect of various sources of finance e.g. Loan Fund like Debts, Own Fund like equity
or preference shares. They also show whether the firm is exposed to serious financial strain or is
justified in the use of debt funds.
5. Inter Firm and Intra Firm Comparison:- Comparison of the firms ratio with the
industry average will helps evaluate the firms position vis-à-vis the industry. It will help in
analyzing the firms strength & Weakness and take corrective action. Trend analysis of ratio
over a period of years will indicate the direction of the firm’s financial policies.
6. Budgeting- Ratio are not mere post –mortem of operations. They helps in depicting future
financial positions. Ratios have Predatory value and are helpful in Planning & forecasting.
26
 LIMITATIONS OF RATIO ANALYSIS –
Ratio analysis is a widely used tool of financial analysis. Yet, it suffers from various limitations. The
operational implication of this is that while using ratios, the conclusion should not be taken on their
face value. Some of the limitations which characterize ratio analysis are;

1) Diversified product lines.

2) Financial data are badly distorted by inflation.
3) Seasonal factors may also influence financial data.
4) To give good shape to the popularly used financial ratio.
5) Difference in accounting policies and accounting period.
6) Financial ratios are interrelated not interdependent.
7) It is very difficult to generate whether a particular ratio good or bad.
8) There is no standard set of ratios against which a firm’s ratio can be compared.

4.3 TYPES OF RATIO

27
Capital Budgeting (Long term Investment decision)
Its involve the process of –
a. Decision making with regards to investment in fixed assets

Or

b. Decision making with regards to investment of Money in long term projects.

 Scope of Capital Budgeting:-

Capital investment decisions are part of the Capital Budgeting process, which is concerned with
decision making in the following areas-
1. Determining which specific projects a Firm should accept.
2. Determining the total amount of Capital expenditure which the Firm should undertake.
3. Determining how the total amount of Capital expenditure should be finance.

 Importance of Capital Budgeting Decision :-

a. Cost:- Capital Budgeting required huge amount of investment therefore proper costing is to be
needed while taking decision in Capital Budgeting.

b. Time: - Capital Budgeting provides cash inflows or returns after specific period but cash
outflows made immediately. Hence time factor must consider while making decision.

c. Risk: - the longer time required recover returns, the greater risk. Therefore decision should be
taken after a careful review of all available information.

d. Not reversible decision: - in Capital Budgeting decision are not reversible in nature hence
commitment of resources should be made on proper evaluation. Ex. Plant & Machinery
purchased for Textile will project cannot be used for any other purpose say refining of crude oil.

e. Complexity: - Capital Budgeting decision are based on forecasting of future event & inflows
which required various application of statistical & probabilities techniques. Careful judgment &
application of mind is necessary but such process is so complex.

Various types of Capital Budgeting Decisions

Based of Firm Existence Based on Nature of Decision

Mutually Exclusive
Decision
Cost Reduction Decision Revenue Expansion Decision Accept or Reject
Decision
Replacement Decision Expansion Decision Contingent Decision

Modernization Decision Diversification Decision

28
 Based on Firm Existence
A. Cost Reduction Decision :- these decisions focus on reduction of operating cost and
improving efficiency they can classify in to-
1. Replacement Decision
2. Modernization Decision

1. Replacement Decision:- To replace an existing assets with a new and improved one
Ex. In Computer new version will choose etc.

2. Modernization Decision: - To install new machinery in the place of an old one which has
become technologically outdated.
Ex. Typewriter Replace with Computer.

B. Revenue Expansion Decision :- these decisions focus on improving sales, Product lines
improved versions of products tec. These are sub classified in to –
1. Expansion Decision
2. Diversification Decisions

1. Expansion Decision: - To add capacity to existing Product lines to meet increased demand to
improve production facilities & to increases market shares of existing products.

2. Diversification Decisions: - To diversify and enter into new product line, venture in to new
market to reduce business risk by dealing in different products & operating in different markets.

 Based on Nature of Decision

1. Mutually Exclusive Decisions: - Decisions are said to be mutually exclusive if two or more
alternatives proposals are such that the acceptance of one proposal will exclude acceptance of
the other alternative proposals. For example.- if a firm may be considering proposal to buy
either low cost machines or high cost super model machine. In mutually exclusive decision out
of these one machine will purchased.

2. Accept or Reject Decisions: - Such decisions are opposites of Mutually Exclusive decisions.
The accept or reject decisions occur when proposals are independent & do not compete with
each other. The firm may accept or reject a proposal on the basis of a minimum returns on the
required investment. In these all proposals that give a returns higher than a certain desired rate
are accepted and rest are rejected.

3. Contingent Decisions: - these are dependent proposals. The investments in one proposal
required invest in one or more other proposals.
For Example: - if a company accept a proposal to set up a factory in remote area it may have to
invest in infrastructure also i.e. building of roads, & houses for employees etc.

29
Investment Appraisal Techniques or Project Evaluation Techniques.
Financial Managements main aim to maximize the profitability of the Firm, this aim must be consider
while deciding Capital Investment for that Finance Manager has various alternatives & techniques to
access & appraisal of Projects & Capital Investments which are as follows-

Investment Appraisal Techniques (Methods)

Traditional Methods Modern Methods

(Does not consider Time Value of Money) (Consider Time Value of Money)

Simple Payback Method(PBP) Discounted Payback period (DPBP)

Accounting/ Avg. Rate of Returns Net Present Value (NPV)

Profitability Index (PI)

Internal Rate of Returns (IRR)

Time Value of Money

Meaning: -
Time Value of Money means that, “Worth of a rupee value of today is different from worth of a
rupee value in Future & Past”
It means that rupee received today is different vale from the worth of rupee received Yesterday
& Tomorrow. The preference for money now (today) as compared to future money is known as Time
Preference of Money.
Reasons for Time Preference of Money
a) Risk- There is always uncertainty about receipt of Money in future, the longer the time period
of returns, the greater is the risk involves hence present money is preferred.
b) Preference for Present Consumption- most of times persons or companies prefer present
consumption than future consumption. e.g. Due to urgency of need (say Consumer Durables )
c) Inflation – In an Inflationary situation, a rupee today represents a greater purchasing power
than a rupee one year later. For Example In the present prices of petrol is Rs. 50 per Liter, 20
liter of the petrol can be purchased with Rs. 1000/- now. If the prices of petrol increases to
Rs.65 in next year that time only 15.38 liter of petrol can be purchased with same Rs. 1000/-.
d) Investment Opportunities- Present money is preferred due to availability of Investments
opportunities for earning additional cash Flows. For Example Rs. 1,00,000/- available in hand
now earn interest at bank rate, rather than Rs. 1,00,000/- received after 3 year.

30
Methods of Analysis of Time Value of Money

Methods

Compounding Method Discounting Method

Present Money to a Future date Future Money to the Present date

1. Compounding Method- in this, we calculate the present money value to a future date. i.e. finding out
future value of present money.

The following formulas are applicable –

(a) Future Value of a Single Cash Flows = Amount (1+r)n {Amount Relates to Time 0}

(b) Future Value of an Annuity = Amount X [(1+r)n-1] {Amount Relates to n years}

r
2. Discounting Method- Future money to present data. i.e. finding out present value of future money.
Discounting is the opposite of compounding and hence, Present value of Future Cash Flows is given by
the following formula-

(a) Present Value = FV1 + FV2 + FV3 + FV4 + ……… + FVn

(1+k)1 (1+k)2 (1+k)3 (1+k)4 (1+k)n

Where 1,2,3,4,…. N represent future time periods and FV=Cash Flows arising at those future
points of time.

31
 SHORT NOTES

1. Capital Rationing :- When company having restricted funds to invest in capital assets, in
such situation the objective of the firm is to maximize the wealth of the shareholders with the available
funds. Hence such investment planning is called as “Capital Rationing”
In such situation companies have a number of projects that all yield a positive NPV but company does
not have that much of fund to accept all the projects or investment.
There are two possible situations of Capital Rationing
a. Generally, firms fix up maximum amount that can be invested in capital Projects, during a given
Period of time, say a year. This budget ceiling imposed internally is called as “Soft Capital
Rationing”
b. There may be a market constraint on the amount of funds available for investment during a
period. This inability to obtain funds from the market , due to external factors. Hence it’s called
as “Hard Capital Rationing”
It means that two factors leading capital rationing i.e. Internal Factor & External Factors.
Whenever capital rationing exists the firms should allocated the limited funds available in such a way
that maximize the NPV of the Firms.
2. Commercial Paper :-

Commercial Paper is debt instrument for short term borrowing with freely negotiable interest rate.
It means commercial paper is an unsecured money market instrument issued in the form of a
Promissory note.
Eligible Issuers of Commercial Papers:-
a) Corporate
b) Primary Dealers
c) All-India Financial Institutions (FI)
That have been permitted to raise short term resources under the umbrella limit fixed by RBI are
eligible to issue to issue CP.
Investors for Commercial Paper:-
1. Individuals
2. Banking Companies
3. Other corporate bodies registered of incorporated in India
4. Unincorporated bodies
5. Non Resident Indians (NRI’s)
6. Foreign Institutional Investors (FII’s)
Investment by FII’s should be within the limit set for their investment by
SEBI.

Maturity:-
Commercial Paper can be issued for maturities between a minimum of 7 days and maximum up to
1year from date of issue.
Denominators:-
It can be issued in denomination of Rs.5 lacks or multiples thereof. Amount invested by a single
investor should not be less than Rs. 5 lacks.

3. Bonus shares (Scrip Dividends):-

32
 When company is in profit & its accumulated profits & reserves will also in huge amount that
time capital employed higher than the amount of share capital. The profit earned by company might
appear to be much higher as compared to share capital. Hence to avoid this abnormality in the
capital structure, part of free reserves can be distributed among the existing shareholders by issue of
“Bonus Shares” (without any charge) sometimes bonus shares also called as “Scrip Dividends”.
In India bonus shares are issue in addition to the cash dividend and not in lieu of cash dividend. The
declaration of the bonus shares will increases the Paid-up share capital and reduce the reserves &
surplus (retained earnings) of the company.

Advantages of Bonus shares:-

For the share holders-
1. Tax benefits- receipt of the bonus shares are tax-free in the hands of share holders.
2. Increases in No Shares- bonus shares are increase the quantity of shares of shareholders, which
is beneficial in future to gaining more dividend or money by selling it.
3. Indication of higher future profits- the issue of bonus shares is normally interpreted by
shareholders as an indication of higher profitability, which have favorable impact on value of
shares.
4. Psychological Value- the declaration of bonus shares issue may have a favorable psychological
effect on the shareholders. The receipt of bonus shares gives them a chance to sale their shares
to make capital gain without impairing their principal investment.

For the Company-

1. Conservation of Cash- Issue of bonus shares allows company to retain cash. Such cash utilize
by company for investment in Profitable projects which can generate additional cash inflow in
future.
2. Only means to pay dividend under financial difficulty and contractual restrictions- in some
situation, even if the company’s intention is not to retain earnings, the bonus issue (with small
amount of dividend) is the only means to pay dividend and satisfy the desire of shareholders.
3. More attractive share price- sometimes the intension of accompany in issuing bonus shares is to
reduce the market price of the shares and make it more attractive to investors.

33
 4. Leverage

Dictionary meaning of “To Lever” is giving an attachment or support to something. In financial

management leverage means addition of Loan capital (Loan Fund) to Own Capital (Own
Fund). In simple words leverage means giving support to Own Capital by Loan Capital. It gives
an advantage of availability of cash within business but increases two types of risk i. e.
1. Payment of Interest / Fixed dividend
2. Repayment of Principal amount.
Thus more is the leverage more is the risk.

A firm which has debt in its capital structure is called as a Levered Firm, whereas a Firm
having no debts i.e. financed only by Equity, is called Unlevered Firm.

-: Types of Leverage :-

Operating Leverage Financial Leverage Combine Leverage

Contribution EBIT OL X FL
OL = EBIT FL = EBT or
Contribution
EBT
When two levels are given degree of leverage computed.

%change in EBIT %change in EPS %change in EPS

DOL= ------------------------ DFL= ------------------------ DCL= -----------------------
% change in Sales %change in EBIT %change in Sales

1. Operating Leverage :-
Operating leverage is defined as the firm’s ability to use fixed operating costs to magnify
effect changes in sales on its EBIT.

34
 A change in sales will lead to a change in profit i.e. EBIT. However, variable costs will
change in proportion to sales while fixed costs will remains constant. Therefore a change in
sales will lead to a more than proportional change in EBIT, & the effect of change in sales on
EBIT is measured by Operating Leverage.
When sales increases, fixed costs will remains the same irrespective of level of output and
so the percentage increases in EBIT will be higher than increase in sales. This is the favorable
effect on Operating Leverage.
When Sales decrease, the reserve process will be applicable and hence, the percentage
decreases in EBIT will be higher than decreases in Sales. This is the adverse effect of Operating
Leverage.
Measurement:-
Contribution
Operating Leverage = ------------------
EBIT
 When two levels are given degree of leverage computed.

% change in EBIT
Operating Leverage = -------------------------
% Change in Sales

Significance:-

1. To Measures effect on EBIT:- OL measures the impact of change in sales on operating

income. Suppose OL, of a Firm is 1.67 times, it implies that 1% change in sales will lead
to 1.67% change in EBIT. Hence if sales increases by 20%, EBIT increases by 20% X
1.67 = 33.%. Also, if sales decreases by say 40%, EBIT Falls by 67%.
2. To Evaluate the impact of Fixed Costs:- OL depends on the amount of Fixed Costs. If
Fixed Costs are higher, OL is higher and Vice versa.
3. Effect on High DOL:- If OL is high, it implies that fixed costs are high. Hence the
Breakeven point (No Profit, No Loss Situation) would be reached at a higher level of
sales. Due to the high BEP the Margin of Safety and Profits would be low. This means
the operating risk are higher. Hence a low OL is preferred.

35
 4. Above BEP:- A high OL means that profit (EBIT) may be wiped off, even for a
marginal reduction in sales. Hence a Firm should operate sufficiently above the BEP to
avoid the danger of fluctuations in sales and profits.

2. Financial Leverage:-
Financial Leverage is Defined as the ability of a Firm to use fixed financial charges
(Interest) to magnify the effect of changes in EBIT (i.e. operating profits), on the EPS.
Financial Leverage occurs when a company has debt content in its capital structure & fixed
financial changes e.g. interest on debenture. These fixed financial charges do not vary with the
EBIT. They are fixed and are to be paid irrespective of levels of EBIT. When EBIT increases,
the interest payable on the debt remains constant and hence residual income available to Equity
shareholders will also increases more than proportionately. Hence an increase in EBIT will lead
to a higher percentage increase in EPS. This measured by the Financial Leverage.

Measurement :-
EBIT
Financial Leverage = ------------------
EBT
 When two levels are given degree of leverage computed.

% change in EPS
Financial Leverage = -------------------------
% Change in EBIT

Significance:-
a. To Measures effect on EPS:- FL measures the impact of change in EBIT (operating
income) on EPS. Suppose FL, of a Firm is 4 times, it implies that 1% change in EBIT will
lead to 4% change in EPS. Hence if EBIT increase by 10%, EPS increases by 10% X 4
=40%. Also, if EBIT decreases by say 5% EPS falls by 20%
b. Impact of Fixed Financial Charges:- FL depends on the magnitude of interest and
fixed financial charges. If these costs are higher, FL is higher and vice-versa.
c. Effect of High Financial Leverage:- If FL is high, it implies that fixed interest charges
are high. This means that the Financial risk are higher.

36
d. ROCE Vs Interest Rate:- FL is considered to be favorable or advantages to the Firm, only if
Return on Capital Employed (ROCE) is greater than Rate of Interest on Debt. In such a case, the
use of debt funds is justified, thus magnifying the residual earnings available to equity shareholders.
E. Trading on Equity (Gearing Effect) :- When Return on Capital employed is more than Interest
rate on Debt Capital(ROCE>Interest Rate on Debt Fund), Company earns at a higher rate on its
investment and pays a lower rate of returns to the suppliers of long term debt funds.
The difference between EBIT and the cost of debt funds would enhance the earnings of Equity
shareholders. This will maximize Return on Equity(ROE) and Earning per Shares(EPS). Therefore
equity shareholders gain in a situation where the company earns a high rate of returns and pays a lower
rate of returns to the suppliers of long term debt funds.
Hence gain from Financial Leverage (Degree of Financial Leverage) arise due to –
a. Excess of return on investment over effective cost (Cost after considering taxation effect, since
the interest cost on debt is tax-deductible expense) of debt funds.
b. Reduction Leverage in the number of Equity shares issued due to the use of debts funds.
Financial Leverage in such cases is therefore called as “Trading on Equity”

3. Combine Leverage:-
It is used to measure the total risk of a Firm i.e. Operating Risk & Financial Risk.
Effect of fixed operating cost (i.e. Operating Risk) is measured by operating leverage. Effect of fixed
interest charges (i.e. Financial Risk) is measured by Financial Leverage. The combined effect of these
is measured by Combined Leverage.

Measurement :-
Combine Leverage = Operating Leverage X Financial Leverage
OR
Contribution
Combine Leverage = ------------------
EBT
 When two levels are given degree of leverage computed.

% change in Sales
Combine Leverage = -------------------------
% Change in EPS
Significance:- Combine Leverage measures the combined impact, i.e. effect of changes in
Sales on EPS. If it is 2 times, it implies that a 10% increase Sales will lead to 20% increase in
EPS

37