Study Material (Financial Management)

Indian Education Society’s
Management College and Research Centre

Mumbai
(AICTE Approved)
ISO 9001 : 2000
STUDY MATERIAL
IES MCRC Ms. Gazia Sayed Financial Management

IES Management College and Research Centre
STUDY MATERIAL
(Financial Management)
(MFM/MMM/MIM – II Year, Semester : III)
By
(Ms. Gazia Sayed)

Academic Year (2017-18)
All rights with IES MCRC

CONTENTS
REVISED SYLLABUS BY MUMBAI UNIVERSITY ................................................................................................ 1

SESSION PLAN................................................................................................................................................................. 3
ASSESSMENT PLAN ...................................................................................................................................................... 7
Chapter 1 ................................................................................................................................................................................ 8
FINANCIAL MANAGEMENT – AN OVERVIEW ................................................................................................... 8
Chapter 2 .............................................................................................................................................................................. 14
FINANCIAL STATEMENT ANALYSIS .................................................................................................................... 14
Chapter 3 .............................................................................................................................................................................. 16
FUND FLOW ANALYSIS ............................................................................................................................................. 16
Chapter 4 .............................................................................................................................................................................. 19
CASH FLOW ANALYSIS .............................................................................................................................................. 19
Chapter 5 .............................................................................................................................................................................. 27
RATIO ANALYSIS.......................................................................................................................................................... 27
Chapter 6 .............................................................................................................................................................................. 51
WORKING CAPITAL MANAGEMENT ................................................................................................................... 51
Chapter 7 .............................................................................................................................................................................. 57
INVENTORY MANAGEMENT ................................................................................................................................... 57
Chapter 8 .............................................................................................................................................................................. 61
RECEIVABLES MANAGEMENT ............................................................................................................................... 61
Chapter 9 .............................................................................................................................................................................. 64
CASH MANAGEMENT ................................................................................................................................................. 64
Chapter 10 ........................................................................................................................................................................... 67
CAPITAL BUDGETING DECISIONS ........................................................................................................................ 67
Chapter 11 ........................................................................................................................................................................... 75
SOURCES OF FINANCE ............................................................................................................................................... 75
Chapter 12 ........................................................................................................................................................................... 77
COST OF CAPITAL ........................................................................................................................................................ 77
Chapter 13 ........................................................................................................................................................................... 82
CAPITAL STRUCTURE PLANNING ........................................................................................................................ 82
Chapter 14 ........................................................................................................................................................................... 86
DIVIDEND POLICY DECISIONS ............................................................................................................................... 86
Chapter 15 ........................................................................................................................................................................... 88
CREDIT RATING OF COUNTRIES/ STATE / INVESTMENT AND INSTRUMENTS ............................. 88

Chapter 16 ........................................................................................................................................................................... 90
INFRASTRUCTURE FINANCING ............................................................................................................................. 90
REFERENCES ................................................................................................................................................................. 93
MUMBAI UNIVERSITY QUESTION PAPER ......................................................................................................... 94

1
REVISED SYLLABUS BY MUMBAI UNIVERSITY
Financial Management University Assessment 100 marks (15 Sessions of 3 Hours Each)
Sem III
SL. No Particulars Sessions
1 Objective of Financial Management 2 Sessions

Financial Performance Appraisal using Ratio Analysis, Funds of 3 Hours
Flow Analysis & Cash Flow Analysis Each
2 Sources of Finance - Short Term/Long Term, Domestic / 2 Sessions
Foreign, Equity/Borrowings/Mixed etc. of 3 Hours
Cost of Capital & Capital - Structure Planning, Capital Each
Budgeting & Investment Decision Analysis (using Time
Value
3 Working Capital Management - Estimation & 2 Sessions
Financing, Inventory Management, Receivable of 3 Hours
Management, Cash Management Each
Divided Policy / Bonus - Theory & Practice
4 Investment (Project) identification, feasibility analysis with 2 Sessions
sensitivities, constraints and long term cash flow projection of 3 Hours
Financing Options - structuring & evaluation off-shore/ on- Each
shore Instruments, multiple option bonds, risk analysis,
financial engineering, leasing, hire purchase, foreign direct
investment, private placement, issue of convertible bonds etc.
5 Financial Benchmarking -- concept of shareholder value 3 Sessions
maximization, interest rate structuring, bond valuations of 3 Hours
Banking - consortium banking for working capital Each
management, credit appraisal by banks, periodic reporting,
enhancement of credit limits, bank guarantees, trade finance,
receivable financing, documentary credit, routing of
documents through banks, correspondent banking, sales and
realisation with foreign country clients, process of invoicing,
reail products, high value capital equipment, periodic
invoicing for large value infrastructure projects, Escrow
accounts
6 Valuation of projects and investment opportunities - 2 Sessions
due diligence procedures of 3 Hours
Credit Rating of Countries/ State / Investment & Each
Instruments
Joint Venture formulations - FIPS / RBI
Infrastructure financing
Issues & considerations, financial feasibility, pricing &
earning model
7 Case Studies and Presentations 2 Sessions
of 3 Hours
Each
Reference Text:
1. Financial Management - Brigham
2. Financial Management - Khan & Jain
3. Financial Management - Prasanna Chandra
4. Financial Management - Maheshwari
5. Financial Management – S.C.Pandey

2
6. Van Horne & Wachowiz: Fundamentals of Financial Management (Prentice Hall India)
7. Sharan: Fundamentals of Financial Management (Pearson)
8. Financial Management – Rajiv Srivastava & Anil Misra – Oxford Publications
9. Financial Management – Chandra Hariharan Iyer – International Book House Ltd
10.Fundamentals of Financial Management – Sheeba Kapil – Pearson Publications
10. Strategic Financial Management – Prasanna Chandra

3
SESSION PLAN
Indian Education Society

Management College and Research Centre
Mumbai
Program: MFM/MMM/MIM – II Year Semester : III
Subject: Financial Management
Objective: To gain in-depth knowledge of corporate finance and understand the functions
of financial management. Students should learn to analyze corporate financial statements
and other parts of the annual report.
Faculty Name: Ms. Gazia Sayed
Contact No. 9819852124 Email ID: gazia.sayed@ies.edu
Methodology: Lecture, Discussion and exercise solving
Sr. Topic Details No. of Teaching Actual

No. session Methodology date(s) of
s (lecture / case/ taking the
planned test topic
/quiz/presentati
ons/ any other)
1 Overview, concepts,
fundamentals and functions of
Corporate Finance:
1. Objectives of Financial
Management
2. Functions of Financial
Theoretical
Management 1
Discussion
3. Financial Benchmarking
Reading Material :
Book – Financial Management by
Khan and Jain; chapter 1
2 Analysis of Financial Statements

with reference to Fund Flow
Statement
Theoretical
Reading Material : 1 Discussion and
Book – Financial Accounting for exercises
Management by Dinesh D
Harsolekar, chapter 15
3 Financial performance appraisal

using Cash Flow Analysis
Theoretical
1. Investing Activities
1 Discussion and
2. Financing Activities
exercises
3. Operating Activities using
direct and indirect method

4
Reading Material :
Book – Financial Accounting for
4 Financial Performance Appraisal

using Cash Flow Analysis
1. Full cashflow statement
2. Adjustments or treatment for
tax, dividend, depreciation,
purchase of assets against shares
Lecture and
etc. 1
exercises
Reading Material :
Book – Financial Accounting for

using Ratio Analysis
1. Concept of ratios and its
importance
2. Types of ratios with help of
DuPont analysis Theoretical
3. Liquidity ratios 1 Discussion and
4. Leverage ratios exercises
Reading Material :

using Ratio Analysis
1. Profitability ratios
2. Improving ROI with help of
Profitability ratios
3. Turnover ratios Lecture and
1
4. Extended Du Pont exercises
Reading Material :
7 Working Capital Management

1. Need for working capital
2. Determinants of working
capital
3. Computation, assessing and Theoretical
controlling working capital 1 Discussion and
exercises
Reading Material :

5
8 Working Capital Management

1. Operating and cash cycle
2. Reviewing factors effecting the
working capital requirement and
cash cycle
3. Credit appraisal process of Lecture and
1
banks exercises
Reading Material :
9 Inventory Management
1. Costs included in inventory
2. Different inventory valuation
methods and its impact on COGS
and Profit Theoretical
3. Valuation of inventory 1 Discussion and
exercises
Reading Material :
10 Receivables Management
1. Credit policies
2. Credit terms
3. Collection policies
4. Tradeoff between benefits and
costs associated with different Theoretical
credit extension - liberal or 1 Discussion and
stringent policies exercises
Reading Material :
11 Cash Management
1. Cash budget
Theoretical
Reading Material : 1 Discussion and
Book – Financial Management by exercises
12 Long Term Investment Decision

1. Investment identification and
feasibility analysis with
sensitivities
2. Capital Budgeting
Theoretical
3. Calculation of project cost -
1 Discussion and
outflow and inflow of cash
exercises
Reading Material :

6
13 Capital Budgeting
1. Project appraisal using time
value of money
Lecture and
1
Reading Material : exercises
14 Sources of Finance, Financing

Options and Company‘s Cost of
Capital
1. Specific and composite cost of
capital
2. Joint Venture formulations Theoretical
3. Infrastructure financing 1 Discussion and
4. Credit Rating exercises
Reading Material :
15 Capital Structure Planning

1. Factors determining capital
structure
2. Concept of optimum capital
structure
3. Designing capital structure Theoretical
using EBIT-EPS and EBIT-MPS 1 Discussion and
approach exercises
Reading Material :
16 Divided Policy / Bonus - Theory

and Practice
1. Determinants of dividend
policy
2. Retention ratio and its impact
on wealth of shareholders Theoretical
1
Discussion
Reading Material :
Khan and Jain; chapter 24 and
25

7
ASSESSMENT PLAN
Indian Education Society

Management College and Research Centre, Mumbai
Total Marks: 100

Sr. No. Evaluation Components Weightage of Marks
I Internal Assessment 40%
1 Mid Term Test 15
2 Assignments 15
3 Project presentation 10
II Final examination: University 60%
Reference Books:
1. Financial Accounting for Managers – Dr. Dinesh Harsolekar
2. Financial Management - Brigham
Additional Reading:
1. Financial Management - Prasanna Chandra
2. Financial Management - Maheshwari
3. Financial Management –Pandey
4. Fundamentals of Financial Management - Van Horne & Wachowiz
5. Indian Journal of Finance (Issue and volume will be intimated during the course)
6. Finance India (Issue and volume will be intimated during the course)

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CHAPTER 1
FINANCIAL MANAGEMENT – AN OVERVIEW
Every organization needs finance to meet their requirements in the economic world. All kind of
business activity depends on the finance. Hence, it is called as lifeblood of business
organization. Whether the business concerns are big or small, they need finance to fulfill their
business activities. Finance may be defined as the art and science of managing money. The
major areas of finance are Financial Services and Managerial Finance or Financial
Management. Financial Services is concerned with the design and delivery of advice and
financial products to individuals, businesses and governments within the areas of banking are
related institutions, personal financial planning, investments, real estate, insurance and so on.
Financial Management is concerned with the duties of the financial managers in the business
firm. Financial managers actively manage the financial affairs of any type of business, amely,
financial and non-financial, private and public, large and small, profit seeking and not for
profit. They perform such varied tasks as budgeting, financial forecasting, cash management,
credit administration, investment analysis, funds management and so on. Financial
Management as an integral part of overall management is not a totally independent area. It
shows heavily related disciplines and fields of study, such as economic, accounting, marketing,
production and quantitative methods.
Scope of Financial Management

Financial management provides a conceptual and analytical framework for financial decision
making. Financial management is an integral part of overall management. It covers both
financial function of acquisition of funds and allocation of funds. Thus, apart from this involves
acquiring the external funds and the main concern of financial management is the efficient and
allocation of funds to various uses. Financial management covers wide area with
multidimensional approaches. The following are the important scope of financial management.
1. Financial Management and Economics

Economic concepts like micro and macroeconomics are directly applied with the
financial management approaches. Investment decisions, micro and macro
environmental factors are closely associated with the functions of financial manager.
Financial management also uses the economic equations like money value discount
factor, economic order quantity etc. Financial economics is one of the emerging area,
which provides immense opportunities to finance, and economical areas.
2. Financial Management and Accounting

Accounting records includes the financial information of the business concern. Hence,
we can easily understand the relationship between the financial management and
accounting. In the olden periods, both financial management and accounting are
treated as a same discipline and then it has been merged as Management Accounting
because this part is very much helpful to finance manager to take decisions. But
nowaday‘s financial management and accounting discipline are separate and
interrelated.
3. Financial Management or Mathematics

Modern approaches of the financial management applied large number of mathematical
and statistical tools and techniques. They are also called as econometrics. Economic
order quantity, discount factor, time value of money, present value of money, cost of
capital, capital structure theories, dividend theories, ratio analysis and working capital
analysis are used as mathematical and statistical tools and techniques in the field of
financial management.

9
4. Financial Management and Production Management

Production management is the operational part of the business concern, which helps to
multiple the money into profit. Profit of the concern depends upon the production
performance. Production performance needs finance, because production department
requires raw material, machinery, wages, operating expenses etc. These expenditures
are decided and estimated by the financial department and the finance manager
allocates the appropriate finance to production department. The financial manager
must be aware of the operational process and finance required for each process of
production activities.
5. Financial Management and Marketing

Produced goods are sold in the market with innovative and modern approaches. For
this, the marketing department needs finance to meet their requirements. The financial
manager or finance department is responsible to allocate the adequate finance to the
marketing department. Hence, marketing and financial management are interrelated
and depends on each other.
6. Financial Management and Human Resource

Financial management is also related with human resource department, which provides
manpower to all the functional areas of the management. Financial manager should
carefully evaluate the requirement of manpower to each department and allocate the
finance to the human resource department as wages, salary, remuneration,
commission, bonus, pension and other monetary benefits to the human resource
department. Hence, financial management is directly related with human resource
management.
Objectives of Financial Management

Effective procurement and efficient use of finance lead to proper utilization of the finance by
the business concern. It is the essential part of the financial manager. Hence, the financial
manager must determine the basic objectives of the financial management. Objectives of
Financial Management may be broadly divided into two parts such as:
1. Profit maximization
2. Wealth maximization
1. Profit Maximization
Main aim of any kind of economic activity is earning profit. A business concern is also
functioning mainly for the purpose of earning profit. Profit is the measuring techniques
to understand the business efficiency of the concern. Profit maximization is also the
traditional and narrow approach, which aims at, maximizes the profit of the concern.
Profit maximization consists of the following important features.
a. Profit maximization is also called as cashing per share maximization. It leads to
maximize the business operation for profit maximization.
b. Ultimate aim of the business concern is earning profit, hence, it considers all the
possible ways to increase the profitability of the concern.
c. Profit is the parameter of measuring the efficiency of the business concern. So it
shows the entire position of the business concern.
d. Profit maximization objectives help to reduce the risk of the business.
2. Wealth Maximization
Wealth maximization is one of the modern approaches, which involves latest
innovations and improvements in the field of the business concern. The term wealth
means shareholder wealth or the wealth of the persons those who are involved in the
business concern. Wealth maximization is also known as value maximization or net
present worth maximization. This objective is a universally accepted concept in the field
of business.

10
Role of Financial Management

Role of financial management is very important which are undertaken by finance manager.
1. In performing financial analysis and planning : The concern of financial analysis and
planning is –
a. Transforming financial data into a form that can be used to monitor financial
condition.
b. Evaluating the need for increased / reduced productive capacity and
c. Determining the additional / reduced financing required.
This activity is fully depend on the financial management. It proves financial
management plays on important role in performing financial analysis and planning.
2. In making investment decisions : Financial management plays an very important role

in making investment decisions like current assets as well as fixed assets. Financial
manager must determine and maintain certain optimum level of each assets. He should
also decide which of the best fixed asset acquired and when the existing assets need to
be modified or replaced or liquidated.
3. In making financing decisions : Financial management again plays an vital role in

making financing decision. It means the finance manager consider which appropriate
mix of short term and long term financing selected and the best individual short term or
long term sources of financing at a given point of time. These decisions are dedicated as
per necessities, but same require an in-depth analysis of the available financing
alternatives, the financial manager considers their costs and their long term
implications.
Functional Areas of Financial Management

Financial management can be broken down into three different functional areas are as follows–
1. The investment decision
2. The financing decision and
3. The dividend policy decision
1. Investment Decision : The investment decision relates to the selection of assets in

which the funds will be invested by firm. The assets can be acquired fall into 2
categories :
i. Long term assets (fixed assets) which yields a return over a period of time.
ii. Short term or current assets defined as those assets which in the normal course
of business are convertible into cash without diminution in value usually within
a year.
The investment decision policy is also known as capital budgeting management. If the
funds are invested in a long term period for acquiring fixed assets is called as capital
budgeting management and vice-versa. If the funds are invested in a current assets is
popularly for short term period known as working capital management.
2. Financing Decision : The second major decision involved in financial management is

the financing decision. This is concern with the financing mix or capital structure or
leverage. The term capital structure refers to the proportion of debt and equity capital.
It means the choice of the proportion of these sources of finance is the capital
requirement. It gives the theoretical relationship between the employment of debt and
the return to the shareholders.
3. Dividend policy Decision : The major third decision area of financial management is
decision relating to the dividend policy. The dividend decision should be analysed in
relation to the financing decision of a firm. The two alternatives are available, i.e. i) The
available profits can distributed among the shareholders in the form of dividend or ii)
The available profits can be reinvested into business. The decision as to which course
should be followed depends largely on a significant element in the dividend decision, the

11
dividend pay our ratio, that is, what proportion of net profits should be paid out to the
shareholders.
FINANCIAL BENCHMARKING
Financial benchmarking involves identifying some model to replicate. It is a practice that is
used by corporations attempting to remain competitive among a field of industry participants.
For example, the process can be applied to compare results for sales, income or market share.
Investors also use this approach in order to establish acceptable expectations for returns, or
profits.
Financial ratios are a very common tool for finance benchmarking. Each ratio uses information
from a company‘s financial statement in order to achieve a result. A logical way for businesses
to perform financial benchmarking is to compare performance with companies that adhere to
similar business model. This creates a fair analysis as to whether or not standards are being
kept. Given that a number of factors can determine one company‘s finances, it may be prudent
to create a universe of competitors that is as large as possible. The businesses should be
similar in size to the organization that is performing financial benchmarking. Comparisons
should be performed against businesses that operate in the same industry, as well.
One way to compare financial benchmarking is to draw an analysis between the quarterly
income performances of a business to its rivals. The focus of the comparison could be on the
profit margins achieved by individual companies. A profit margin ratio could be expressed as a
percentage and it reflects income relative to sales. If one company‘s results are lower than the
industry standard, this shortcoming should become evident through financial benchmarking. If
there is a notable discrepancy in an analysis, it could mean that changes need to be made in a
company‘s pricing structure.
Corporations invest in the future, including that of the individual employees who make up an
organization, in a variety of ways. Financial benchmarking can be done by evaluating the
compensation for staff members who fulfill similar roles. A company might use any difference
as a selling point when attempting to attract new talent. This strategy could also be applied to
the bonus structures that some employers use when rewarding personnel for achieving
success.
Investors might use financial benchmarking as a means to judge the way that an asset
portfolio performs. If the securities in a fund deliver similar results to that of some other
barometer, the portfolio is probably meeting expectations. When returns are below the
benchmark, however, the fund is under-performing. This use of comparison is useful for
investors to realize whether or not a fund manager is producing the types of profits that were
promised. A money manager could lose clients for failing to replicate returns in some other
barometer.
Advantages of Financial Benchmarking

Financial benchmarking provides a sure-fire means of:
1. Identifying Relative Strengths and Weaknesses: Identifying relative strengths and

weaknesses in business performance by making comparisons with the competition.
Benchmarking focuses improvement efforts on issues critical to success. Provides
quantitative financial performance status and targets to the operating managers that
are based on improving competitive positions.
2. Developing a Framework for Managing Change: It creates a structured, widely

available, quantitative system for regularly measuring competitive financial
performance, based on a standard analytical grid of companies, metrics and segments.

12
This is contrasted to catch-as-catch-can ad hoc reports that are seldom updated or

used as a basis for management action.
3. Identifying New Ideas for Business Strategy and Planning: It assist in strategic
planning efforts by showing strengths, weaknesses, opportunities and threats among
company and competitors. It highlight financial metrics that may be out of line with
best practices in business and adjust the business model accordingly.
4. Prioritising Improvement Actions: It ensures that improvement targets are based on

what has been achieved in actual practice. It gives executive management and board
directors‘ objective relative financial performance targets to measure operating
managers. It can be used as basis for management compensation programmes that
encourage competitive gains in the marketplace.
5. Involving and Energising Staff in Continuous Improvement: It raises an awareness

of financial performance at all levels of the company. Financial benchmarking provides
confidence that the organisation‘s performance compares favourably with best practice.
6. Communicating with Investors Assuring that ‘Best Value’ is being Achieved: It

demonstrates competitive performance versus other companies in the same business to
investors and analysts to justify current market valuation. It shows investors and
analysts that the managers have a grasp of company‘s competitive position and have
plans in place to improve it over time.
7. Comparing the Performance of Different Sub-Units in a Larger Organisation with

Outside Pure-Play Peers: It helps to identify under-performing or over-performing
divisions or business units to highlight candidates for spin-offs, divestitures, mergers,
or acquisition.
8. Tracking Industry and Market Sectors to Understand the Underlying Economics of

the Business: This can include views up and down the food chain, tracking groups of
key customers, peers, and critical suppliers.
9. Providing Competitive Financial Information: Arming sales and marketing

managers with competitive financial information to use in sales presentations. Identify
weak points of competitors.
4.1.3. Disadvantages of Financial Benchmarking

Following are the disadvantages of financial benchmarks:
1. False Results: Financial benchmarks are based upon the financial statement or ratios.
In case financial statement/ratio is incorrect or the data upon which ratios are based is
incorrect, ratio calculated will also be false and defective.
2. Absence of Standard University Accepted Terminology: Different meanings are

given to particular term such as some firms take profit before interest and after tax;
others may take profit before interest and tax. This ratio can be comparable only when
both the firms adopt uniform terminology.
3. Qualitative Factors: Financial benchmarking is the quantitative measurement of the

performance of the business. It ignores the qualitative aspect of the firm. It shows that
it is only one sided to measure the efficiency of business.
4. Ignoring Price Level Changes: The comparability of benchmark suffers if the prices of
the commodities in two different years are not same. Change in price affects the cost of

13
production, sales and also the value of assets. It means that it will not be meaningful
for comparison if the price of commodities is different.
5. Misleading Result in Absolute Data: In the absence of actual data the size of the
business cannot be known. If gross profit ratio of two firms is 25%, it may be just
possible that the gross profit of one is `2,500 and sale `10,000. Whereas the gross
profit and sales of other is `5,00,000 and 20,00,000. Profitability of two firms is same
but the magnitude of their business is quite different.
---------------------

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CHAPTER 2
FINANCIAL STATEMENT ANALYSIS
Fundamental analysis is a stock valuation methodology that uses financial and economic
analysis to envisage the movement of stock prices. The fundamental data that is analysed
could include a company‘s financial reports and non-financial information such as estimates of
its growth, demand for products sold by the company, industry comparisons, economy-wide
changes, changes in government policies etc.
The outcome of fundamental analysis is a value (or a range of values) of the stock of the
company called its ‗intrinsic value‘ (often called ‗price target‘ in fundamental analysts‘
parlance). To a fundamental investor, the market price of a stock tends to revert towards its
intrinsic value. If the intrinsic value of a stock is above the current market price, the investor
would purchase the stock because he believes that the stock price would rise and move
towards its intrinsic value. If the intrinsic value of a stock is below the market price, the
investor would sell the stock because he believes that the stock price is going to fall and come
closer to its intrinsic value.
To find the intrinsic value of a company, the fundamental analyst initially takes a top-down
view of the economic environment; the current and future overall health of the economy as a
whole. After the analysis of the macro-economy, the next step is to analyse the industry
environment which the firm is operating in. One should analyse all the factors that give the
firm a competitive advantage in its sector, such as, management experience, history of
performance, growth potential, low cost of production, brand name etc. This step of the
analysis entails finding out as much as possible about the industry and the inter-relationships
of the companies operating in the industry.
The next step is to study the company, its products and its financial statements. The financial
data can be obtained from the annual reports of company. Generally an annual report of a
company consists of directors‘ report, auditor‘s report, management discussion and analysis
and financial statements.
Financial Statements
A financial statement is an official document of the company, which explores the entire
financial information of the company. The main aim of the financial statement is to provide
information and understand the financial aspects of the company. Hence, preparation of the
financial statement is important as much as the financial decisions. Financial statements
consist of balance sheet, income statement, cash flow statement and notes to accounts.
Analysis of Financial Statement

Analysis of financial statement is very necessary to understand the financial positions during a
particular period. According to Myres, ‗Financial statement analysis is largely a study of the
relationship among the various financial factors in a business as disclosed by a single set of
statements and a study of the trend of these factors as shown in a series of statements‘.
Financial statement analysis is interpreted mainly to determine the financial and operational
performance of the business concern. A number of methods or techniques are used to analyse
the financial statement of the business concern. Some of the commonly used methods or
techniques are :
1. Comparative Statement Analysis

Comparative statement analysis is an analysis of financial statement at different period
of time. This statement helps to understand the comparative position of financial and
operational performance at different period of time. Comparative financial statements

15
again classified into two major parts such as comparative balance sheet analysis and
comparative profit and loss statement analysis.
2. Trend Analysis
The financial statements may be analysed by computing trends of series of information.
It may be upward or downward directions which involve the percentage relationship of
each and every item of the statement with the common value of 100%. Trend analysis
helps to understand the trend relationship with various items, which appear in the
financial statements. These percentages may also be taken as index number showing
relative changes in the financial information resulting with the various period of time. In
this analysis, only major items are considered for calculating the trend percentage.
3. Common Size Analysis

Another important financial statement analysis technique is common size analysis in
which figures reported are converted into percentage to some common base. In the
balance sheet the total assets figures is assumed to be 100 and all figures are expressed
as a percentage of this total and in the profit and loss statement the net sales figures is
assumed to be 100 and all figures are expressed as a percentage of this total. It is one
of the simplest methods of financial statement analysis, which reflects the relationship
of each and every item with the base value of 100%.
4. Fund Flow Statement

Funds flow statement is one of the important tools, which is used in many ways. It
helps to understand the changes in the financial position of a business enterprise
between the beginning and ending financial statement dates. It is also called as
statement of sources and uses of funds. Institute of Cost and Works Accounts of India,
defines funds flow statement as ―a statement prospective or retrospective, setting out
the sources and application of the funds of an enterprise. The purpose of the statement
is to indicate clearly the requirement of funds and how they are proposed to be raised
and the efficient utilization and application of the same‖.
5. Cash Flow Statement

Cash flow statement is a statement which shows the sources of cash inflow and uses of
cash out-flow of the business concern during a particular period of time. Cash flow
statement provides a summary of operating, investment and financing cash flows and
reconciles them with changes in its cash and cash equivalents such as marketable
securities. Institute of Chartered Accountants of India issued the Accounting Standard
(AS-3) related to the preparation of cash flow statement in 1998.
6. Ratio Analysis
Ratio analysis is a commonly used tool of financial statement analysis. Ratio is a
mathematical relationship between one number to another number. Ratio is used as an
index for evaluating the financial performance of the business concern. An accounting
ratio shows the mathematical relationship between two figures, which have meaningful
relation with each other.
The important analysis is cash flow analysis and ratio analysis. These topics will be dealt in
detailed in the next chapter.

16
CHAPTER 3
FUND FLOW ANALYSIS
Funds flow statement is one of the important tools used in analyzing the financial health of the
company. It helps to understand the changes in the financial position of a business enterprise
between the beginning and ending financial statement dates. It is also called as statement of
sources and uses of funds. Fund flow statement shows the sources and uses of funds as well
as net change in working capital. It is a financial statement which shows as to how a business
entity has obtained its funds and how it has applied or employed its funds during the
particular year or period.
Uses / advantages of Fund Flow Statement

1. Fund flow statement helps the management in the assessment of long range forecasts
of a cash requirements and availability of liquid resources. The manager can judge the
quality of management decisions.
2. With the help of Fund Flow Statement, the investors are able to measure as to how the
company has utilized the funds supplied by them and its financial strength. Also, the
investors can judge the company‘s capacity to generate funds from operations.
3. It serves as effective tools to the Management for economic analysis as it supplies
additional information which cannot be provided by financial statement based on
historical data.
4. Fund flow statement explains the relationship between changes in working capital and
net profits.
5. Fund flow statement helps the management in making planning process of a company.
It is also useful in assessing the resources available and the manner of utilization of the
resources.
6. It explains the financial consequences of business activities. It also provides explicit and
clean answer to questions regarding liquid and solvency position of the company.
7. Fund Flow Statement provides clues to the creditors and financial institutions as to the
ability of a company to use funds effectively in the best interest of the investors,
creditors and owners of the company.
Limitations of Fund Flow Statements

1. It should not be overlooked that Fund Statements ignore noncash transactions,
therefore it is considered as cruder device than the financial statement.
2. Fund Flow Statements merely rearrange a part of the information contained in financial
statements. They do not serve as original evidence of financial status.
3. Though changes in cash resources are more significant, they are not highlighted by
Fund Statements except being shown by them as a part of working capital.
4. As Fund Flow Statements are prepared from information provided by financial
statements, they are essentially historical in nature.
Ex 1
The following two balance sheets are available as on 31st March 2012 and 31st March 2013.
Liabilities 2012 (Rs.) 2013 (Rs.)

Equity Capital 4,00,000 4,50,000
10 % Pref. share capital 3,00,000 2,00,000
General Reserve 1,90,000 2,50,000
Surplus 1,30,000 2,60,000
12 % Debentures 2,00,000 3,00,000
Sundry Creditors 30,000 35,000

17
Expenses payable 10,000 9,000

Provision for Taxation 32,000 45,000
12,92,000 15,49,000
Assets 2012 (Rs.) 2013 (Rs.)

Land and Building 3,50,000 4,60,000
Machinery 5,02,000 5,04,000
Investments 70,000 1,20,000
Stock 1,05,000 1,35,000
Sundry debtors 1,50,000 2,10,000
Cash and Bank 50,000 60,000
Preliminary expenses 65,000 60,000
12,92,000 15,49,000
After taking into consideration the following additional information, prepare funds flow
statement and schedule of changes in working capital for the year April 2012 to March 2013.
i. Depreciation charged on machinery during the year is Rs.75,000
ii. A machine with a book value of Rs.30,000 was sold for Rs.18,000
iii. During the year preference shares were redeemed at 10 % premium.
---------------------
Ex.2
Following are the summarized Balance Sheets of A Co. Ltd. As on 31st December, 2001 and
2002
Liabilities 2001 (Rs.) 2002 (Rs.)

Share Capital 2,00,000 2,50,000
General Reserve 50,000 60,000
Profit and Loss A/c. 30,500 30,600
Bank Loan 70,000 -
Sundry Creditors 1,50,000 1,35,000
5,30,500 5,10,600
Assets 2001 (Rs.) 2002 (Rs.)
Land & Building 2,00,000 1,90,000
Machinery & Plant 1,50,000 1,69,000
Stock 1,00,000 74,000
Sundry debtors 80,000 64,000
Cash 500 600
Bank - 8,000
Goodwill - 5,000
5,30,500 5,10,600
Additional information supplied:

During the year ended 31st December, 2002:
a. Machinery was purchased for Rs.8,000
b. Depreciation written off : Building Rs.10,000; Machinery Rs.14,000.
Prepare a Statement of sources and Application of Funds for the year ended 31st December,
2002.
---------------------

18
Ex.3
From the following balance sheets of ABC Ltd. make out the statement of sources and uses of
funds:
Liabilities 2014 (Rs.) 2015 (Rs.) Assets 2014 (Rs.) 2015 (Rs.)
Equity share capital 3,00,000 4,00,000 Goodwill 1,15,000 90,000
8 % Redeemable Pref. shares 1,50,000 1,00,000 Land and Building 2,00,000 1,70,000
General Reserve 40,000 70,000 Plant 80,000 2,00,000
Profit & Loss A/c 30,000 48,000 Debtors 1,60,000 2,00,000
Proposed dividend 42,000 50,000 Stock 77,000 1,09,000
Creditors 55,000 83,000 Bills receivable 20,000 30,000
Bills payable 20,000 16,000 Cash in hand 15,000 10,000
Provision for taxation 40,000 50,000 Cash at bank 10,000 8,000
6,77,000 8,17,000 6,77,000 8,17,000
Additional information:
Depreciation of Rs.10,000 and Rs.20,000 have been charged on plant account and land and
building respectively in 2001.
---------------------
Ex.4
From the following two Balance Sheets as on 1st April 2004 and 31st March 2005 prepare
funds flow statement and schedule of changes in working capital.
Liabilities 2004(Rs.) 2005 (Rs.) Assets 2004 (Rs.) 2005 (Rs.)

Equity Capital 1,50,000 1,80,000 Land and Building 75,500 1,55,200
Share Premium - 10,000 Machinery 71,100 81,800
General Reserve 20,000 30,000 Furniture 8,600 9,500
Surplus 10,500 30,800 Stock 45,500 48,700
Term Loan 25,000 50,000 Sundry Debtors 38,600 42,500
Sundry Creditors 11,500 10,600 Bills Receivable 17,100 19,200
Bills Payable 9,700 8,000 Bank Balance 7,500 7,000
Expenses Payable 6,200 7,500
Proposed Dividend 20,000 25,000
2,63,900 3,63,900 2,63,900 3,63,900
Additional Information :
1. Depreciation written off during 2004-05 is as under

(i) Machinery Rs.12,000
(ii) Furniture Rs.1,200
2. Out of Rs.30,000 equity capital raised Rs.10,000 worth equity shares issued at par for the
purchase of a small machinery.
---------------------

19
CHAPTER 4
CASH FLOW ANALYSIS
Information about the cash flows of an enterprise is useful in providing users of financial
statements with a basis to assess the ability of the enterprise to generate cash and cash
equivalents and the needs of the enterprise to utilise those cash flows. The economic decisions
that are taken by users require an evaluation of the ability of an enterprise to generate cash
and cash equivalents and the timing and certainty of their generation. The Statement deals
with the provision of information about the historical changes in cash and cash equivalents of
an enterprise by means of a cash flow statement which classifies cash flows during the period
from operating, investing and financing activities.
Benefits of Cash Flow Information

1. A cash flow statement, when used in conjunction with the other financial statements,
provides information that enables users to evaluate the changes in net assets of an
enterprise, its financial structure (including its liquidity and solvency) and its ability to
affect the amounts and timing of cash flows in order to adapt to changing
circumstances and opportunities.
2. Cash flow information is useful in assessing the ability of the enterprise to generate
cash and cash equivalents and enables users to develop models to assess and compare
the present value of the future cash flows of different enterprises.
3. It also enhances the comparability of the reporting of operating performance by different
enterprises because it eliminates the effects of using different accounting treatments for
the same transactions and events.
4. Historical cash flow information is often used as an indicator of the amount, timing and
certainty of future cash flows.
5. It is also useful in checking the accuracy of past assessments of future cash flows and
in examining the relationship between profitability and net cash flow and the impact of
changing prices.
Definitions
1. Cash comprises cash on hand and demand deposits with banks.
2. Cash equivalents are short term, highly liquid investments that are readily convertible
into known amounts of cash and which are subject to an insignificant risk of changes
in value.
3. Cash flows are inflows and outflows of cash and cash equivalents.
4. Operating activities are the principal revenue-producing activities of the enterprise
and other activities that are not investing or financing activities.
5. Investing activities are the acquisition and disposal of long-term assets and other
investments not included in cash equivalents.
6. Financing activities are activities that result in changes in the size and composition of
the owners‘ capital (including preference share capital in the case of a company) and
borrowings of the enterprise.
Operating Activities
The amount of cash flows arising from operating activities is a key indicator of the extent to
which the operations of the enterprise have generated sufficient cash flows to maintain the
operating capability of the enterprise, pay dividends, repay loans and make new investments
without recourse to external sources of financing. Cash flows from operating activities generally
result from the transactions and other events that enter into the determination of net profit or
loss. Examples of cash flows from operating activities are:
a. cash receipts from the sale of goods and the rendering of services;
b. cash receipts from royalties, fees, commissions and other revenue;
c. cash payments to suppliers for goods and services;

20
d. cash payments to and on behalf of employees;

e. cash receipts and cash payments of an insurance enterprise for premiums and claims,
annuities and other policy benefits;
f. cash payments or refunds of income taxes unless they can be specifically identified with
financing and investing activities; and
g. cash receipts and payments relating to futures contracts, forward contracts, option
contracts and swap contracts when the contracts are held for dealing or trading
purposes
Investing Activities
The separate disclosure of cash flows arising from investing activities is important because the
cash flows represent the extent to which expenditures have been made for resources intended
to generate future income and cash flows. Examples of cash flows arising from investing
activities are:
a. Cash payments to acquire fixed assets (including intangibles). These payments include
those relating to capitalised research and development costs and self-constructed fixed
assets;
b. Cash receipts from disposal of fixed assets (including intangibles);
c. Cash payments to acquire shares, warrants or debt instruments of other enterprises
and interests in joint ventures (other than payments for those instruments considered
to be cash equivalents and those held for dealing or trading purposes);
d. Cash receipts from disposal of shares, warrants or debt instruments of other
enterprises and interests in joint ventures (other than receipts from those instruments
considered to be cash equivalents and those held for dealing or trading purposes);
e. Cash advances and loans made to third parties (other than advances and loans made
by a financial enterprise);
f. Cash receipts from the repayment of advances and loans made to third parties (other
than advances and loans of a financial enterprise);
g. Cash payments for futures contracts, forward contracts, option contracts and swap
contracts except when the contracts are held for dealing or trading purposes, or the
payments are classified as financing activities; and
h. Cash receipts from futures contracts, forward contracts, option contracts and swap
contracts except when the contracts are held for dealing or trading purposes, or the
receipts are classified as financing activities
Financing Activities
The separate disclosure of cash flows arising from financing activities is important because it is
useful in predicting claims on future cash flows by providers of funds (both capital and
borrowings) to the enterprise. Examples of cash flows arising from financing activities are:
a. cash proceeds from issuing shares or other similar instruments;
b. cash proceeds from issuing debentures, loans, notes, bonds, and other short or long-
term borrowings; and
c. cash repayments of amounts borrowed
Cash Flow Statement

Cash flow statement means a statement of showing net changes in the position of cash and
cash equivalents. As per AS 3, this would include cash in hand and savings, current account
balances with banks, demand deposits with banks and cash equivalents. Cash equivalents are
defined as short term and highly liquid investments that are readily convertible into cash
which are subject to insignificant risk of changes in values.
Uses / Advantages of Cash Flow Statement

1. Efficient Cash Management : The most important function of management is to
manage the cash resources in such a way that adequate cash is available for meeting
the expenses. It helps to plan and co-ordinate the financial operation of the business.

21
2. Internal Financial Management : It provides a clear picture of cash flow operations.

Therefore, it is very useful for internal financial management.
3. Knowledge of changes in Cash Position : It enables the management to know about
the causes of changes in cash position. The finance manager can explain the
relationship between profit and cash balance.
4. Success or failure of Cash Planning : Cash flow statement helps to management in
making the comparison between actual and budgeted cash flow statement to know the
success or failure in cash management. It also helps in taking necessary remedial
measures in cash of any deviations.
5. Projected Cash Flow : It helps to know the projected cash inflow and cash outflow.
6. Supplemental to Fund Flow Statement : It is supplementary to Fund flow statement
for analysis of cash.
7. Tool of Analysis : It analysis is certainly a better tool of analysis than the fund flow
analysis for short term decisions.
Limitations of Cash Flow Statement:

1. Misleading of Inter – Industry Comparison : Cash flow statement does not measure
the economic efficiency of one company in relation to another company. Therefore, due
to inter-industry comparison of cash flow may mislead.
2. Misleading Inter – Firm Comparison : The terms and conditions of purchases and
sales of different firms may not be the same. Hence, inter firm comparison becomes
misleading.
3. Influence of Management Policies : Management policies influence the cash easily by
making certain payments in advance or by postponing certain payments.
4. Cannot tally with Income Statement : Cash Flow Statement can not be tally with
income statement. Therefore, net cash flow does not mean income of the business.
5. Not a substitute to other Statement : It cannot be substitute to other statements. For
e.g. Fund Flow Statement and Balance Sheet.
Ex.1
Classify the activities as (a) Operating Activities; (b) Investing Activities and (c) Financing
Activities
1. Issue of debentures
2. Payment of Interest
3. Sale of Land
4. Cash sales
5. Receipt of Dividend
6. Payment of Income Tax
7. Refund of loan taken
8. Cash received from Debtors
9. Rent paid
10. Refund of Income Tax
11. Payment of divided
12. Payment to creditors
13. Purchase of machinery
14. Purchase of Mutual fund scheme
15. Sale of goods
16. Long-term loan taken
17. Issue of preference shares
18. Issue of bonus shares
19. Cash deposited in bank
20. Purchased of fixed assets against issue of shares
---------------------

22
Ex.2
Following are the summary of Cash transactions extracted from the books of X ltd.
Cash Inflow ` Cash Outflow `

Opening balance 35,000 Payment to Creditors 4,50,000
Receipts from Debtors 7,00,000 Purchase of Building 2,50,000
Issue of share capital 3,00,000 Payment of office expenses 50,000
Sale of land 1,25,000 Payment of salaries 1,00,000
Sale of machinery 75,000 Payment of Income tax 75,000
Sale of GOI bonds 5,000 Payment of dividend 25,000
Loan taken 70,000 Repayment of loan 20,000
Cash sale of goods 1,00,000 Interest paid 5,000
Closing Balance 4,35,000
14,10,000 14,10,000
Prepare a cashflow statement.
---------------------
Ex.3
Calculate cashflow from investing and financing activity
Particulars 2012 ` 2013 `
Liabilities and equities
Equity Share capital 5,00,000 8,00,000
Preference share capital 2,50,000 1,50,000
Non-convertible debentures 2,00,000 1,50,000
Loan taken 1,00,000 1,50,000
Mortgage loan 1,50,000 2,00,000
Current liabilities 50,000 50,000
Total 12,50,000 15,00,000
Assets
Land 2,00,000 2,00,000
Plant and machinery 3,50,000 5,00,000
Building 3,00,000 4,00,000
Furniture 1,00,000 50,000
Long term investments 2,50,000 2,80,000
Current assets 50,000 70,000
Total 12,50,000 15,00,000
Additional information:
1. No depreciation on land and plant and machinery
2. Depreciation of `50,000 had been charged on Building and `10,000 on furniture.
---------------------
Ex.4
Calculate cashflow from operating activities using Direct and indirect method
Particulars ` `
Income :
Sales
Cash 2,50,000
Credit 1,00,000 3,50,000
Less : Expenses

23
Purchases
Cash 50,000
Credit 1,25,000 1,75,000
Salaries 13,000
Wages
10,000
Add : outstanding +5,000 15,000
Insurance
28,000
Less : prepaid -8,000 20,000
Rent 25,000
Electricity 20,000
Depreciation 14,000 2,82,000
Profit 68,000
---------------------
Ex. 5
Calculate cashflow from operating activities using indirect method
Balance Sheet (As on December 31, 2013 and 2014)

Equities and Liabilities
Equity Share Capital 3,20,000 3,20,00
Profit & Loss Account 75,000 87,000
Bills Payable 22,000 21,000
Outstanding Wages 4,000 7,000
4,57,000 4,69,000
Assets
Net Fixed Assets 3,00,000 3,00,000
Debtors 50,000 55,000
Inventories 78,000 85,000
Prepaid Insurance 9,000 6,000
Cash Balance 20,000 23,000
4,57,000 4,69,000
---------------------
Ex. 6
The Balance Sheets of Arial Ltd. are as follows:

I. EQUITY AND LIABILITIES
1. Shareholders‘ fund
8 % Preference Share Capital 75,000 50,000
2. Non-Current Liabilities --- ---
3. Current Liabilities

24

TOTAL 3,38,500 4,08,500
II. ASSETS
1. Non-current assets
Goodwill 57,500 45,000
Land and building 1,00,000 85,000
Plant 40,000 1,00,000
2. Current assets
Stock 38,500 54,500
Debtors 80,000 1,00,000
Bills Receivables 10,000 15,000
Cash at Bank 5,000 4,000
Cash in Hand 7,500 5,000
TOTAL 3,38,500 4,08,500
Additional Information:
1. Depreciation of `5,000 and `10,000 have been charged on Plant and Land & Building
respectively.
2. `17,500 Income Tax was paid during the year 2015.
Prepare Cash Flow Statement and summarize your findings.
---------------------
Ex.7
From the following Balance Sheet calculate the cashflow.

Outstanding Wages 0 5,000
2,28,000 3,08,000
Assets
Building 1,00,000 91,000
Investment 50,000 64,000
Debtors 50,000 75,000
Prepaid Insurance 8,000 6,000
Cash Balance 20,000 72,000
2,28,000 4,08,500
---------------------

25
Ex.8
The following are the two balance sheets as on 31 st March 2012 and 31st March 2013.

Equity Capital 3,20,000 3,80,000
Profit and loss account 37,650 42,450
Term Loan 40,000 30,000
Creditors 36,200 35,000
Outstanding expenses 4,000 6,000
Provision for tax 15,000 18,000
Proposed dividend 12,000 14,000
5,25,650 5,97,650
Assets
Land and Building 1,75,000 1,70,500
Goodwill 10,000 15,000
Machinery 1,52,950 2,12,150
Patents 18,000 14,000
Stock 78,900 85,200
Debtors 69,700 75,600
Prepaid expenses 7,600 8,500
Accrued commission 5,000 5,500
5,25,650 5,97,650
1. Depreciation on building charged was `4,500 and on machinery `18,500.
2. Tax liability for the previous year came to `13,000 which was paid from the Provision
account.
3. Dividends paid during the year are `10,000. The balance `2,000 is still lying in the
proposed dividend account.
4. A small proprietary business was purchased for `45,000. The entire purchase consideration
was paid through issue of equity shares. The assets purchased were, goodwill `10,000 and
machinery `35,000.
5. One machine was purchased for `60,000.
From the above balance sheets and additional information prepare cash flow statements.
---------------------
Ex.9
From the condensed comparative Balance Sheets of Madhu Ltd. and additional information,
prepare a cash flow statement.

Liabilities:
Share Capital (`10 each) 70,000 80,000
Share premium A/c. 9,000 11,000
Retained Earnings 23,820 30,820
7% Mortgage loan - 20,000
Outstanding Salaries 2,000 1,400
Provision for Taxation 1,000

26
1,400
Total 1,12,720 1,50,620
Assets:
Plant and Machinery 62,000 66,000
Accumulated Dep. on Plant and Machinery (37,000) (26,200)
Buildings 95,000 1,16,000
Accumulated Dep. on Buildings (43,000) (45,000)
Investments 10,000 12,000
Stock 10,220 9,620
Debtors 8,600 7,600
Prepaid expenses 720 800
Cash 6,180 9,800
Total 1,12,720 1,50,620
1. Plant costing `16,000 (accumulated depreciation `14,800) was sold during the year for
`1,200.
2. Buildings were acquired during the year at a cost of `21,000. In addition to cash
payment of `1,000; a 7 % Mortgage loan was raised for the balance.
3. Dividends of `8,000 paid during the year.
4. A sum of `13,900 was transferred to provision for taxation account in 2003.
---------------------
Ex.10
The following are the summarized Balance Sheets of Kevin Ltd. as on 31.3.2012 and
31.3.2013:
Liabilities 2012 ` 2013 `

Share Capital 2,00,000 2,50,000
Bank Loan (Long-Term) 70,000 -
Sundry Creditors 1,50,000 1,35,200
5,30,500 5,10,800
Assets 2012 ` 2013 `
Furniture - 5,000
Land and buildings 2,00,000 1,90,000
Machinery 1,50,000 1,69,000
Stock 1,00,000 74,000
Sundry Debtors 80,000 64,200
Cash 500 800
Bank - 7,800
5,30,500 5,10,800
During the year ended 31st March, 2013.

1. Dividend of `23,000 was paid.
2. Machinery was purchased for `35,000.
3. Depreciation written off on Machinery `12,000.
4. Income – tax provided during the year was `33,000.
You are required to prepare a Cash Flow Statement.
---------------------

27
CHAPTER 5
RATIO ANALYSIS
Ratio analysis is an important and powerful technique or method, generally, used for analysis
of Financial Statements. Ratios are used as a yardstick for evaluating the financial condition
and performance of a firm. Analysis and interpretation of various accounting ratios gives a
better understanding of financial condition and performance of the firm in a better manner
than the perusal of financial statements. Ratio is a mathematical relationship between one
number to another number. Ratio is used as an index for evaluating the financial performance
of the business concern. An accounting ratio shows t h e m a t h e m a t i c a l
r e l a t i o n s h i p b e t w e e n t w o f i g u r e s , w h i c h
h a v e m e a n i n g f u l r e l a t i o n w i t h e a c h o t h e r .
Scope
With a single financial ratio, no conclusion is to be arrived at. The ratios are to be studied in
relation to each other, in comparison of the past ratios of the firm as well as ratios of the
industry, better with its immediate competitors to understand their relative significance and
impact. Ratios are the symptoms of health of an organisation like blood pressure, pulse or
temperature of an individual. Ratios are the indicators for further investigation.
Standards of comparison
A single ratio is not meaningful. For proper interpretation and understanding, ratios are to be
compared. Comparison can be with
 Past ratios i.e. ratios from previous years‘ financial statements of the same firm.
 Competitors‘ ratios i.e. similar ratios of the nearest successful competitors.
 Industry ratios i.e. ratios of the industry to which the firm belongs to.
 Projected ratios i.e. ratios developed by the firm which were prepared, earlier, and
projected to achieve.
Forms
The ratio can be expressed in 3 terms:
 Simple or pure ratio
 Percentage
 Rate
Simple or pure ratio - It gives a simple relationship between two figures. Example current
ratio, it means consider the relationship between current assets and current liabilities, if the
current assets are Rs.4,00,000/- and current liabilities are Rs.2,00,000/-, the ratio is derived
by dividing Rs.4,00,000/- by Rs.2,00,000/-, then the answer is 2 which will be expressed on
2:1.
Percentage - Some ratio‘s is expressed in terms of percentage. The relationship between profit
and sales is expressed in percentage. For example- If sales are Rs.10,00,000/- and gross profit
is Rs.5,00,000/- then it is expressed as gross profit being 50% of sales.
Rate - Ratios are also expressed in terms of rates. i.e. number of times or certain period. The
relationship between stock is expressed in terms of rates. For Example- If stock turnover rate is
said to be 6 times in a year, it mean that the stock is converted into sales 6 times in 12
months.
Advantages of Ratios Analysis

Ratio analysis is an important and age-old technique of financial analysis. The following are
some of the advantages /benefits of ratio analysis:

28
 Simplifies financial statements: It simplifies the comprehension of financial

statements. Ratios tell the whole story of changes in the financial condition of the
business
 Facilitates inter-firm comparison: It provides data for inter-firm comparison. Ratios

highlight the factors associated with successful and unsuccessful firm. They also reveal
strong firms and weak firms, overvalued and undervalued firms.
 Helps in planning: It helps in planning and forecasting. Ratios can assist management,
in its basic functions of forecasting, planning, co-ordination, control and
communications.
 Makes inter-firm comparison possible: Ratios analysis also makes possible

comparison of the performance of different divisions of the firm. The ratios are helpful
in deciding about their efficiency or otherwise in the past and likely performance in the
future.
 Help in investment decisions: It helps in investment decisions in the case of investors

and lending decisions in the case of bankers etc.
Limitations of Ratios Analysis

The ratios analysis is one of the most powerful tools of financial management. Though ratios
are simple to calculate and easy to understand, they suffer from serious limitations.
 Limitations of financial statements: Ratios are based only on the information which
has been recorded in the financial statements. Financial statements themselves are
subject to several limitations. Thus ratios derived, there from, are also subject to those
limitations. For example, non-financial changes though important for the business are
not disclosed by the financial statements. Financial statements are affected to a very
great extent by accounting conventions and concepts. Personal judgment plays a great
part in determining the figures for financial statements.
 Comparative study required: Ratios are useful in judging the efficiency of the business
only when they are compared with past results of the business. However, such a
comparison only provide glimpse of the past performance and forecasts for future may
not prove correct since several other factors like market conditions, management
policies, etc. may affect the future operations.
 Ratios alone are not adequate: Ratios are only indicators, they cannot be taken as
final regarding good or bad financial position of the business. Other things have also to
be seen.
 Problems of price level changes: A change in price level can affect the validity of ratios
calculated for different time periods. In such a case the ratio analysis may not clearly
indicate the trend in solvency and profitability of the company. The financial
statements, therefore, be adjusted keeping in view the price level changes if a
meaningful comparison is to be made through accounting ratios.
 Lack of adequate standard: No fixed standard can be laid down for ideal ratios. There
are no well accepted standards or rule of thumb for all ratios which can be accepted as
norm. It renders interpretation of the ratios difficult.

29
 Limited use of single ratios: A single ratio, usually, does not convey much of a sense.
To make a better interpretation, a number of ratios have to be calculated which is likely
to confuse the analyst than help him in making any good decision.
 Personal bias: Ratios are only means of financial analysis and not an end in itself.
Ratios have to be interpreted and different people may interpret the same ratio in
different way.
 Incomparable: Not only industries differ in their nature, but also the firms of the
similar business widely differ in their size and accounting procedures etc. It makes
comparison of ratios difficult and misleading.
Types of Ratios
Several ratios can be grouped into various classes, according to the activity or function they
perform. Ratios can be classified according to the way they are constructed and their general
characteristics. Therefore the ratios can be classified as:
 Based on financial statement
 Based on user
 Based on function
1. Based on financial statement

The relationship between two figures which is expressed, it is taken from financial statement
i.e. profit and loss a/c, balance sheet or both. This can be grouped as follows.
a. Balance sheet ratio – The relationship between two figures is expressed by taking
figures from balance sheet itself. There is no need to refer income statement. Actually,
the relationship between the assets and liabilities is current ratio, liquid ratio,
proprietary ratio capital gearing ratio, debt equity ratio, and stock-working capital ratio.
b. Income statement ratio – The relationship between two groups is expressed from income
statement itself. Mostly, it shows the relationship between profitability and sales of the
firm. For Example - gross profit ratio, operating ratio, net profit ratio, net operating
profit ratio and stock turnover ratio.
c. Combined ratios – Under these ratio‘s the relationship between two figures is expressed
by taking figures on from Balance Sheet and another from Income Statement. It shows
the relationship between the profits and investment of the firm. For e.g. Return on
Capital employed, Earning Per Share, Debtors Turnover Ratio, etc.
2. Based on users
a. Ratio for shareholders – Shareholders are interested in the safety of their funds and
capital appreciation. It includes return on proprietors‘ funds and return on equity
capital.
b. Ratio for Short Term Creditors - Basically, creditors are interested in knowing the firm‘s
ability to meet short term obligation in time. This includes current ratio, liquid ratio.
c. Ratio for Management - The management is interested in the returns on their
investment. For e.g. Return on capital employed, turnover ratio, operating ratio etc.
d. Ratios for Long Term Creditors - They are interested in companies‘ ability to pay
interest and repay the debts when it is actually due. E.g. Debt Equity Ratio, Proprietary
Ratio etc.
3. Based on functions:
a. Liquidity ratios
b. Leverage or capital structure ratios
c. Profitability ratios
d. Activity or turnover ratios
LIQUIDITY RATIOS OR SOLVENCY RATIOS

30
Liquidity ratios are highly useful to creditors, banks and financial institutions that provide
short-term credit. Short-term refers to a period not exceeding one year. Liquidity ratios
measure the firm‘s ability to meet current obligations, as and when they fall due. A firm should
ensure that it does not suffer from lack of liquidity and also does not have excess liquidity. In
the absence of adequate liquidity, the firm would not be able to pay creditors, who have
supplied goods and services, on the due date. Loss of creditworthiness may result in legal
problems, finally, culminating in the closure of business of a company, even. If the firm
maintains more liquidity, it will not experience any difficulty in making payments. However, a
higher degree of liquidity is bad, as idle assets earn nothing, while there is cost for the funds.
The firm‘s funds will be, unnecessarily, tied up in liquid assets. Both inadequate and excess
liquidity are not desirable. It is necessary for the firm to strike a proper balance between high
liquidity and lack of liquidity.
1. Current Ratio
Current ratio is defined as the relationship between current assets and current liabilities. It is
also known as working capital ratio. This is calculated by dividing total current assets by total
current liabilities.
Current ratio = Current asset
Current Liability
Current assets are those that can be realized within a short period of time, generally one year.
Similarly, current liabilities are those that are to be paid, within a period of one year.
2. Liquid / Quick /Acid Test Ratio / Near Money Ratio

Liquid ratio establishes the relationship between liquid assets and current liabilities. Liquid
assets are those that can be converted into cash, quickly, without loss of value. Cash and
balance in current account with bank are the most liquid assets. Other assets that are
considered, relatively, liquid are debtors, bills receivable and marketable securities (temporary,
quoted investments purchased, instead of holding idle cash). Inventories and prepaid expenses
are excluded from this category. Inventories are considered less liquid as they require time for
realizing into cash and have a tendency to fluctuate, in value, at the time of realization. Prepaid
expenses cannot be recovered in cash, normally, hence they are excluded. This is calculated as:
Liquid Ratio = Quick Assets
Quick or Current Liabilities
3. Cash Ratio or Absolute Liquid Ratio

Cash is the most liquid asset. Although receivables (debtors) and bills receivable are, generally,
better realizable than inventories, still, there are doubts regarding their realization, more so, in
time. So, they are not considered, immediately, available for making payments and so excluded
for the calculation of cash ratio.
Cash Ratio = Cash and Bank + Short-term Securities
Quick or Current Liabilities
Ex. 1
The following data is available for the year ended December 31, 2014. Calculate the liquidity
ratios:
Particulars `
(1) Shareholder's Funds
a. Share capital
Equity shares of ` 100 each 8,00,000
b. Reserves and surplus
General reserve 1,40,000
Retained earnings 25,000
(2) Share application money pending allotment ---
(3) Non-Current Liabilities

31
Debentures 1,77,600
(4) Current Liabilities
Creditors 3,95,400
Proposed dividend 40,000
Provision for tax 54,000
Bank over draft 1,20,000
TOTAL 17,52,000
II. ASSETS
(1) Non-current assets
a. Fixed assets 9,40,000
b. Non-current investments 75,000
(2) Current assets
Stock in trade 3,41,000
Sundry Debtors 2,85,000
Cash and bank balance 91,000
Marketable securities 20,000
TOTAL 17,52,000
------------------------
Ex. 2
The following is the Balance Sheet of a firm :
Particulars `
Share Capital 30,000
Current Liabilities
Creditors 8,000
Bills Payable 2,000
Provision for tax 3,500
Total 43,500
II. Assets
Non-current assets
Fixed Assets 16,500
Current assets
Cash 1,000
Book Debts 6,000
Bills Receivable 2,000
Stock 18,000
Total 43,500
Calculate the net working capital, current ratio and quick ratio.
------------------------
Ex. 3
From the following income statement and balance sheet calculate defensive interval ratio.
Income Statement
Particulars (`) (`)
Sales 62,13,600
Interest received 2,500
Total Income 62,16,100
Less : Expenses

32
Opening stock of Raw Material 20,000

Interest paid 18,000
Purchase of raw materials 2,10,000
Power and fuel 15,500
Wages 75,000
Salaries 60,000
Bonus to employees 29,600
Rent and taxes paid 8,200
Advertisement 19,700
Discount allowed 2,100
Depreciation 50,000 5,08,100
Net Profit 57,08,000
Balance Sheet
Particulars (`)
Share Capital 10,00,000
Long term bank loan 1,00,000
Retained Earnings 57,08,000
Outstanding Expenses 50,000
Accounts payable 29,500
Total liabilities 68,87,500
Goodwill 50,000
Buildings 38,00,000
Plant and machinery 27,79,400
Cash and bank balance 31,900
Accounts receivable 1,26,200
Marketable Investments 1,00,000
Total Assets 68,87,500
------------------------
Ex. 4
From the following data calculate the liquidity ratios and comment on the same.
Industry : Household & Personal Products (Indian Rupee in Crores)

Companies Colgate Dabur Hindustan Marico Godrej
Palmol. India Unilever Consumer
Prod
Particulars Mar 2015 Mar 2015 Mar 2015 Mar 2015 Mar 2015
Current Assets, Loans & Advances
Inventories 252.23 550.6 2,602.68 791.59 489.51
Raw Materials 43.13 159.65 751.99 247.39 176.61
Work-in Progress 9.69 77.17 294.83 107.2 47.11
Finished Goods 135.54 189.96 1,331.48 346.3 235.41
Packing Materials 0 65.38 108.99 61.44 0
Stores and Spare 14.09 0.86 60.99 7.3 5.41
Goods in transit 4.81 11.8 54.4 0 0
Goods in trade 44.96 45.78 0 16.4 24.97
Other Inventory 0 0 0 5.56 0
Sundry Debtors 69.64 338.79 782.94 130.55 142.94
Debtors more than Six months 11.71 21.53 56.05 7.07 9.64
Considered good 1.77 6.37 18.85 4.18 2.9
Considered doubtful 9.94 15.16 37.2 2.89 6.74
Debtors Others 67.88 332.42 764.09 126.37 140.04
Considered good 67.88 332.42 764.09 126.37 140.04

33
Less : Provisions for Doubtful Debts 9.94 15.16 37.2 2.89 6.74
Cash and Bank 254.45 123.94 2,537.56 96.97 495.36
Cash in hand 0 0.82 0.74 0.18 0.27
Balances at Bank 254.45 121.21 2,536.82 96.03 495
With Scheduled Banks 254.45 121.21 2,536.82 96.03 495
Stamps, Cheques, Demand Drafts 0 1.91 0 0.76 0.09
Other Current Assets 8.46 73.74 251.47 41.35 7.53
Interest accrued on Investments 1.51 53.01 39.39 0 0
Interest accrued and or due on loans 0 0 10.51 3.51 7.11
Export Incentives receivables 0 4.4 0 0.18 0
Prepaid Expenses 5.05 0 0 8.25 0
Claim Received 0.08 0 192.19 0.05 0
Others 1.82 16.33 9.38 29.36 0.42
Loans and Advances 1,204.46 501.62 465.08 867.49 72.06
Advances recoverable in cash or kind 18.4 15.09 381.52 59.22 0
To Employees 1.77 3.35 0 0 0
For Purchases 16.63 11.74 0 59.22 0
To Others 0 0 381.52 0 0
Advance income tax and TDS 1,108.33 388.84 0 705.42 0
Due From Subsidiaries 0 0 0 10.57 0
Loans 0.71 0 0 25.75 0
To a subsidiary 0 0 0 3.89 0
To Employees 0.71 0 0 2.1 0
To Others 0 0 0 19.76 0
Balances with customs authorities 60.05 66.69 0 6.53 52.54
Inter corporate deposits 12.2 0 0 60 0
Securities Deposits 4.76 0 0 0 0.21
Sundry Deposits 0 14.87 0 0 0
Other Loans & Advances 0 17.6 83.56 0 19.67
Less: Advances considered doubtful 0 1.47 0 0 0.36
Total Current Assets 1,789.23 1,588.69 6,639.73 1,927.95 1,207.40
Less : Current Liabilities and Provn
Current Liabilities
Sundry Creditors 514.41 636.44 4,851.54 404.38 804.53
Acceptances 0 120.2 437.36 0 0
Unclaimed Dividend 121.44 5.2 92.3 0.27 6.75
Investor Education Protection Fund 0.64 0 0 0 0
Unearned revenue 4.85 6.54 43.42 26.09 0
Interest Accrued But Not Due 0 0 0 1.02 0
Deposits from Customers 0 0 0 0.21 0
Trade and Other deposits 0.15 6.35 0 0 0.39
Statutory Liability 78.5 83.01 404.16 17.29 50.25
Other Liabilities 80.28 198.25 368.17 103.39 626.33
Provisions
Proposed Equity Dividend 0 131.74 1,947.12 0 0
Provision for Corporate Dividend Tax 0 26.82 396.39 0 17.33
Provision for Tax 1,170.60 390.99 6.73 713.08 0
Provision for Gratuity 0 0 0 2.6 21.54
Provision for post-retirement benefits 0.33 0.34 50.86 0.55 0
Provision for leave encashment 1.91 0 0 6.02 2.79
Provisions for contingencies 0 0 0 42.25 0
Other Provisions 0 40.69 184.77 0 0
------------------------
Ex. 5
From the following data calculate the liquidity ratios and comment on the same.
Industry Name: Automobile Two & Three Wheelers

Balance Sheet (`in Millions)
Hero Honda
Companies MotoCorp TVS Motor Bajaj Auto Motor
Particulars Mar 2013 Mar 2013 Mar 2013 Mar 2013

34

Inventories 636.76 509.66 636.28 199.98
Sundry Debtors 665 300.52 767.58 55.97
Cash and Bank 181.04 17.45 558.85 2.73
Other Current Assets 178.05 171.23 1406.47 36.2
Loans and Advances 407.4 130.65 117.57 24.24
Current Liabilities and Provisions
Current Liabilities 2760.98 1200.75 2525.77 315.31
Provisions 1409.7 53.42 1607.86 0.9
Industry average – Current ratio (x) - 0.91 Quick Ratio (x) – 0.65
------------------------
Ex. 6
From the following data calculate the liquidity ratios.
Industry Name: IT - Software

Infosys Wipro L&T TCS Tech

Companies Infotech Mahindra
Inventories 0.00 479.40 0.0 12.34 0.00
Sundry Debtors 8,627.00 8,144.20 1,031.44 17,036.76 4,240.80
Cash and Bank 27,722.00 15,667.50 133.43 16,502.50 1,819.50

Other Current Assets 3,021.00 5,748.80 144.13 4,446.83 1,439.50
Loans and Advances 2,633.00 4,626.80 540.05 1,684.24 1,532.00
Less : Current Liabilities and Provisions
Current Liabilities 5,670.00 13,250.30 616.44 9,444.28 3,953.80
Provisions 8,045.00 4,115.00 279.20 7,019.35 1,477.30
Industry average – Current ratio (x) - 3.49; Quick Ratio (x) – 3.47
------------------------
LEVERAGE RATIOS
Leverage ratios indicate the long-term solvency of the firm. Leverage ratios indicate the mix of
debt and owners‘ equity in financing the assets of the firm. These ratios measure the extent of
debt financing in a firm. This ratio is important for long term-creditors like debenture holders,
financial institutions that provide long term capital.
1. Debt-Equity Ratio
This ratio is calculated to measure the relative claims of outsiders and owners against the
firm‘s assets. The ratio shows the relationship between the external liabilities (outsiders‘ funds)
and internal equities (shareholders‘ funds).
Debt-equity ratio = Debt = Non-Current Liabilities
Equity Net Worth
2. Proprietary ratio

35
It compares proprietor‘s funds with total liabilities or total assets. It is expressed in terms of
percentage. It determines to what extent total assets are financed by proprietors. It also
compares proprietors funds with total assets and total liabilities.
Proprietary ratio = Proprietary fund
Total Assets
3. Capital Gearing Ratio

Gearing means the process of increasing the equity shareholders‘ return through the use of
debt. Equity shareholders earn more when the rate or return on total capital is more than the
rate of interest on debts. It shows balance between debt and equity and it also shows whether a
company is practicing trading on equity.
Capital gearing ratio = Funds Bearing Fixed Rate of Return
Funds Not Bearing Fixed Rate of Return
Funds bearing fixed rate of interest and dividend includes Preference share capital, debentures,
loans etc. Funds not bearing fixed rate of interest and dividend includes equity share capital,
reserves and surplus, fictitious assets and accumulated losses.
Capital gearing ratio = Preference share capital + Debentures + Long Term Debt
Equity shareholders‘ funds
4. Interest Coverage Ratio

The interest coverage ratio is used to test the firm‘s debt-servicing capacity. The interest
coverage ratio shows the number of times the interest charges are covered by funds that are
ordinarily available to pay interest charges. This ratio indicates the extent to which earnings
can fall, without causing any embarrassment to the firm, regarding the payment of interest
charges. The higher the IC ratio, better it is both for the firm and lenders. For the firm, the
probability of default in payment of interest is reduced and for the lenders, the firm is
considered to be less risky. However, too high a ratio indicates the firm is very conservative in
not using the debt to its best advantage of the shareholders. On the other hand, a lower
coverage ratio indicates the excessive use of debt. When the coverage ratio is low, compared to
the industry, it should improve its operational efficiency or retire the debt, early, to have a
coverage ratio, comparable to the industry.
Interest coverage ratio = Earnings before interest and tax
Interest charges
5. Debt Service Coverage Ratio

It shows the relationship between net profits and interest plus installments payable on loans. It
is expressed as a pure number. This ratio indicates the company‘s ability to pay interest and
principal amount on time as it indicates whether company is able to pay interest and
repayment of loan out of earnings of the company. It is more useful for lender as it takes care
of total repayment liability.
DSCR = Earnings before interest and tax
Interest + Installment due on loans
6. Dividend coverage ratio

Dividend coverage ratio essentially calculates the capacity of the firm to pay a dividend.
Generally, this ratio is calculated specifically for preference equity shareholders. Preference
shareholders have the right to receive dividends. The dividends of preference shares may be
postponed but payment is compulsory and therefore they are considered as a fixed liability.
The ratio is relevant for capital providers but especially important for preference shareholders.
These shareholders have a preferred right to receive dividends over normal equity shareholders.
The dividend payout to equity shareholders is at the discretion of the management but in the
case of preference shareholders, the dividend payout is compulsory. The payout of dividend can
be postponed but cannot be avoided.
Fixed dividend coverage ratio = Net profit
Annual Preference dividend

36
Ex. 1
From the following data, calculate the Debt/Equity Ratio, Debt to total Capital ratio,
Proprietary ratio, Capital Gearing Ratio, Interest Coverage Ratio and Dividend Coverage Ratio.
`
8% Preference Share Capital 3,00,000
Equity Share Capital 11,00,000
Capital Reserve 5,00,000
General Reserve 1,98,500
Profit and Loss Account (Dr. bal) 10,000
6% Debentures 5,00,000
Sundry Creditors 2,40,000
Bills Payable 1,20,000
Proposed Dividend 2,00,000
Provision for Taxation 2,27,500
Outstanding Creditors 1,60,000
EBIT 6,80,000
Tax 35 %
------------------------
Ex. 2
The following is the Balance Sheet as on March 31.
Particulars `
Preference Share Capital 50,000
Profit and Loss account 30,000
General reserve 40,000
Bills Payable 50,000
Total 8,40,000
II. Assets
Land and Buildings 1,40,000
Plant and Machinery 3,50,000
Stock 2,00,000
Sundry Debtors 1,00,000
Bills Receivable 10,000
Cash at Bank 40,000
Total 8,40,000
Calculate :
1. Current Ratio
2. Liquid Ratio
3. Debt Equity Ratio
4. Inventory to Working Capital Ratio
5. Proprietary Ratio
6. Capital Gearing Ratio
7. Current Assets to Fixed Assets Ratio
------------------------

37
Ex. 3
Calculate the Debt/Equity Ratio and Proprietary ratio:
Total Assets = ` 2,60,000
Long Term Debts = ` 1,80,000
Current Liabilities = ` 20,000
------------------------
Ex. 4
Calculate the Debt/Equity Ratio and Debt to Total Capital ratio:
Capital Employed = ` 24,00,000
Long Term Debt = ` 16,00,000
------------------------
Ex. 5
You, as a credit manager of the IDA bank, have been approached by two companies for a loan
of `1,00,000 for 2 years, with no collateral offered. Since the bank has reached its quota for
loan of this type, only one of these requests can be granted. The relevant information is
supplied to you by both the companies.
Particulars Company X Company Y

Assets :
Cash at Bank 1,70,000 3,00,000
Sundry Debtors 2,74,000 4,24,000
Stock 9,00,000 13,50,000
Fixed assets 10,00,000 10,20,000
Total 23,44,000 30,94,000
Liabilities and equities

Current liabilities 5,00,000 6,40,000
Long term loan 8,00,000 10,00,000
Equity share capital 8,00,000 12,00,000
Retained earnings 2,44,000 2,54,000
Total 23,44,000 30,94,000
------------------------
PROFITABILITY RATIOS
Profitability ratios are used to measure the operating efficiency of the company. Besides
management, lenders and owners of the company are interested in the analysis of the
profitability of the firm. If profits are adequate, there would be no difficulty for lenders,
normally, to get payment of interest and repayment of principal. Owners want to get required
rate of return on investment. The finance manager should evaluate the efficiency of the
company, in terms of profits. So, profit is important to everyone associated with the firm.
Generally, two major types of profitability ratios are calculated:
A. Profitability ratios based on sales
B. Profitability ratios based on investment
A. Profitability ratios based on sales

Profit is a factor of sales. Profit is earned, after meeting all expenses, as and when sales are
made. The ratios calculated under this category are:
1. Gross Profit Ratio

38
The first ratio in relation to sales is gross profit ratio or gross margin ratio. The ratio can be
calculated by
Gross Profit Ratio = Gross Profit X 100
Net Sales
The ratio reflects the efficiency with which a firm produces/sells its different products. Gross
Profit Ratio indicates the spread between the cost of goods sold and revenue. Analysis gives the
clues to the management how to improve the depressed profit margins. The ratio indicates the
extent to which the selling price can decline, without resulting in losses on operations of a firm.
2. Net Profit Ratio

Net profit is obtained, after deducting operating expenses, interest and taxes from gross profit.
The net profit ratio is calculated by
Net Profit Ratio = Net Profit X 100
Net Sales
Net profit includes non-operating income so the later may be deducted to arrive at profitability
arising from operations. Net Profit ratio indicates the overall efficiency of the management in
manufacturing, administering and selling the products. Net profit has a direct relationship with
the return on investment. If net profit is high, with no change in investment, return on
investment would be high. If there is fall in profits, return on investment would also go down.
For a meaningful understanding, both the ratios — gross profit ratio and net profit ratio —
have to be interpreted together. If gross margin increases but net margin declines, this
indicates operating expenses have gone up. Further analysis has to be made which operating
expense has contributed to the declining position for control. Reverse situation is also possible
with gross margin declining, and net margin going up. This could be due to increase of cost of
production, without any change in selling price, and operating expenses reducing more to
compensate the change. The crux is both the Gross Profit ratio and Net Profit Ratio are to be
analyzed, together, to find out the causes of increase/decline of profit for control and corrective
action.
3. Operating Profit ratio

Operating profit ratio indicates the relationship between Operating profit or EBIT and Sales.
Operating Profit ratio = Operating profit X 100
Net Sales
B. Profitability ratios based on investment

These ratios are also called as composite ratios. These ratios help the stakeholders to
determine their returns on investments.
1. Return on capital employed

This ratio measures the relationship between net profit (before interest & tax) and the capital
employed to earn it. It is expressed as a percentage.
Return on capital employed (or) Return on investment = EBIT X 100
Capital Employed
Capital Employed = Proprietors fund + Long Term Loans or Fixed Assets + Current Assets -
current liabilities. It gives clear index or utilization of assets earning capacity. This ratio
measures the overall profitability from the total funds employed. It means, measures the
relationship between net profit before interest, tax and capital employed to earn net profit.
2. Return on proprietors fund / proprietors equity / net worth

It measures the relationship between profits available to proprietor funds.
Return on proprietors fund = Net profit after tax
Shareholders fund
Higher ratio signifies better utilization of funds. It also measures the overall performance of a
business in regards utilization of total resources available.
3. Return on Equity Share Capital

39
It indicates the rate of earning on equity share capital.

Return on Equity Share Capital = Net Profit after Tax - Preference Dividend X 100
Equity Share Capital
It includes an investor in shares of company whether continue to hold or dispose off such
shares. It also enables investors to compare earnings of the company with that another
company. Higher ratio signifies better utilization of shareholders fund and higher return on
equity share capital.
4. Earnings Per Share

It shows earning per equity share, whether or not company declares dividend.
Earnings per share = Net profit after interest and tax – Dividend on Preference shares
Number of equity shares
Higher ratio signifies better utilization of funds available and the company may pay dividend at
a higher rate in future. Higher ratio indicates higher overall profitability and effective utilization
of equity capital.
5. Dividend Payout Ratio

It shows the relationship between the dividends paid to equity shareholders out of the profits
available to equity shareholders.
Payout ratio = Dividend per share X 100
Earnings per share
Dividend per share equity share means dividend paid on one equity share. Earnings per share
is calculated as per above formula. It measures dividend paying capacity of the company.
Higher ratio signifies the company has utilized larger portion of its earning for payment of
dividend. Low ratio indicates that smaller portion of earning has been utilized for payment of
dividend. It also indicated that larger portion of earnings had been retained.
6. Price Earnings Ratio

It brings out the relationship between the market price per share and earnings per share.
Price earnings ratio = Market price per share
Earnings per share
It indicates the relationship between market price of share and current earning per share. It
also helps in determining the future value of the share.
7. Dividend Yield Ratio

It shows the relationship between dividend per share earned by shareholder on market price of
each share.
Dividend yield ratio = Dividend per share X 100
Market price per share
This ratio indicates the ultimate current return which investors will get as a percentage on its
current market value of shares. It also indicates dividend policy of the company.
Ex. 1
From the following particulars calculate the profitability ratios related to sales:
Particulars 2015 2014

` In Lakhs ` In Lakhs
Net Sales 9,855 9,101
Other Income 87 83
Total Income 9,942 9,184
Cost of Material Consumed 3,833 3,314
Changes in inventories -67 105
Employee Cost 820 742
Finance Cost - Interest 140 370
Depreciation and amortization expense 346 340

40
Other expenses 156 157

Exceptional Income / Expenses 7 14
Tax Rate = 35%
------------------------
Ex. 2
From the following particulars calculate the following ratios :
1. Gross profit ratio
2. Pre-tax profit ratio
3. Net profit ratio
4. Cost of goods sold ratio
5. Employee benefits expense ratio
Particulars `
Sales 1,60,000
Expenses :
Excise Duty 5,000
Purchases 40,000
Depreciation on fixed assets 10,000
Return outward (4,000)
Return inward 5,000
Printing and Stationery 6,000
Staff Welfare Expenses 8,000
Interest Expense 12,000
Octroi 3,000
Freight 6,000
Salaries and Wages 15,000
Payment to the Auditors 7,000
Contribution to Provident Fund 5,000
Employee Insurance 4,000
Opening stock of raw material 6,000
Closing stock of raw material (8,000)
Profit before tax 40,000
Provision for Tax 14,000
Profit After Tax (PAT) 26,000
------------------------
Ex. 3
The following figures related to the trading activities of Z Ltd., for the year ended 31st March.
`
Sales 8,35,000
Closing Stock 45,000
Purchases 32,750
Advertising 25,000
Rent 25,000
Provision for Taxation 14,250
Salaries 36,000
Salesmens‘ Salaries 57,000
Depreciation on Delivery Van 8,000
Printing and Stationery 17,500
Audit Fees 12,000
Opening Stock 2,25,000

41
Interest paid 30,000

Depreciation on Fixed Assets 45,000
You are required to compute the following ratios:

a. Gross Profit Ratio b. EBIT Margin
c. Pre Tax Profit Ratio d. After Tax Profit Ratio
------------------------
Ex. 4
The summarised Financial Statements of Gem Ltd. for the year ended March 31, are as under:
Profit and Loss Account (For the year ended March 31)
Particulars `
Sales 80,00,000
Cost of Goods Sold 64,00,000
Depreciation 1,50,000
Marketing & Administration Expenses 2,50,000
Interest 3,00,000
Tax 3,60,000
Net Profit 5,40,000
Balance Sheet (As on March 31)

Particulars `
Preference Share Capital 5,00,000
Reserves and Surplus 18,00,000
Debentures 8,00,000
Creditors 2,80,000
Bills Payable 1,20,000
Total 80,00,000
Assets
Fixed Assets 63,00,000
Inventory 9,00,000
Debtors 5,00,000
Marketable Securities 2,10,000
Cash 90,000
Total 80,00,000
You are required to calculate (1) Gross Profit Margin; (2) Net Profit Margin; (3) Return on Total
Assets; (4) Return on Networth; (5) Return on Capital Employed.
------------------------
Ex. 5
The following data has been extracted from the annual accounts of the company:
Particulars `
Share Capital 60,00,000
Investment Allowance Reserve 6,00,000
12 % Mortgage Loan 30,00,000
Profit and Loss Balance (Debit Balance) 1,00,000
Profit Before Tax 26,00,000

42
Provision for Taxation 8,00,000

Proposed Dividend 10,00,000
From the above details calculate Return on Capital Employed.
------------------------
Ex. 6
Calculated price/earning ratio from the following information:
Equity share capital (`10 per Share) `2,50,000
Reserves (including current year‘s profit) `2,00,000
10% Preference Share Capital `2,50,000
9% Debentures `2,00,000
Profit before interest `3,30,000
Market Price per Share `50
Tax rate 50 %
------------------------
Ex. 7
A company has a net income after tax of `2,00,000 and 80,000 share outstanding, selling at a
market price of `30. What is the company‘s P/E ratio?
------------------------
Ex. 8
Bharat electronics has sales of ` 3 crores, asset turnover ratio of 6 for the year, and net profit
of ` 6 lakhs. What is the company‘s return on assets?
------------------------
Ex. 9
The following information is supplied to you for the year ending 31st March, 2013.
Share Capital:
10 % Preference shares of `20 each ` 6,00,000
Equity Shares of `20 each `16,00,000
`22,00,000
Profit after Tax @ 10 % ` 5,40,000
Depreciation ` 1,20,000
Equity Dividend paid 20 %
Market Price of Equity ` 80
You are required to state the following, showing the necessary workings :
a. Earnings Per Share b. Dividend Per Share
c. Cash Earnings Per Share d. Dividend Payout Ratio
e. Price Earnings Ratio f. Dividend Yield
g. Earnings Yield
------------------------
Ex. 10
The Balance Sheet of Y Ltd. stood as follows :
Liabilities 31-03-13 31-03-14

43
Capital 2,50,000 2,50,000

Reserves and Surplus 1,00,000 1,16,000
Long Term Loans 1,20,000 1,00,000
4,70,000 4,66,000
Assets 31-03-13 31-03-14

Fixed Assets 3,00,000 4,00,000
Less : Depreciation 1,00,000 1,40,000
2,00,000 2,60,000
Current Assets :
Stock 1,00,000 1,20,000
Debtors 50,000 70,000
Other Current Assets 25,000 25,000
Current Liabilities:
Creditors 19,400 1,00,000
Other Current Liabilities 5,600 29,000
Misc. Expenses 70,000 60,000
4,70,000 4,66,000
You are given the following information for the year 2013-14:
Sales 6,00,000
EBIT 1,50,000
Interest 24,000
Provision for Tax 60,000
Proposed Dividend 50,000
From the above particulars calculate the following ratios and interpret them for the year 13-14:
a. Return on Capital Employed b. Current Ratio

c. Interest Coverage ratio d. Proprietary Ratio
e. Return on Net Worth
------------------------
Ex. 11
From the following data calculate the leverage and profitability ratios.
Industry : Automobiles-Trucks/Lcv
Balance Sheet
Force Ashok Tata Mahindra
Motors Leyland Motors Vehicle
EQUITIES AND LIABILITIES
Share Capital 13.18 284.59 643.78 962.25
Reserve and Surplus 1,303.70 4,834.11 14,218.81 558.3
Long Term Borrowings 33.91 2,647.01 14,709.95 307.34
Total Liabilities 1,350.79 7,765.70 29,572.54 1,827.89
ASSETS
Fixed Assets 1,612.18 8,555.31 31,814.21 2,368.19
Less: Accumulated Depreciation 974.63 3,299.76 16,030.98 513.83
Net Block 637.55 5,255.55 15,783.23 1,854.36

44
Capital Work in Progress 239.76 120.14 6,040.79 118.08

Non-Current Investments 101.2 3,651.25 19,566.40 604.24
Current Assets 1,037.61 4,284.54 51.73
Inventories 392.55 1,398.53 4,802.08 383.2
Sundry Debtors 108.68 1,257.69 1,114.48 318.91
Cash and Bank 303.03 751.29 944.75 40.57
Other Current Assets 4.25 514.28 1,072.30 268.11
Loans and Advances 229.09 362.75 619.14 34.78
Less : Current Liabilities and Provisions 638.71 5,035.52 20,370.63 1,623.20
Current Liabilities 554.52 4,779.47 19,757.54 1,533.23
Provisions 84.19 256.05 613.09 89.97
Deferred Tax Assets / Liabilities -26.61 -510.27 0 -171.16
Total Assets 1,350.79 7,765.70 29,572.54 1,827.89
Income Statement
Force Ashok Tata Motors Mahindra
Motors Leyland Vehicle
Gross Sales 2,638.90 14,840.21 39,524.34 6,132.78
Less: Sales Returns 0.00 354.27 0.00 0.00
Less: Excise 275.18 923.75 3,229.60 1,011.72
Net Sales 2,363.72 13,562.18 36,294.74 5,121.06
EXPENDITURE :
Increase/Decrease in Stock -6.12 -52.61 -733.81 -33.37
Raw Materials Consumed 1,647.16 10,017.82 27,920.47 4,387.86
Power & Fuel Cost 38.98 82.49 395.88 30.31
Employee Cost 277.73 1,184.00 3,091.46 176.67
Other Manufacturing Expenses 102.39 232.19 3,552.14 60.04
General and Administration Expenses 17.82 899.52 3,244.40 33.43
Selling and Distribution Expenses 79.51 171.64 745.44 17.22
Miscellaneous Expenses 78.39 0.49 434.99 24.07
Less: Pre-operative Expenses Capitalised 19.13 0.00 1,118.75 0.00
Total Expenditure 2,216.72 12,535.55 37,532.22 4,696.23
Operating Profit 147.00 1,026.63 -1,237.48 424.83
Other Income 65.78 124.47 1,881.41 27.68
Operating Profit 212.78 1,151.11 643.93 452.51
Interest 6.55 393.51 1,611.68 90.27
PBDT 206.23 757.60 -967.75 362.24
Depreciation 81.28 416.34 2,603.22 123.10
Profit Before Taxation & Exceptional Items 124.94 341.26 -3,570.97 239.14
Exceptional Income / Expenses 0.00 100.94 -403.75 0.00
Profit Before Tax 124.94 442.20 -3,974.72 239.14
Provision for Tax 23.58 107.39 764.23 86.11
Profits After Tax 101.36 334.81 -4,738.95 153.03
Earnings Per Share 76.93 1.18 -14.72 1.59
------------------------
Ex. 12
From the following data calculate the leverage and profitability ratios.
Industry Name: IT - Software

Mahindra Hathway
Companies Infosys Satyam Wipro TCS Soft. Devel.
Share Capital 287 235.4 492.6 295.72 0.3
Equity - Authorized 300 280 530 225 0.4
Equity - Issued and paid up 287 235.4 492.6 195.72 0.3
Preference Capital Paid Up 0 0 0 100 0
Face Value 5 2 2 1 10
Share Warrants 0 0 0 0 0
Total Reserve 35772 3078.8 23682 32266.53 -1.82
Securities Premium 3065 4346 1175.8 1918.47 0
Capital Reserves 54 0 113.9 0 0

45
Profit & Loss Account Balance 25383 -1259.4 7837.1 24602.85 -1.82
General Reserves 7270 0 14377.3 5515.11 0
Exchange Fluctuation reserve 0 0 50.1 174.61 0
Hedging Reserve 0 -34.3 127.8 55.49 0
Other Reserves 0 26.5 0 0 0
Shareholder's Funds 36059 3314.2 24229.5 32562.25 -1.52
Non-Current Liabilities 120 1410.5 299.7 604.49 0
Secured Loans 0 23.3 50.4 81.59 0
Unsecured Loans 120 1387.2 249.3 522.9 0
Current Liabilities and Provision 6793 2307 16124.6 9676.91 4.35
Current Liabilities 3005 1365.7 12715.2 5780.77 4.35
Provisions 3788 941.3 3409.4 3896.14 0
Total Liabilities 42972 7031.7 40653.8 42843.65 2.83
Income Statement (`in Millions)

Mahindra Hathway
Companies Infosys Satyam Wipro TCS Soft. Devel.
Software Services & Operating Revenues 36765 5955.1 29805.7 46874.72 0
Sale of Equipments & licenses 0 9.2 2908.3 1552.24 0
Processing Charges / Service Income 0 0 58.8 0 3.43
Other operational income 0 0 456.8 0 0
Less: Excise 0 0 3.1 0.82 0
Net Sales 36765.00 5964.30 33226.50 48426.14 3.43
Other Income 2217.00 458.70 1325.30 2230.39 0.03
Total Revenue 38982 6423 34551.8 50656.53 3.46
EXPENDITURE :
Raw Materials Consumed 0 8.6 2683.2 25.02 0
Employee Cost 19932 3635.4 15904.2 23899.59 0
Cost of Software developments 2465 487.5 3552.4 2219.86 0
General and Administration Expenses 1464 554.2 2268.4 2091.42 0.11
Selling and Marketing Expenses 151 57.1 162.4 35.07 0.05
Interest 3 11.2 352.4 30.62 0.01
Depreciation 956 149.4 701.3 802.86 0.04
Other Operating Expenses 1611 209.1 714.5 5796.03 3.16
Miscellaneous Expenses 126 105.6 1007.9 52.88 0.27
Total Expenditure 26708 5218.1 27346.7 34953.35 3.64
Profit Before Tax & Exceptional Items 12274 1204.9 7205.1 15703.18 -0.18
Exceptional Income / Expenses 83 51.8 0 0 0
Profit Before Tax 12357 1256.7 7205.1 15703.18 -0.18
Provision for Tax 3241 53.9 1554.9 2916.84 0
Profits After Tax 9116 1202.8 5650.2 12786.34 -0.18
Industry Average
Total Debt/Equity (%) - 0.10
Interest Cover(x) - 25.67
Core EBITDA Margin (%) - 25.55
EBIT Margin (%) - 26.40
Pre Tax Margin (%) - 25.37
ROA (%) - 22.13
ROE (%) - 24.72
ROCE (%) - 30.11
Q.1 Which company has the least Debt/Equity Ratio
Q.2 Which company has the highest Debt/Equity Ratio
------------------------
ACTIVITY OR TURNOVER RATIOS

46
1. Stock Turnover Ratio / Stock Velocity / Inventory Turnover Ratio

Stock turnover ratio shows the relationship between the cost of goods sold and the average
stock.
Inventory turnover ratio = Cost of goods sold (or) = Average inventory X 365
Average inventory Cost of goods sold
Cost of goods sold = Opening stock + Purchases + Direct expenses - closing stock. Average
stock = (Opening stock + Closing stock) / 2. Stock turnover ratio helps in determining the
frequency of inventory replacement. It also helps in determining the liquidity of business
organization.
2. Inventory Holding Period

This ratio explains the time period for which the raw mater, WIP and finished goods are hold in
stock.
Inventory Holding Period = Number of days or months in a year
Inventory turnover ratio
3. Debtors Turnover Ratio / Accounts Receivable / Turnover Debtors Velocity

This shows the relationship between net credit sales and average trade debtors.
Debtors turnover = Net Credit sales (or) = Average accounts receivable X 365
Average accounts receivable Net Credit sales
Net Credit Sales = Gross Credit Sales minus Sales Returns. Debtors and bills receivable may be
taken at the average of opening and closing amounts. If the details are not available only the
closing balance may be considered.
4. Debt Collection Period

This ratio gives average debt collection period and indicates the extend to each the debts have
being collected in time.
Debt Collection Period = Number of days or months in a year
Debtors Turnover Ratio
It indicates credit and collection policy and it also indicates effectiveness of collection from
debtors.
5. Creditors Turnover Ratio

This shows the relationship between the net credit purchases and the average trade creditors.
Creditors turnover = Net Credit purchases (or) = Average accounts Payable X 365
Average accounts payable Net Credit purchases
Net Credit Purchases = Gross Credit Purchases – Purchase Return - Allowances on Credit
Purchases. Creditors and bills payable may be taken at the average of the opening and closing
amount. If the details are not available, only the closing balance may be considered.
6. Creditors Payment Period

This shows the relationship between number of days or months in a year with the promptness
in payment of credit purchases.
Creditor Payment Period = Number of days or months in a year
Creditors Turnover Ratio
It should be compared with actual credit available from suppliers and whether the company is
taking full benefit of the credit period allowed by creditors.
7. Assets Turnover Ratio

It shows the relationship between net sales and total assets.
Assets turnover ratio = Net Sales
Total assets
Net Sales = Gross sales minus Returns minus Allowances. Total Fixed Assets = Fixed Assets +
Investment + Current Assets but excluding fictitious assets. It indicates how efficiency assets
are employed overall.

47
8. Fixed Assets Turnover Ratio

It indicates the frequency of fixed assets utilization.
Fixed assets turnover = Net Sales
Fixed assets
Net Sales = Gross Sales minus Sales Return minus Allowances. Fixed Assets includes assets
acquired for long term use in the business and not for sale in ordinary course of business. E.g.
Goodwill, Land and Building, Plant and Machinery, Vehicles etc. It indicates efficiency in or
extend of utilization of fixed assets. Higher ratio indicates high degree of efficiency in utilization
and low degree signifies vice-versa.
Ex. 1
From the following information, calculate stock turnover ratio :
Opening Stock `20,000; Closing Stock `10,000; Direct expenses including Cost of Material
Consumed `100,000; Sales `1,80,000
------------------------
Ex. 2
From the following information, calculate stock turnover ratio. Opening stock `58,000; Excess
of Closing stock over opening stock `4,000; sales `6,40,000; Gross Profit @ 25% on cost
------------------------
Ex. 3
A trader carries an average stock of `80,000. His stock turnover is 8 times. If he sells goods at
profit of 20% on sales. Find out the gross profit.
------------------------
Ex. 4
Calculate the Debtors Turnover Ratio and debt collection period (in months) from the following
information:
Total sales = `2,00,000
Cash sales = `40,000
Debtors at the beginning of the year = `20,000
Debtors at the end of the year = `60,000
------------------------
Ex. 5
Cash purchases `1,00,000; cost of goods sold `3,00,000; opening stock `1,00,000 and closing
stock `2,00,000. Creditors turnover ratio 3 times. Calculate the opening and closing creditors if
the creditors at the end were 3 times more than the creditors at the beginning.
------------------------
Ex. 6
From the following information, calculate Fixed Assets Turnover Ratio:
Gross fixed asset `4,00,000; Accumulated depreciation `1,00,000; Marketable securities
`20,000; Prepaid expense `20,000; Other current Assets `1,30,000; Current liabilities `50,000;
Gross sales `18,30,000; Sale return `30,000
------------------------
Ex. 7

48
From the following information, calculate (i) Fixed Assets Turnover (ii) Working Capital
Turnover and (iii) Asset Turnover Ratios :
Liabilities `
Preference Shares Capital 6,00,000
Profit and Loss Account 2,00,000
14% Loan 1,00,000
Creditors 1,40,000
Total 20,00,000
Assets `
Plant and Machinery 6,00,000
Land and Building 7,00,000
Motor Car 2,50,000
Furniture 50,000
Stock 1,70,000
Debtors 1,20,000
Bank 90,000
Cash 20,000
Total 20,00,000
Sales for the year were `60,00,000.
------------------------
Ex. 8
The following are the ratios relating to the activities of National Traders Ltd. :
Debtors Velocity (months) 3

Stock Velocity (months) 8
Creditors Velocity (months) 2
Gross Profit (%) 25
Gross Profit for the current year ended December 31 amounts to ` 4,00,000. Closing Stock of
the year is ` 10,000 above the opening stock. Bills receivable amount to ` 25,000 and bills
payable to ` 10,000. Find out : (a) Sales; (b) Sundry Debtors; (c) Closing Stock and (d) Sundry
Creditors.
------------------------
Ex. 9
Find out current ratio.
Debtors `18,000; Bills receivable `13,000; Stock twice of debtors; Cash `16,000; Advance to
suppliers `15,000; Creditors for goods `27,000; Bills payable `8,000; Outstanding expenses
`15,000; Prepaid expenses `5,000 Long Term Investment `12,000
------------------------
Ex. 10

49
The ratio of current assets (`6,00,000) to current liabilities is 1.5:1. The accountant of this firm
is interested in maintaining a current ratio of 2:1 by paying some part of current liabilities. You
are required to suggest him the amount of current liabilities which must be paid for this
purpose.
------------------------
Ex. 11
The debt-equity ratio of a company is 1:2. Which of the following suggestions would (i) increase,
(ii) decrease, and (iii) not change it.
a. Issue of equity shares,
b. Cash received from debtors
c. Redemption of debentures for cash,
d. Purchased goods on credit,
e. Redemption of debentures by conversion into shares,
f. Issue of shares against the purchase of a fixed asset,
g. Issue of debentures against the purchase of a fixed asset.
------------------------
Ex. 12
The condensed Balance Sheet of ABC ltd. as on 30th September, 2010 is as follows :-
Liabilities `
Equity Share Capital 60,000
Reserves 20,000
6 % Debentures 50,000
Trade Creditors 20,000
Bills Payable 5,000
1,60,000
Assets `
Fixed Assets 90,000
Inventories 30,000
Marketable Investments 10,000
Debtors 15,000
Cash and Bank Balance 10,000
Short term loan 5,000
1,60,000
The Net Profit of the year was `17,500
Prepare a statement suitable for analysis and indicate the soundness of the financial position
of the Company by calculating the following ratios together with your comments on the same:
1. Current Ratio 2. Liquid Ratio 3. Proprietary Ratio

4. Return on Total Assets 5. Debt-Equity Ratio 6. Return on Equity Capital
7. Return on Shareholders‘ Equity
------------------------
Ex. 13

50
Summarized financial statements of AG Ltd. for the year ended 31 st March, 2011 are as under :
Income Statement for the Year Ended 31st March, 2011

Sales 16,00,000
Less : Cost of Goods Sold 13,10,000
Gross Margin 2,90,000
Less : Other Operating Expenses 40,000
EBIT 2,50,000
Less : Interest 45,000
EBT 2,05,000
Less : Tax 82,000
Net Profit 1,23,000
Balance Sheet as on 31st March, 2011

Liabilities ` `
Paid-up Capital (40,000 equity Shares of `10 each) 4,00,000
Retained Earnings 1,20,000
Debentures 7,00,000
Total 12,20,000
Assets `
Net Fixed Assets 8,00,000
Current Assets:
Inventory 4,00,000
Debtors 1,75,000
Marketable Securities 75,000
Cash 50,000 7,00,000
Less : Current Liabilities
Creditors 1,80,000
Bank Overdraft 30,000
Proposed Dividend 50,000 2,80,000
4,20,000
Total 12,20,000
Industry‘s Average Ratios are :
Current Ratio 2.3 : 1 Debt-Equity Ratio 2:1

Quick Ratio 1.4 : 1 Net Profit Margin 7.5 %
Average Collection Period 34 days
Note: Consider 360 days in a year.
From the above facts and figures, you are required to calculate the:
1. Current Ratio, Quick Ratio, Debt-Equity Ratio, Net Profit Margin Ratio, and Debtors
Collection Period.
2. Interpret them to identify the problem area and bring out the reasons in the respect of
identified problem areas. Also, provide the solutions for the same.
------------------------

51
CHAPTER 6
WORKING CAPITAL MANAGEMENT
Every organization requires Fixed Capital for purchase of fixed assets viz. Land and Building,
Plant and Machinery, Furniture, Vehicles etc. In addition to fixed capital an organisation also
requires additional capital for financing day to day activities. Such capital which is required for
financing day to day activities in the business is called Working Capital. Working Capital is
that part of the funds of a business which is used for day to day operation. It is the money
required to keep the business running smoothly. (It is required for smooth conduct of business
activities.) In the absence of Working Capital, fixed assets cannot be employed gainfully. It is
the working capital which decides success or failure of an organisation. It is the life blood of an
organisation. Forecasting Working Capital and Control of Working Capital is a continuous
process and therefore, part of parcel of the overall management of the business.
Working Capital Cycle

The working (operating) capital cycle is the time that elapses between investing in a product or
service and receiving payment for that product or service. The starting point of the working
capital cycle is usually when the business purchase raw materials or hires people for the
service. The ending point of the working capital cycle is when the customer makes the
payment, regardless of whether such payment comes pre-paid for the service or purchase,
payment takes place at time of purchase or obtaining the service, or the payment comes later
owing to sale on credit.
Cash
Collection Purchase of
from Raw
Debtors Material
Conversion
Sale of
of Raw
Finished
material into
Goods
WIP
Conversion
of WIP into
Finished
Goods
Working Capital Cycle is cash-flows in a cycle; into, around and out of a business. It is the
business's life blood and every manager's primary task is to help keep it flowing and to use the
cash-flow to generate profits. If a business is operating profitably, then it should, in theory,
generate cash surpluses. If it doesn't generate surpluses, the business will eventually run out
of cash and expire.

52
Classification of Working Capital

Working Capital can be classified into :
 Gross and Net Working Capital
 Permanent and Temporary Working Capital
 Positive and Negative Working Capital
 Gross and Net Working Capital

Gross Working Capital is equal to total current assets only. It is identified with current
assets alone. It is the value of non – current assets of an organisation and includes all
current assets only. Items of current assets are stock of raw material, work in progress,
finished goods spares and consumables, stores, sundry debtors, bills receivables, cash
and bank balances, prepaid expenses, accrued income, advance payments, short term
investments etc. Gross Working Capital indicates the quantum of Working Capital
available to meet current liabilities. This is very useful for planning of business
activities in normal course.
Net Working Capital is the excess of current assets over current liabilities i.e. current
assets less current liabilities. Net Working Capital = Total Current Assets (–) Total
Current Liabilities. In other words, total value of current assets is reduced by total
current liabilities such as sundry creditors, bills payable, bank overdraft, income
received in advance, outstanding liabilities, etc.
 Permanent and Temporary Working Capital

A business organisation must always have a minimum amount of Working Capital to
meet the current liabilities as and when they arise. In other words a concern must have
minimum amount of fund to ensure liquidity and solvency. It is the minimum aggregate
of cash, inventory and debtors maintained to carry on business operations smoothly at
any time during an accounting period such minimum amount of Working Capital
required to enable the concern to operate at the any level of activity is called permanent
Working Capital.
If the business organisation wants to increase its level of activity and produce and sell
more goods, naturally it will need additional amount of Working Capital. If the increase
in level of activity is temporary or seasonal, the additional Working Capital required is
called Temporary Working Capital. The amount of Temporary Working Capital varies
with the level of activity (level of production). When the production is at higher level,
larger Temporary Working Capital is needed, when the production level is lower, smaller
amount of Temporary Working Capital is required. Therefore, Temporary Working
Capital is also called as Variable or Fluctuating Working Capital.
 Positive and Negative Working Capital

When current assets exceed current liabilities, the Working Capital is said to be positive
Working Capital. In other words when current assets are more than current liabilities,
the net current asset is a positive figure and hence it is called Positive Working Capital.
Such Working Capital indicates favourable liquidity and solvency position of the
business.
When the current assets are less than the current liabilities, the Working Capital is said
to be Negative Working Capital. In other words when current assets are less than
current liabilities the net current asset is negative figure and hence it is called Negative
Working Capital. Such Working Capital indicates lack of liquidity and adverse solvency
position of the business.
Factors Determining Working Capital Requirements

The amount of Working Capital required by a business organisation depends on many factors.
They are as follows.

53
 Nature of Business
 Size of Business
 Production Policies
 Terms of Purchase and Sale
 Production Process
 Turnover of Circulating Capital
 Dividend Policies
 Seasonal Variations
 Business Cycle
 Change in Technology
 Turnover of Inventories
 Taxation Policies
Importance of Working Capital

The following points will highlight the importance of Working Capital. Adequate Working
Capital:
 Enables a company to meet its obligations
 Ensures the credit standing of a company
 Facilitates obtaining Credit from banks without any difficulty
 Ensures solvency of a company
 Enables a company to make prompt payments to its creditors and thereby take
advantage of cash and quantity discounts offered by them
 Enhances the goodwill of a company as it can meet its operational expenses and
maturing liabilities in time
 Improves the prospects of prosperity and progress of a company
 Enables an organisation to tide over difficult periods successfully
Thus, adequate Working Capital is an important factor for prosperity and smooth running of a
business organisation. It is rightly called as the ―backbone‖ of the financial structure of a
business organisation.
Computation (Estimation) of Working Capital

The common methods used to estimate the Working Capital are:
 Percent of sales method : Based on the past experience, a ratio can be determine
between Sales and Working Capital requirements. This ratio can be use for estimating
the Working Capital requirement in future. It is the simple and tradition method to
estimate the Working Capital requirements. Under this method, first the sales to
Working Capital ratio is calculated and based on that the Working Capital requirements
are estimate. This method also expresses the relationship between the Sales and
Working Capital.
 Operating Cycle : Working Capital requirements depend upon the operating cycle of
the business. The operating cycle begins with the acquisition of raw material and ends
with the collection of receivables. Each component of the operating cycle can be
calculated to estimate the working capital requirement.
Ex. 1
A Proforma cost Sheet of a company provides the following particulars:
Elements of Cost: Amount Per Unit (`)

Materials 120
Direct labour 45
Overheads 90
Total cost 255

54
Profit 45
Selling Price 300
The following further particulars are available:
a. Raw materials are in stock on an average for one month.

b. Raw materials are in process on an average for half a month.
c. Finished goods are in stock on an average for 1 and a half month.
d. Credit allowed by suppliers is three months.
e. Lag in payment of wages is 2 weeks.
f. Lag in payment of overheads is one month.
g. 1/4th output is sold against cash.
h. Cash in hand and at bank is expected to be `37,500.
i. Credit allowed to customers is 2 months.
You are required to prepare a statement showing the working capital (in weeks) needed to
finance level of activity of 15,600 units of production. You may assume that production is
carried on evenly throughout the year and a time period of 4 weeks is equivalent to a month -
48 weeks in a year.
-------------------------------------------
Ex. 2
From the following information, prepare a statement showing the working capital requirement.
The budgeted profit and loss account for a year is as under:
Sales 18,00,000
Less : Material 7,20,000
Labour 5,40,000
Expenses 1,80,000 14,40,000
Profit 3,60,000
1. The production and sales take place evenly throughout the year.
2. Raw Material carried in stock for 1 month and finished goods for ½ month.
3. The production cycle takes one month.
4. There is a custom in market that both purchases of raw material and sales of finished
goods to give 2 months credit.
5. 25% of sales are for cash and balance on credit
6. Cash on hand is estimated at `25,000.
7. Labour and expenses are outstanding for 2 weeks.
8. A margin of 10% of net current assets is kept for contingencies.
-------------------------------------------
Ex. 3
The Board of Director of Century Ltd. requests you to prepare a statement showing the
requirements of working capital for a forecast level of activity of 52,000 units in the ensuing
year (52 weeks) from the following information made available :
Cost Per Unit

Raw Material 400
Direct Labour 150
Overheads Manufacturing 200
Overheads Selling and Distribution 100
850

55
Additional Information :
a. Selling Price `1,000 per unit

b. Raw Material in Stock Average 4 weeks
c. Work – in – Progress Average 4 weeks
d. Finished Goods in Stock Average 4 weeks
e. Credit allowed to Debtors Average 8 weeks
f. Credit allowed by Suppliers Average 4 weeks
g. Cash at Bank is expected to be `50,000
h. All sales are on credit basis.
i. All the activities are evenly spread out during the year
j. Debtors are to be valued at sales.
-------------------------------------------
Ex. 4
The following information is extracted from the annual accounts for the year ending 31 st
December 2012.
`
Sales at 3 months credit 40,00,000
Raw Materials 12,00,000
Wages paid – 15 days in arrears 9,60,000
Manufacturing expenses – 1 month in arrears 12,00,000
Administrative expenses – 1 month in arrears 4,80,000
Sales promotion expenses payable ½ years in advance 2,00,000
Income Tax (payable quarterly last installment is due in Dec.12) 4,00,000
The company enjoys one month‘s credit from suppliers of raw materials and maintains 2
months stock of raw materials and 1 ½ months stock of finished goods. Cash balance is
maintained at `2,00,000 as a precautionary balance. Assuming 5% of Gross working capital as
margin, find out net working capital requirement (in months) of the company.
-------------------------------------------
Ex. 5
X & Co. is desirous to purchase a business and has consulted you, and one point on which you
are asked to advise them is the average amount of working capital which will be required in the
first year‘s working.
You are given the following estimates and are instructed to add 10% to your computed figure to
allow for contingency:
Details Figures for the years

1. Amount blocked up in stocks: `
Stock of Finished goods (500 units @ Rs.10) 5,000
Stock of stores and materials 8,000
2. Average credit sales:
Inland sales – 6 weeks credit 3,12,000
Export sales – 1 weeks 78,000
3. Lag in payment of wages and other outgoings:
Wages – 1 weeks 2,60,000
Stock of materials – 1 ½ months 48,000
Rent and Royalties – 6 months 10,000
Clerical staff – ½ month 62,400

56
Manager‘s Salary – ½ month 4,800

Miscellaneous Exps. – 1 ½ months 48,000
4. Payment in Advances:
Sundry expenses (paid quarterly in advance) 8,000
-------------------------------------------
OPERATING AND CASH CONVERSION CYCLE
Ex. 1
The relevant financial information for Xavier Ltd. for the year ended 2011 is given below:
Beginning of 2011 End of 2011

Sales 80,000
Cost of goods sold (Including Raw 56,000
Material consumed of `45,000)
Raw Material Inventory 9,000 12,000
Accounts Receivable 12,000 16,000
Accounts Payable 7,000 10,000
What is the length of the operating cycle? The cash cycle? Assume 360 days in a year.
- - - - - - - - - - - - - - - - -
Ex. 2
The relevant financial information for Apex Ltd. is given below:
Beginning of 20X0 End of 20X0

Sales 1,000
Cost of goods sold 750
Raw Material inventory 110 120
Accounts Receivable 140 150
Accounts Payable 60 66
What is the length of the operating cycle and the cash cycle assuming no direct expenses?
- - - - - - - - - - - - - - - - -

57
CHAPTER 7
INVENTORY MANAGEMENT
Inventories constitute the most significant part of current assets of the business concern. It is
also essential for smooth running of the business activities. A proper planning of purchasing of
raw material, handling, storing and recording is to be considered as a part of inventory
management. Inventory management means, management of raw materials and related items.
Inventory management considers what to purchase, how to purchase, how much to purchase,
from where to purchase, where to store and when to use for production etc.
Kinds of Inventories
Inventories can be classified into five major categories.
 Raw Material
It is basic and important part of inventories. These are goods which have not yet been
committed to production in a manufacturing business concern.
 Work in Progress
These include those materials which have been committed to production process but
have not yet been completed.
 Consumables
These are the materials which are needed to smooth running of the manufacturing
process.
 Finished Goods
These are the final output of the production process of the business concern. It is ready
for consumers.
 Spares
It is also a part of inventories, which includes small spares and parts.
Stock Level
Stock level is the level of stock which is maintained by the business concern at all times.
Therefore, the business concern must maintain optimum level of stock to smooth running of
the business process. Different level of stock can be determined based on the volume of the
stock.
Minimum Level
The business concern must maintain minimum level of stock at all times. If the stocks are less
than the minimum level, then the work will stop due to shortage of material.
Re-order Level
Re-ordering level is fixed between minimum level and maximum level. Re-order level is the level
when the business concern makes fresh order at this level. Re-order level = maximum
consumption × maximum Re-order period.
Maximum Level
It is the maximum limit of the quantity of inventories, the business concern must maintain. If
the quantity exceeds maximum level limit then it will be overstocking. Maximum level = Re-
order level + Re-order quantity – (Minimum consumption × Minimum delivery period)
Danger Level
It is the level below the minimum level. It leads to stoppage of the production process. Danger
level=Average consumption × Maximum re-order period for emergency purchase
Average Stock Level

It is calculated such as, Average stock level= Minimum stock level + ½ of re-order quantity
maximum level

58
Lead Time
Lead time is the time normally taken in receiving delivery after placing orders with suppliers.
The time taken in processing the order and then executing it is known as lead time.
Safety Stock
Safety stock implies extra inventories that can be drawn down when actual lead time and/or
usage rates are greater than expected. Safety stocks are determined by opportunity cost and
carrying cost of inventories. If the business concerns maintain low level of safety stock, it will
lead to larger opportunity cost and the larger quantity of safety stock involves higher carrying
costs.
Economic Order Quantity (EOQ)

EOQ refers to the level of inventory at which the total cost of inventory comprising ordering
cost and carrying cost. Determining an optimum level involves two types of cost such as
ordering cost and carrying cost. The EOQ is that inventory level that minimizes the total of
ordering of carrying cost. EOQ can be calculated as EOQ = 2ab/c, where, a = Annual usage of
inventories (units), b = Buying cost per order, c = Carrying cost per unit
Ex.1
Find out the economic order quantity and the number of orders per year from the following
information:
Annual consumption: 36,000 units
Purchase price per units: `54
Ordering cost per order: `150
Inventory carrying cost is 20% of the average inventory.
------------------------
Ex.2
From the following information calculate, (1) Re-order level (2) Maximum level (3) Minimum
level (4) Average level
Normal usage: 100 units per week
Maximum usage: 150 units per week
Minimum usage: 50 units per week
Re-order quantity (EOQ) 500: units
Log in time: 5 to 7 weeks
------------------------
Ex.3
The following are the receipts and issue transactions of material ‗X‘ during 20X1 in a firm;
20X1
Jan 2 Receipt of 50 units @ `10 per unit.
Jan 4 Receipt of 100 units @ `10.50 per unit.
Jan 6 Issue of 40 units
Jan 18 Receipt of 75 units @ `10.75 per unit.
Find the value of closing stock using FIFO and Average method of pricing the issues.
------------------------

59
Ex.4
Show the stores ledger entries, as they would appear when using
a. The weighted average method.
b. The FIFO method of pricing issues, in connection with the following transactions:
April Unit Value

1. Balance in hand 300 600
2. Purchased 200 440
4. Issued 150
11. Issued 150
19. Issued 200
27. Issued 250
------------------------
Ex.5
The following is the summary of the receipts and issue of materials in a warehouse during
January.
January
1 Opening balance 500 units @ `25 p.u.
3 Issue 70 units.
4 Issue 100 units.
8 Issue 80 units.
13 Received from suppliers 200 units @ `24.50 p.u.
14 Returned to store (warehouse) 15 units @ `24 p.u.
16 Issue 180 units
18 Spoiled in store (warehouse) 80 units
20 Received from suppliers 240 units @ `24.75 p.u.
24 Issued 304 units.
25 Received from supplier 320 units @ `24.50 p.u.
26 Issue 112 units.
27 Returned to store 12 units @ `24.50 p.u.
28 Received from supplier 100 units @ `25 p.u.
Prepare a store (warehouse) ledger card from the above transactions under the FIFO method.
------------------------
Ex.6
With the help of following information relating to the first week of September calculate the cost
of materials under FIFO method and Weighted Average Method of issue of materials.
The transactions in connection with the materials are as follows:
Receipts Issues
Days Units Rate per unit (`) Units
1st 40 15.00
2nd 20 16.50
3rd 30
4th 50 14.50
5th 20
6th 40
------------------------

60
Ex.7
Draw a stores ledger under Perpetual Inventory System, recording the following transactions
that took place in a month under FIFO and weighted average methods of pricing of materials.
2015
Jan. 1 Opening stock 200 pieces @ `2 each
Jan. 5 Purchases 100 pieces @ `2.20 each
Jan. 22 Issues 150 pieces
Jan. 28 Issues 200 pieces.
------------------------
Ex.8
From the following inventory data, calculate the Gross Profit, COGS and ending inventory
under FIFO, LIFO and weighted average cost methods. The company uses Periodic Inventory
System.
Date Particulars
January 1 Beginning Inventory 2 units @ `2 p.u. `4
January 7 Purchase 3 units @ `3 p.u. `9
January 19 Purchase 5 units @ `5 p.u. `25
Units available 10 units `38
Units Sold 7 Units `30
------------------------
Ex.9
The following are the transactions of a retail business for the month of April - 2014. The
business uses Periodic Inventory System i.e. Valuation of inventory on a monthly basis
Date Particulars Tonne Cost / Tonne

in `
01/04/14 Opening Stock 1000 30
05/04/14 Purchases 200 32
15/04/14 Purchases 200 35
Total Sales 1100 40
Find out the Gross Profit of the Business for the month of April-2004, If Inventory is valued at
1. FIFO Method and
2. Weighted Average Method.
------------------------

61
CHAPTER 8
RECEIVABLES MANAGEMENT
The term receivable is defined as debt owed to the concern by customers arising from sale of
goods or services in the ordinary course of business. Receivables are also one of the major
parts of the current assets of the business concerns. It arises only due to credit sales to
customers, hence, it is also known as Account Receivables or Bills Receivables. Management of
account receivable is defined as the process of making decision resulting to the investment of
funds in these assets which will result in maximizing the overall return on the investment of
the firm. The objective of receivable management is to promote sales and profit until that point
is reached where the return on investment in further funding receivables is less than the cost
of funds raised to finance that additional credit. The costs associated with the extension of
credit and accounts receivables are as follows:
 Collection Cost
This cost incurred in collecting the receivables from the customers to whom credit sales
have been made.
 Capital Cost
This is the cost on the use of additional capital to support credit sales which
alternatively could have been employed elsewhere.
 Administrative Cost
This is an additional administrative cost for maintaining account receivable in the form
of salaries to the staff kept for maintaining accounting records relating to customers,
cost of investigation etc.
 Default Cost
Default costs are the over dues that cannot be recovered. Business concern may not be
able to recover the over dues because of the inability of the customers.
Factors Considering the Receivable Size

Receivables size of the business concern depends upon various factors. Some of the important
factors are as follows:
1. Sales Level
Sales level is one of the important factors which determines the size of receivable of the
firm. If the firm wants to increase the sales level, they have to liberalise their credit
policy and terms and conditions. When the firms maintain more sales, there will be a
possibility of large size of receivable.
2. Credit Policy
Credit policy is the determination of credit standards and analysis. It may vary from
firm to firm or even some times product to product in the same industry. Liberal credit
policy leads to increase the sales volume and also increases the size of receivable.
Stringent credit policy reduces the size of the receivable.
3. Credit Terms
Credit terms specify the repayment terms required of credit receivables, depend upon
the credit terms, size of the receivables may increase or decrease. Hence, credit term is
one of the factors which affects the size of receivable.

62
4. Credit Period
It is the time for which trade credit is extended to customer in the case of credit sales.
Normally it is expressed in terms of ‗Net days‘.
5. Cash Discount
Cash discount is the incentive to the customers to make early payment of the due date.
A special discount will be provided to the customer for his payment before the due date.
6. Management of Receivable
It is also one of the factors which affects the size of receivable in the firm. When the
management involves systematic approaches to the receivable, the firm can reduce the
size of receivable.
Ex. 1
A firm is currently selling a product @ `10 per unit. The most recent annual sales (all credit)
were 30,000 units. The variable cost per unit is `6 and the average cost per unit, given a sales
volume of 30,000 units is `8. The total fixed cost is `60,000. The average collection period is 30
days. The firm is contemplating a relaxation of credit standards that is expected to result in a
15% increase in units‘ sales. The average collection period would increase to 45 days with no
change in bad debts expenses. The increase in collection expenses may be assumed to be
negligible. It is also expected that increased sales will result in additional net working capital to
the extent of `10,000. The required return on investment is 15%. Should the firm relax the
credit standards?
---------------------
Ex. 2
A company which currently sells goods on a net 30-day term is considering the possibility of
lengthening its credit terms to 60 days. The current year sale is anticipated to be of the order of
2,00,000 units at a selling price of `10 each, with an average total unit cost at this volume of
`9.50 (including `8.00 as variable cost and `1.50 as fixed cost). Lengthening credit period is
expected to boost sales by 25% to 2,50,000 units. The company anticipates to produce
additional units of sale at `8.00 per unit because it is hoped that overhead costs would be
spread over higher volume of production resulting in cost reduction by 1.50 paise per unit on
additional sales units. The management anticipates that as a result of increase in credit period
from one month to two months, collection costs would increase from `6,000 to `8,000 annually
and bad debt losses would increase from 2% to 2.5% of sales. The finance manager of the
company feels that any additional investment in receivables should earn at least 13% on
investment.
---------------------
Ex. 3
The average collection period which is at present 45 days is expected to increase to 75 days. It
is also likely that the bad debts expenses will increase from the current level of 1% to 3% of
sales. Total credit sales are expected to increase from the current level of 1,20,000 units to
1,38,000 units. The present average cost per unit is `17, the variable cost and the sales per
unit is `15 and `20 per unit respectively. Should the firm extend the credit period if the firm
expects a rate of return of 15%.
---------------------
Ex. 4
A firm is contemplating stricter collection policies. The following details are available :

63
1. At present, the firm is selling 54,000 units on credit at a price of `48 each; the variable
cost per unit is `38 while the average cost per unit is `44; average collection period is
58 days; and collection expenses amount to `15,000; bad debts are 3% of sales.
2. If the collection procedures are tightened, additional collection charges amounting to
`30,000 would be required, bad debts will be 1%; the collection period will be 40 days;
sales volume is likely to decline by 750 units.
Assume a 20% rate of return on investments, what would be your recommendations? Should
the firm implement the decision?
---------------------
Ex. 5
Super Sports, dealing in sports goods has an annual sale of `50 lakh and currently extending
30 days credit to the dealers. It is felt that sales can pick up considerably if the dealers are
willing to carry increased stocks, but the dealers have difficulty in financing their inventory.
The firm is, therefore, considering shifts in credit policy. The following information is available :
1. The average collection period now is 30 days

2. Variable costs, 80% of sales
3. Fixed Costs, `6 lakh per annum
4. Required return on investment : 20%
Credit Policy Average Collection period (Days) Annual Sales (` lakh)

A 45 56
B 60 60
C 75 62
D 90 63
Determine which policy the company should adopt.
---------------------
Ex. 6
Surya Industries Ltd. is considering the revision of its credit policy with a view to increase its
sales and profits. Currently all its sales are on credit and the customers are given one month‘s
time to settle the dues. It has a contribution of 40 % on sales and it can raise additional funds
at a cost of 20% p. a. The marketing director of the company has given the following options:
Particulars Current Position Option I Option II Option III

Sales (` lakh) 200 210 220 250
Credit period (Months) 1 1½ 2 3
Bad Debts (% of sales) 2 2½ 3 5
Cost of Collection (` lakh) 1.20 1.30 1.50 3.00
Advise the company to take the right decision.
---------------------

64
CHAPTER 9
CASH MANAGEMENT
Business concern needs cash to make payments for acquisition of resources and services for
the normal conduct of business. Cash is one of the important and key parts of the current
assets. Cash is the money which a business concern can disburse immediately without any
restriction. The term cash includes currency, cheques held by the business concern and
balance in its bank accounts. Management of cash consists of cash inflow and outflows, cash
flow within the concern and cash balance held by the concern etc.
Cash Management Models

Cash management models analyse methods which provide certain framework as to how the
cash management is conducted in the firm. Cash management models are the development of
the theoretical concepts into analytical approaches with the mathematical applications. There
are three cash management models which are very popular in the field of finance.
1. Baumol model
The basic objective of the Baumol model is to determine the minimum cost amount of
cash conversion and the lost opportunity cost. It is a model that provides for cost
efficient transactional balances and assumes that the demand for cash can be
predicated with certainty and determines the optimal conversion size. Total conversion
cost per period can be calculated as t= Tb/C, where, T = Total transaction cash needs
for the period, b = Cost per conversion, C = Value of marketable securities
Opportunity cost can be calculated as i = C/2 where, i = interest rate earned, C/2 =
Average cash balance
Optimal cash conversion can be calculated as C =  2bT / i, where, C = Optimal
conversion amount, b = Cost of conversion into cash per lot or transaction, T =
Projected cash requirement, i = interest rate earned
2. Miller-Orr model
This model was suggested by Miller Orr. This model is to determine the optimum cash
balance level which minimises the cost of management of cash. Miller-Orr Model can be
calculated as
C = bE (N) + iE (M)
t
where, C = Total cost of cash management, b = fixed cost per conversion, E(M) =
expected average daily cash balance, E (N) = expected number of conversion, t =
Number of days in the period, i = lost opportunity cost.
3. Orgler’s model
Orgler model provides for integration of cash management with production and other
aspects of the business concern. Multiple linear programming is used to determine the
optimal cash management. Orgler‘s model is formulated, based on the set of objectives
of the firm and specifying the set of constrains of the firm.
Ex. 1
From the following forecasts of Income and Expenditure, prepare a cash budget for the months
from January to April, 2015.
Nov 14 Dec 14 Jan 15 Feb 15 Mar 15 April 15

Sales (Credit) 30,000 35,000 25,000 30,000 35,000 40,000
Purchases (Credit) 15,000 20,000 15,000 20,000 22,500 25,000
Wages 3,000 3,200 2,500 3,000 2,400 2,600
Manufacturing 1,150 1,225 990 1,050 1,100 1,200

65
Expenses
Administrative 1,060 1,040 1,100 1,150 1,220 1,180
Expenses
Selling Expenses 500 550 600 620 570 710
Additional information is as follows :
1. The customers are allowed a credit period of 1 month.

2. A dividend of `10,000 is payable in April.
3. Capital expenditure to be incurred :
Plant to be purchased on 15th Jan for `5,000 and a building has been purchased on 1st
March and the payments are to be made in monthly installments of `2,000 each.
4. The creditors are allowing a credit of 2 months
5. Wages are paid on the first of the next month
6. Lag in payment of other expenses is one month
7. Balance of cash in hand on Jan 1 is `15,000
---------------------
Ex. 2
Forecast the cash requirement for three months ending 30th June 2015 from the information
given below:
Months Sales Materials Wages Overheads

February 14,000 9,600 3,000 1,700
March 15,000 9,000 3,000 1,900
April 16,000 9,200 3,200 2,000
May 17,000 10,000 3,600 2,200
June 18,000 10,400 4,000 2,300
1. Credit terms are :

Sales – 10% sales are on cash; 50% of credit sales are collected next month and the
balance in the following month.
2. Creditors :
Materials – 2 months
Wages ¼ month
Overhead ½ month
3. Cash and Bank balances as on 1st April 2015 is expected to `6,000
4. Other relevant information.
i. Plant and machinery will be installed in February 2015 at the cost of `96,000. The
monthly installments `2,000 is payable from April onwards.
ii. Dividend @ 5% on Preference Share Capital of `2,00,000 will be paid on 1st June.
iii. Advance to be received for sale of vehicles `9,000 in June.
iv. Dividends from investments amounting to `1,000 are expected to be received in
June.
v. Advance income tax to be paid in June is `2,000
---------------------
Ex. 3
VRK Industries manufactures razor blades. Its sales figures are given below.
Months Actual Sales (`) Month Actual Purchases (`)

November 1,00,000 December 40,000
December 1,00,000

66
Months Forecasted Sales (`) Months Forecasted Purchases (`)

January 1,00,000 January 40,000
February 1,00,000 February 40,000
March 1,20,000 March 45,000
April 1,20,000 April 50,000
May 1,40,000 May 55,000
June 1,40,000 June 55,000
1. Cash and credit sales are expected to be 20 percent and 80 percent respectively.
2. Receivables from credit sales are expected to be collected as follows: 50 percent of
receivables, on an average, one month from the date of sale and balance 50 percent, on
an average, two months from the date of sale. No bad debt losses.
3. `50,000 expected from the sale of a machine in March and `2,000 expected as interest
on securities in June.
4. The payments for these purchases are made a month after the purchase. The payment
for purchases in December will be made in January.
5. Miscellaneous cash purchases of `2,500 per month are planned from January through
June.
6. Wage payments are expected to be `16,000 per month, January through June.
Manufacturing expenses expected to be `20,000 for January and February and `
30,000 from March to June; general administrative and selling expenses are expected to
be `10,000 from January to March and `12,000 from April to June.
7. Dividend payment of `20,000 and tax payment of `18,000 are scheduled in June.
8. A machine worth `55,000 proposed to be purchased on cash in March.
9. Opening cash balance is `20,000. The management policy is to maintain a minimum
cash balance of `18,000. Given the above information work out a statement of Cash
Receipts forecast, Cash Payments forecast and the Cash Budget for the period January-
June.
---------------------

67
CHAPTER 10
CAPITAL BUDGETING DECISIONS
Capital expenditure budget or capital budgeting is a process of making decisions regarding

investments in fixed assets which are not meant for sale such as land, building, machinery or
furniture. The word investment refers to the expenditure which is required to be made in
connection with the acquisition and the development of long-term facilities including fixed
assets. It refers to process by which management selects those investment proposals which are
worthwhile for investing available funds. For this purpose, management is to decide whether or
not to acquire, or add to or replace fixed assets in the light of overall objectives of the firm.
The examples of capital expenditure:

 Purchase of fixed assets such as land and building, plant and machinery, good will, etc.
 The expenditure relating to addition, expansion, improvement and alteration to the
fixed assets
 The replacement of fixed assets
 Research and development project
Need and Importance of Capital Budgeting

 Huge investments: Capital budgeting requires huge investments of funds, but the
available funds are limited, therefore the firm before investing projects, plan are control
its capital expenditure.
 Long-term: Capital expenditure is long-term in nature or permanent in nature.

Therefore financial risks involved in the investment decision are more. If higher risks
are involved, it needs careful planning of capital budgeting.
 Irreversible: The capital investment decisions are irreversible, are not changed back.
Once the decision is taken for purchasing a permanent asset, it is very difficult to
dispose off those assets without involving huge losses.
 Long-term effect: Capital budgeting not only reduces the cost but also increases the
revenue in long-term and will bring significant changes in the profit of the company by
avoiding over or more investment or under investment. Over investments leads to be
unable to utilize assets or over utilization of fixed assets. Therefore before making the
investment, it is required carefully planning and analysis of the project thoroughly.
Capital Budgeting Process

The following procedure may be considered in the process of capital budgeting decisions:
1. Identification of profitable investment proposals
2. Screening and selection of right proposals
3. Evaluation of measures of investment worth on the basis of profitability and uncertainty
or risk
4. Establishing priorities, i.e., uneconomical or unprofitable proposals may be rejected
5. Final approval and preparation of capital expenditure budget
6. Implementing proposal, i.e., project execution
7. Review the performance of projects
Types of Capital Budgeting Proposals

A firm may have several investment proposals for its consideration. It may adopt after
considering the merits and demerits of each one of them. For this purpose capital expenditure
proposals may be classified into :

68
 Independent Proposals
These proposals are said be to economically independent which are accepted or rejected
on the basis of minimum return on investment required. Independent proposals do not
depend upon each other.
 Dependent Proposals or Contingent Proposals

In this case, when the acceptance of one proposal is contingent upon the acceptance of
other proposals, it is called as "Dependent or Contingent Proposals." E.g. construction
of new building on account of installation of new plant and machinery.
 Mutually Exclusive Proposals

Mutually Exclusive Proposals refer to the acceptance of one proposal results in the
automatic rejection of the other proposal. Then the two investments are mutually
exclusive. In other words, one can be rejected and the other can be accepted. It is easier
for a firm to take capital budgeting decisions on such projects.
Methods of Evaluating Capital Investment Proposals

There are number of appraisal methods which may be recommended for evaluating the capital
investment proposals. The methods of evaluations are classified as follows:
1. Traditional methods (or Non-discount methods)

 Pay Back Period
 Accounting Rate of Return
2. Modern methods or Discounted Cashflow methods

 Net Present Value
 Profitability Index
 Internal Rate of Return
 Discounted Pay Back Period
Ex. 1
ABC International is evaluating a project whose expected cash flows are as follows:
Year Cash flow

0 -10,00,000
1 1,00,000
2 2,00,000
3 3,00,000
4 6,00,000
5 3,00,000
What is the NPV, Profitability Index, Pay-Back Period and Discounted Pay-Back Period of the
project, if the discounted rate is 12% for the entire period?
---------------------
Ex. 2
The expected cash flows of a project are as follows:
Year Cash flows of Project A Cash flows of Project B

0 -100,000 -100,000
1 20,000 30,000
2 30,000 50,000
3 40,000 40,000
4 50,000 30,000
5 30,000 20,000

69
The cost of Capital is 14%. Calculate the following:
a. Net present value b. Payback period

c. Benefit-Cost ratio d. Discounted payback period
---------------------
Ex. 3
XYZ Ltd., whose cost of capital is 20%, is considering two mutually exclusive projects, X and Y.
Compute the NPV and Profitability Index for the projects from the following:
Project X (`) Project Y (`)

Cash Inflow : Year 1 10,000 50,000
2 20,000 40,000
3 30,000 20,000
4 45,000 10,000
5 60,000 10,000
1,65,000 1,30,000
---------------------
Ex. 4
A project costs `54,000 and is expected to generate cash inflows of `16,800 annually for 5
years. The WACC of the project is 15%. Calculate the NPV of the project.
---------------------
Ex. 5
What is the NPV of an investment which involves a current outlay of `3,00,000 and results in
an annual cash inflow of `60,000 for 7 years? The overall cost of capital is 16%. Should the
investment be made?
---------------------
Ex. 6
ABC International is evaluating a project whose expected cash flows are as follows:
Year Cash flow

0 -10,00,000
1 1,00,000
2 2,00,000
3 3,00,000
4 6,00,000
5 3,00,000
The cost of capital is 12%. Calculate the IRR.
---------------------
Ex. 7
A project costs `54,000 and is expected to generate cash inflows of `16,800 annually for 5
years. The WACC of the project is 12%. Calculate the IRR of the project.
---------------------

70
Ex. 8
What is the IRR of an investment which involves a current outlay of `3,00,000 and results in
an annual cash inflow of `60,000 for 7 years? The overall cost of capital is 5%. Should the
investment be made?
---------------------
Ex. 9
XYZ Ltd., whose cost of capital is 10%, is considering the following project X. Compute the IRR
for the project:
Project X (`)
Investment 70,000
Cash Inflow : Year 1 20,000
2 15,000
3 20,000
4 30,000
5 15,000
---------------------
Ex. 10
A company, whose cost of capital is 14%, is considering the following investment opportunity.
Compute the IRR.
Investment 150,000
Cash Inflow : Year 1 35,000
2 38,000
3 33,000
4 45,000
5 40,000
6 35,000
7 42,000
---------------------
Ex. 11
The expected cash flows from three projects are as follows:
A B C
Initial Investment (INR) 1,00,000 1,00,000 1,00,000
Year Annual Cash Inflows (INR)
1 10,000 50,000 30,000
2 20,000 40,000 30,000
3 30,000 30,000 30,000
4 40,000 20,000 30,000
5 50000 10,000 30,000
Rank the projects based on Internal rate of return method of capital budgeting.
---------------------
Ex. 12
Mr. Amit is considering two mutually exclusive project ‗X‘ and ‗Y‘. You are required to advise
him about the acceptability of the projects from the following information.

71
Particulars Project X (`) Project Y (`)

Cost of the investment 10,000 10,000
Forecast cash inflows per annum for 5 years
Optimistic 60,000 55,000
Most likely 35,000 30,000
Pessimistic 20,000 20,000
The cut-off rate may be assumed to be 15%.
---------------------
Ex. 13
Two mutually exclusive investment proposals are being considered. The following information
in available:
Particulars Project A (`) Project B (`)

Cost of the investment 1,00,000 1,00,000
Project A (`) Project B (`)

Cash inflows Year ` Probability ` Probability
1 10,000 .2 12,000 .2
2 18,000 .6 16,000 .6
3 8,000 .2 14,000 .2
Assuming cost of capital at 10% advise the selection of the project:
---------------------
Ex. 14
Calculate the Average Rate of Return of the following two proposals. Initial outlay of both are
`1,00,000. Life is Four years. Profits for four years are as follows:
Year Profit After tax

Project A Project B
0 0 0
1 40,000 10,000
2 30,000 20,000
3 20,000 30,000
4 10,000 40,000
---------------------
Ex. 15
Pallavi Company Ltd. is contemplating investment in a machine. There are two machines
available in the market. The details about the two machines are given below :
Particulars Machine A Machine B

Life 3 Years 3 Years
Capital Cost `4,00,000 `4,00,000
Income (After Tax)
I Year `1,60,000 `40,000
II Year 1,20,000 1,40,000
III Year 80,000 2,10,000
Calculate the ARR on investment and advice on the choice of the machine.
---------------------

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CALCULATION OF CASH FLOWS
Ex. 1
A company is considering an investment proposal to install new milling controls at a cost of
`50,000. The company follows written down value method of depreciation. The rate of
depreciation is 10% p.a. The tax rate is 35%. The cost of capital is 11%. CFBDT (Cash Flows
Before Depreciation and Tax) from the investment proposal are as follows:
Year CFBDT (`)

1 16,000
2 14,000
3 15,000
4 13,000
5 19,000
Compute the following :

1. Payback period and Discounted Pay Back Period
2. Net present value at 11% discount rate
3. Profitability index at 11% discount rate.
---------------------
Ex. 2
The company is considering buying a machine with a initial cost of `1,50,000 and an economic
life of 3 yrs. The machine is expected to produce finished goods, which can generate a sales
revenue of `1,20,000 per year and operating expenses will be `35,000 per year. The firm‘s tax
rate is 40% and cost of capital is 18%. The machine will have no salvage value after 3 years.
The company follows SLM of depreciation. What is the NPV of the project?
---------------------
Ex. 3
A plastic manufacturer has under consideration the proposal of production of high quality
plastic glasses. The necessary equipment to manufacture the glasses would cost `1,00,000 and
would last 5 years. The rate of depreciation is 25 per cent on written down value. The expected
salvage value is `10,000. The glasses can be sold at `4.00 each. Regardless of the level of
production, the manufacturer will incur cash cost of `25,000 each year if the project is
undertaken. The variable costs are estimated at `2.00 per glass. The manufacturer estimates
he will sell about 70,000 glasses for the first year and second year, 75,000 glasses during the
third year and 80,000 glasses during the fourth and fifth year; the tax rate is 35 per cent.
Should the proposed equipment be purchased? Assume 20 per cent cost of capital.
---------------------
Ex. 4
Samtron Ltd. requires an investment of `100 lacs in fixed assets to set up a new project of
manufacturing iron rods. The financing will be in the Debt/Equity ratio of 3 : 2. The cost of
debt will be 12 per cent per annum and expected cost of equity will be 17 per cent. The sales
will be `50 lacs, `60 lacs, `70 lacs for the first year, second year, third year and `80 lacs for
fourth and fifth year respectively. The corresponding cost (excluding depreciation and interest
payment) will be 20 per cent of the sales. Depreciation rate is 14 per cent on written down
value. The fixed assets will fetch a salvage value of `20 lacs at the end of the fifth year. Assume
35 per cent as the tax rate. Evaluate the project on the basis of NPV.
---------------------

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Ex.5
ABC Limited is engaged in the manufacture of Ball Pens. As a part of its diversification plans,
the company proposes to set up a plant to produce the ball pens. The details of the scheme are
as follows :
1. Cost of the plant, `200 lakhs and the cost of the machinery, `100 lakhs
2. Cost of the land, `15 lakhs
3. As ABC limited is setting their plant in the SEZ zone, they will get a subsidy from the
government after installation, `10 lakh
4. The sales revenue will be `3.25 per pen in year 1. This will increase by Re.0.25 per unit
every year till year 3. After that, it will increase every year by Re.0.50 per year till year 5
5. Maintenance cost will be `4 lakh in year 1 and the same will increase by `2 lakhs every
year
6. Estimated life, 5 years
7. Discounting factor is cost of capital, 12 per cent
8. Residual value, nil. However, the value of land be `70 lakh, at the end of year 5
9. SCL Limited follows straight line method of depreciation and only the cost of plant and
cost of machinery is subject to depreciation.
10. The gross manufacturing of the pen will be 25 lakh units per annum; 4 per cent of
which will be committed to the Bhrahan Mumbai Municipal Corporation (BMC) schools
as donation as per the agreement.
11. Tax rate, 35 per cent
From the above information, you are required to calculate the Net Present Value (NPV).
---------------------
Ex.6
Jindal Steel Ltd. is planning to produce steel tubes at its existing steel complex. Following is
the plan:
1. Installed capacity of the plant will be 2,000 tonnes, the sales will be at 60%, 80% and
100% of capacity in the 1st year, 2nd year and 3rd and subsequent years.
2. The selling prices will be `2,500 / tonne.
3. H. R. Coils at 1.1 tonne / tonnes of output are the raw materials and their cost is `530 /
tonne.
4. Utilities and consumables are `700 / tonne of output.
5. Salaries and wages will be `1,50,000 every year.
6. Administrative and selling overheads will be `2,00,000 per year.
7. Allocated rent is expected to be `1,00,000 p.a. every year.
8. The average tax rate of the company will be 35%
9. Depreciation is to be charged at 20% of capital cost on written down value basis.
10. Total project cost is estimated at `35,00,000. The equipment cost will be `24,00,000.
Erection cost will be `2,00,000. Building and other capital cost will be `4,00,000 and
working capital is estimated to be `5,00,000.
11. The life of the project is estimate to be 5 years. At the end of the 5 years, fixed assets will
fetch a net salvage value of `8,00,000
12. The company proposes to finance the project with a debt equity ratio of 1.5 : 1. Debt will
be raised from financial institution. The rate of interest will be 14% and the cost of
capital is 18%.
Calculate the cashflows and pay-back period.
---------------------

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Ex.7
A company wants to expand its existing plant. The expansion project will cost INR 1,100 lakhs.
Annual capacity of the plant will be 50,000 units sold at the rate of INR 2,500. The variable
cost to sales ratio will be 50%. The fixed cost per annum will be INR 45 lakhs excluding
depreciation. The set up cost of one time would be INR 100 lakhs. The rate of depreciation is 10
per cent on written down value. The expected salvage value is INR 500 lakhs. The tax rate is 35
per cent. The company will utilize the capacity of plant as under :
Capacity utilization of plant

Year 1 2 3 4 5
capacity 30 50 70 100 100
Should the proposed equipment be purchased? Assume 12 per cent cost of capital.
---------------------

75
CHAPTER 11
SOURCES OF FINANCE
As we are aware finance is the life blood of business it is needed throughout a company's life.
The type and amount of finance required for a business depends on many factors like:
 Type and Nature of Business
 Success of firm
 State of the Economy
 Nature of goods produced
 Technology used
 Amount of capital required
Sources of funds
There are two main types of funds that a company needs:
1. Long Term Funds for Capital Expenditure
2. Short Term Funds for Working Capital
1. Long term funds

The long term investment (capital budgeting) decisions involves the acquisition of long
term or fixed assets. These assets have to be financed with long term sources of finance.
The main sources of long term finance fall into two brood groups
A. Internal Sources of Funds and
B. External Sources of Funds
A. Internal Sources of Funds
These are sources of finance that come from the business assets or activities. Internal
sources are often preferable to a firm as they will usually be cheaper and perhaps easier
to arrange at short notice but these funds may be more limited in scope. The main
internal sources are:
 Depreciation - Allocation of original cost
 Retained Earnings - Profit made reinvested into the business
B. External Sources of Funds

 Equity Capital
 Hybrid Sources of Finance
o Preference Capital
o Convertibles
o Warrants
o Options
 Term loans
 Debentures / Notes / Bonds
 Leasing and Hire-Purchase Finance
 Franchising
 Venture Capital
2. Short term funds

After determining the level of working capital, a firm has to decide how it is to be financed.
The need for financing arises because the investment in working capital (current assets)
that is raw materials, work-in-process, finished goods and receivables fluctuates during the
year.
The main sources of finance for working capital are as follows :
 Accruals

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 Trade Credit
 Commercial Paper
 Public Deposits
 Factoring
 Banks Credit
---------------------

77
CHAPTER 12
COST OF CAPITAL
Cost of capital is an integral part of investment decision as it is used to measure the worth of
investment proposal provided by the business concern. It is used as a discount rate in
determining the present value of future cash flows associated with capital projects. Cost of
capital is also called as cut-off rate, target rate, hurdle rate and required rate of return. When
the firms are using different sources of finance, the finance manager must take careful decision
with regard to the cost of capital; because it is closely associated with the value of the firm and
the earning capacity of the firm. Cost of capital is the rate of return that a firm must earn on
its project investments to maintain its market value and attract funds. Cost of capital is the
required rate of return on its investments which belongs to equity, debt and retained earnings.
If a firm fails to earn return at the expected rate, the market value of the shares will fall and it
will result in the reduction of overall wealth of the shareholders.
Classification of Cost of Capital

Cost of capital may be classified into the following types on the basis of nature and usage:
 Explicit and Implicit Cost
 Average and Marginal Cost
 Historical and Future Cost
 Specific and Combined Cost
Explicit and Implicit Cost - The cost of capital may be explicit or implicit cost on the basis of
the computation of cost of capital. Explicit cost is the rate that the firm pays to procure
financing. Implicit cost is the rate of return associated with the best investment opportunity for
the firm and its shareholders that will be forgone if the projects presently under consideration
by the firm were accepted.
Average and Marginal Cost - Average cost of capital is the weighted average cost of each
component of capital employed by the company. It considers weighted average cost of all kinds
of financing such as equity, debt, retained earnings etc. Marginal cost is the weighted average
cost of new finance raised by the company. It is the additional cost of capital when the
company goes for further raising of finance.
Historical and Future Cost - Historical cost is the cost which as already been incurred for
financing a particular project. It is based on the actual cost incurred in the previous project.
Future cost is the expected cost of financing in the proposed project. Expected cost is
calculated on the basis of previous experience.
Specific and Combine Cost - The cost of each sources of capital such as equity, debt, retained
earnings and loans is called as specific cost of capital. It is very useful to determine the each
and every specific source of capital. The composite or combined cost of capital is the
combination of all sources of capital. It is also called as overall cost of capital. It is used to
understand the total cost associated with the total finance of the firm.
Importance of Cost of Capital

Computation of cost of capital is a very important part of the financial management to decide
the capital structure of the business concern.
1. Importance to Capital Budgeting Decision

Capital budget decision largely depends on the cost of capital of each source. According
to net present value method, present value of cash inflow must be more than the
present value of cash outflow. Hence, cost of capital is used to capital budgeting
decision.

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2. Importance to Structure Decision

Capital structure is the mix or proportion of the different kinds of long term securities.
A firm uses particular type of sources if the cost of capital is suitable. Hence, cost of
capital helps to take decision regarding structure.
3. Importance to Evolution of Financial Performance

Cost of capital is one of the important determine which affects the capital budgeting,
capital structure and value of the firm. Hence, it helps to evaluate the financial
performance of the firm.
4. Importance to Other Financial Decisions

Apart from the above points, cost of capital is also used in some other areas such as,
market value of share, earning capacity of securities etc. hence, it plays a major part in
the financial management.
Computation of Cost of Capital

Computation of cost of capital consists of two important parts:
1. Measurement of specific costs
2. Measurement of overall cost of capital
Measurement of Specific Cost of Capital

It refers to the cost of each specific sources of finance like:
 Cost of debt
 Cost of preference share
 Cost of retained earnings
 Cost of equity
Measurement of Overall Cost of Capital

It is also called as weighted average cost of capital and composite cost of capital. Weighted
average cost of capital is the expected average future cost of funds over the long run found by
weighting the cost of each specific type of capital by its proportion in the firm‘s capital
structure.
COST OF DEBT CAPITAL
Ex. 1
A company pays `15,000 p. a. as the Interest on its perpetual debt of `1,00,000. Determine the
cost of debt assuming the debt is issued at (i) Par, (ii) 10% Discount; and (iii) 10% Premium.
Also calculate the post tax cost of debt if the tax rate is 35% and assuming the debt is issued
at (i) Par, (ii) 10% Discount; and (iii) 10% Premium.
---------------------
Ex. 2
A company had issued 10% debentures of `1000 each at 15% premium and it is redeemable at
par after ten years. The company‘s tax rate is 20%. Determine the cost of debt.
---------------------
Ex. 3
A company issued 11% debentures of `100 for an amount aggregating `1,00,000 at 10%
premium, redeemable at par after five years. The company‘s tax rate is 35%. Determine the
cost of debt. Also calculate the cost of debt if the debt is redeemed at 10% premium and 10%
discount.
---------------------

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Ex. 4
A Ltd. has recently made an issue of non-convertible debentures for ` 5 crores. The terms of
the issue are as follows: Each debenture has a face value of `100 and carries a rate of interest
of 12%. The interest is payable annually and the debenture is redeemable at a premium of 5%
after 5 years. If A Ltd. realizes `97 per debentures and the corporate tax rate is 40%, what is
the cost of the debenture to the company?
---------------------
Ex. 5
A company issued 15% debentures of `1,000 face value to be redeemed after 8 years. The
debenture is issued at a 5% discount. It will also involve floatation costs of 2.5% of face value.
The company‘s tax rate is 35%. What would the cost of debt be?
---------------------
Ex. 6
Ten year 13% debentures of a firm are sold at a rate of `80. The face value of a debenture is
`100. 40% tax rate is assumed. Find out the cost of debt capital?
---------------------
Ex. 7
A company issued 12% debentures of `100 at 10% discount and redeemable at premium of
10% after 8 years. The company‘s tax rate is 35%. Determine the cost of debt.
---------------------
COST OF SHARE CAPITAL
Ex. 1
A company has recently issued a preference shares at a face value of `100 and a dividend rate
of 12% payable annually. The share is redeemable after 10 years at par. If the net amount
realized per share is `96, what is the cost of the preference capital?
---------------------
Ex. 2
ABC Ltd. has issued 14% preference shares of the face value of `1000 each to be redeemed
after 10 years at a premium of 10%. Flotation cost is 5%. Calculate the cost of preference
shares.
---------------------
Ex. 3
The market price per share of X Ltd. is `525. The dividend expected per share a year hence is
`50 and the Dividend Per Share (DPS) is expected to grow at a constant rate of 10% p.a. What
is the cost of the equity capital to the company?
---------------------
Ex. 4
The shares of A Ltd. are selling at `240 per share. The firm has paid a dividend of `24 per
share. The estimated growth of the company is 5 % approx. Determine the cost of equity capital
of the company.
---------------------

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Ex. 5
The details of dividend paid by Cool Ltd. on existing equity shares of `10 each for the past 6
years is given below :
Year 2005 2006 2007 2008 2009 2010

DPS 10.5 11.0 11.6 13.1 14.7 16.4
The current market price of Equity Shares is `50. Determine the cost of equity capital of the
company.
---------------------
Ex. 6
Falcon Ltd. has paid up capital of `10,00,000. Equity shares of `10 each and the current
market price of its equity shares is `42. The dividend declared by the company during last 5
years is given below :
Year 2005 2006 2007 2008 2009

Dividend declared (` lakhs.) 9 10.50 15 18 21
Calculate the cost of equity capital of the company.
---------------------
Ex. 7
From the information provided to the firm by it investment advisors along with the firm‘s own
analysis, it is found that the risk free rate of return equals 10 %, the firm‘s beta equals 1.50
and the return on the market portfolio equals 12.5 %. Compute the cost of equity capital using
CAPM approach.
---------------------
Ex. 8
XZ Ltd. has a beta of 0.80. If the current risk free rate is 6.5 % and the expected return on the
stock market as a whole is 16 %, using SML approach determine the cost of equity capital for
the firm.
---------------------
OVERALL COST OF CAPITAL (WACC)
Ex. 1
The required rate of return on Equity is 16 % and the cost of debt is 12 %. The firm has a
capital mix of 60 % of Equity and 40 % Debt. Calculate the company‘s WACC.
---------------------
Ex. 2
A firm‘s after-tax cost of capital of the specific sources is as follows:
Cost of Debt – 8 %
Cost of Preference Share – 14 %
Cost of Equity Funds – 17 %
The following is the capital structure :

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Source Amount (`)

Debt 3,00,000
Preference Capital 2,00,000
Equity Capital 5,00,000
10,00,000
1. Calculate the WACC, using the Book Value as weights.

2. If, the market value of Debt fund is `2,70,000; Preferences Shares is `2,30,000 and of
Equity Shares is `6,00,000 than calculate the WACC, using the Market Values as
weights.
---------------------
Ex. 3
Priti Sewing Company Ltd. has the following financing mix :
Sources ` in lakhs
Equity Capital (10 lks shares at par value) 100
12 % Preference Share Capital (10,000 shares at par value) 10
Retained Earnings 120
14 % Non- Convertible Debentures (70,000 deb. at par value) 70
14 % Term Loan from RFC 100
Total 400
The equity shares of the company are trading at `25. The next expected dividend per share is
`12.00 and the DPS is expected to grow at a constant rate of 8 %. The preference shares are
redeemable after 7 years at par and the sales proceeds realized at the time of issue is `75 per
share. The debentures are redeemable after 6 years at par and their current market price is
`90 per debenture. The tax rate applicable to the firm is 50 %. What is the WACC of the
company?
---------------------

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CHAPTER 13
CAPITAL STRUCTURE PLANNING
Capital is the major part of all kinds of business activities, which are decided by the size, and
nature of the business concern. Capital may be raised with the help of various sources. If the
company maintains proper and adequate level of capital, it will earn high profit and they can
provide more dividends to its shareholders.
Meaning of Capital Structure

Capital structure refers to the kinds of securities and the proportionate amounts that make up
capitalization. It is the mix of different sources of long-term sources such as equity shares,
preference shares, debentures, long-term loans and retained earnings. The term capital
structure refers to the relationship between the various long-term source financing such as
equity capital, preference share capital and debt capital. Deciding the suitable capital structure
is the important decision of the financial management because it is closely related to the value
of the firm. Capital structure is the permanent financing of the company represented primarily
by long-term debt and equity.
Financial Structure
The term financial structure is different from the capital structure. Financial structure shows
the pattern total financing. It measures the extent to which total funds are available to finance
the total assets of the business. Financial Structure = Total liabilities Or Financial Structure =
Capital Structure + Current liabilities.
Objectives of Capital Structure

Decision of capital structure aims at the following two important objectives:
 Maximize the value of the firm.
 Minimize the overall cost of capital.
Factors Governing the Capital Structure Decision

 Profitability Aspect
 Liquidity Aspect
 Control
 Leverage Ratios for other Firms in the Industry
 Nature of Industry
 Consultation with Investment Bankers and Lenders
 Flexibility of funds for commercial strategies
 Timing of Issue
 Characteristic of the company
 Tax Planning
Optimum Capital Structure

Optimum capital structure is the capital structure at which the weighted average cost of capital
is minimum and the value of the firm is maximum. Optimum capital structure may be defined
as the capital structure or combination of debt and equity that leads to the maximum value of
the firm.
Ex.1
Z Ltd. has a capital structure comprising equity capital only. It has 1,00,000 equity shares of
`10 each. Now the company wants to raise a fund of `2,50,000 for its various investment
purposes after considering the following three alternative methods of financing:

83
1. Issuing 25,000 Equity Shares of `10 each.

2. Borrowing a debt of `2,50,000 at 10% interest and
3. Issuing 2,500, 10% Preference Shares of `100 each.
Show the effect of EPS under various methods of financing if EBIT (after additional investment)
are `3,20,000 and rate of taxation is 40%.
---------------------
Ex.2
The following data is available for the year 2010:
Particulars `
Equity Shares of `10 each 2,00,000
EBIT 60,000
For the year 2011 the company wants to raise `50,000 for the purchase of some fixed assets.
The following options are available for raising the funds.
1. Issue of Equity Shares at a premium of `6
2. Issue of 11% Debentures
3. Issue of 10% Preference Shares
The projected EBIT for the year 2011 will be `1,10,000 and the relevant tax rate will be 30%.
Suggest the company, which alternative it should select in order to maximize the EPS.
---------------------
Ex.3
The capital structure of ABC Ltd. comprises of equity shares, preference shares and debenture.
It has 1,00,000 equity shares of `10 each; 10%, 50,000 preference shares of `10 each and
12%, 20,000 debentures of `100 each. Now the company wants to raise a fund of `5,00,000 for
its some investment purposes. After considering the following three alternative methods of
financing, suggest ABC Ltd. the optimum capital mix if EBIT (after additional investment) is
`10,00,000 and rate of tax is 35%.
1. Issuing 50,000 Equity Shares of `10 each.

2. Issuing 25,000 Equity Shares of `10 each and borrowing a debt of `2,50,000 at 12%
interest and
3. Issuing 25,000, 10% Preference Shares of `10 each and borrowing a debt of `2,50,000
at 12% interest.
---------------------
Ex.4
The current position of a company is as follows :
Particulars `
Equity Capital (`10 per share) 1,00,000
10% Debt 80,000
Surpluses 30,000
Total Capital Employed 2,10,000
Particulars `
Income before interest and taxes 50,000

84
Interest 8,000
Earnings before taxes 42,000
Income Tax 14,700
Income after taxes 27,300
The company wants to make an expansion programme of `1,00,000 for which it have the
following options :
1. If this is financed through debt, the rate of interest on new debt will be 12%.
2. If this is financed through equity, new shares can be sold for `40 per share.
The additional EBIT after the expansion will be `15,000. Which form of financing should it
choose, so that it earns maximum EPS?
---------------------
Ex.5
The capital structure of Dutta Enterprises Ltd. is as follows :
Liabilities ` Assets `
Equity Shares of `10 each 5,00,000 Fixed Assets 8,00,000
12% Preference Shares of `100 each 2,00,000 Working Capital 2,00,000
10% Debentures of `1,000 each 3,00,000
10,00,000 10,00,00
0
The company is in the process of starting a new project requiring an investment of `15,00,000.
After considering the following three alternative methods of financing, suggest Dutta
Enterprises Ltd. the optimum capital mix that will maximize the EPS, if Company‘s return on
capital employed (ROCE) is 32% (on existing as well as new funds) and rate of tax is 35%.
1. Issuing 1,00,000 Equity Shares of `10 each and borrowing the balance through debt
funds at 14% interest.
2. Issuing 10,000, 12% Preference Shares of `100 each and borrowing a debt of `5,00,000
at 10% interest and
3. Issuing 50,000 Equity Shares of `10 each, issuing 5,000, 12% Preference Shares of
`100 each and issuing 500, 10% Debentures of `1,000 each.
Note: ROCE = EBIT / Total Capital Employed
---------------------
Ex.6
Elite India Ltd., a four year young company, is growing rapidly. Presently it has 80,000 equity
shares of `50 each and 10% debentures of `20,00,000. The summary of income statement for
last year is given below :-
`
Sales 50,00,000
Less : V. Expenses 25,00,000
F. Expenses 9,00,000 34,00,000
EBIT 16,00,000
Interest 2,00,000
EBT 14,00,000
Tax (35%) 4,90,000
PAT 9,10,000
EPS 11.38

85
The company further wants to expand its activities for which it is planning to make an
additional investment of `20,00,000.
There are two financing options : either 40,000 equity shares of `50 each, or debt funds of
`20,00,000 at 12% interest.
The company wants to assess its position for two levels of sales projections for next year viz.
`70,00,000 and `1,20,00,000.
The ratio of variable expenses to sales will remain the same next year and fixed expenses will
be `13,00,000 at `70,00,000 sales and `26,00,000 at `1,20,00,000 sales. For both the levels of
sales projections the P/E ratio is expected to be 2.5 in case of debt option and 3 in case of
equity option.
If the objective of the company is to maximize the market price of it shares then which
financing option should it go for if the sales are `70,00,000 and if the sales are `1,20,00,000?
---------------------
Ex.7
The Smart Ltd. requires `25,00,000 for a new plant. This plant is expected to yield earnings
before interest and taxes of `5,00,000. While deciding about the financial plan, the company
considers the objective of maximizing earnings per share. It has three alternatives to finance
the project-by raising debt of `2,50,000 or `10,00,000 or `15,00,000 and the balance, in each
case, by issuing equity shares. The company‘s share is currently selling at `150, but is
expected to decline to `125 in case the funds are borrowed in excess of `10,00,000. The funds
can be borrowed at the rate of 10 per cent upto `2,50,000. Any amount borrowed over
`2,50,000 but less than `10,00,000 will have an interest rate of 15 per cent and if the funds
borrowed are over `10,00,000 the interest rate applicable will be 20 per cent. The tax rate
applicable to the company is 50 per cent. Which form of financing should the company choose?
---------------------
Ex.8
A company needs `12 lakhs for the installation of a new factor which would yield an annual
EBIT of `2,00,000. The company has the objective of maximizing earnings per share. It is
considering the possibility of issuing equity shares plus raising a debt of `2,00,000 or
`60,00,000 or `10,00,000. The current market price per share is `40, which is expected to drop
to `25 per share if the market borrowings were to exceed `7,50,000.
Cost of borrowings are indicated as under:

Upto `2,50,000 10% p.a.
Between `2,50,001 and `6,25,000 14% p.a.
Between `6,25,000 and `10,00,000 16% p.a.
Assuming a tax rate of 30 per cent, work out the EPS and the scheme which would meet the
objective of the management.
---------------------

86
CHAPTER 14
DIVIDEND POLICY DECISIONS
Distribution of profit among the shareholders is a very crucial part of the business concern,
because these decisions are directly related with the value of the business concern and
shareholder‘s wealth. Like financing decision and investment decision, dividend decision is also
a major part of the financial manager. When the business concerns decide dividend policy, they
have to consider certain factors such as retained earnings and the nature of shareholder of the
business concern.
Meaning of Dividend
Dividend refers to the business concerns net profits distributed among the shareholders. It
may also be termed as the part of the profit of a business concern, which is distributed among
its shareholders. According to the Institute of Chartered Accountant of India, dividend is
defined as ―a distribution to shareholders out of profits or reserves available for this purpose‖.
Factors Determining Dividend Policy

 Profitable Position of the Firm - Dividend decision depends on the profitable position of
the business concern. When the firm earns more profit, they can distribute more
dividends to the shareholders.
 Uncertainty of Future Income - Future income is a very important factor, which affects
the dividend policy. When the shareholder needs regular income, the firm should
maintain regular dividend policy.
 Legal Constrains - The Companies Act 1956 has put several restrictions regarding
payments and declaration of dividends. Similarly, Income Tax Act, 1961 also lays down
certain restrictions on payment of dividends.
 Liquidity Position - Liquidity position of the firms leads to easy payments of dividend. If
the firms have high liquidity, the firms can provide cash dividend otherwise, they have
to pay stock dividend.
 Sources of Finance - If the firm has finance sources, it will be easy to mobilise large
finance. The firm shall not go for retained earnings.
 Growth Rate of the Firm - High growth rate implies that the firm can distribute more
dividends to its shareholders.
 Tax Policy - Tax policy of the government also affects the dividend policy of the firm.
When the government gives tax incentives, the company pays more dividends.
 Capital Market Conditions - Due to the capital market conditions, dividend policy may
be affected. If the capital market is prefect, it leads to improve the higher dividend.
Types of Dividend Policy

Dividend policy depends upon the nature of the firm, type of shareholder and profitable
position. On the basis of the dividend declaration by the firm, the dividend policy may be
classified under the following types:
 Regular dividend policy
 Stable dividend policy
 Irregular dividend policy
 No dividend policy
1. Regular Dividend Policy

Dividend payable at the usual rate is called as regular dividend policy. This type of
policy is suitable to the small investors, retired persons and others.

87
2. Stable Dividend Policy

Stable dividend policy means payment of certain minimum amount of dividend
regularly.
This dividend policy consists of the following three important forms:
o Constant dividend per share
o Constant payout ratio
o Stable rupee dividend plus extra dividend
3. Irregular Dividend Policy

When the companies are facing constraints of earnings and unsuccessful business
operation, they may follow irregular dividend policy. It is one of the temporary
arrangements to meet the financial problems. These types are having adequate profit.
For others no dividend is distributed.
4. No Dividend Policy
Sometimes the company may follow no dividend policy because of its unfavourable
working capital position of the amount required for future growth of the concerns.
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88
CHAPTER 15
CREDIT RATING OF COUNTRIES/ STATE / INVESTMENT AND INSTRUMENTS
Credit rating is one of the fee based financial services which are provided by specialized
agencies like CRISIL, ICRA and CARE. It is a mechanism by which the reliability and viability
of a credit instrument is brought out. It is usually the effort of investors in financial instrument
to minimize or eliminate default risk. Credit rating service is useful to the investors. According
to Securities Exchange Board of India, credit rating is a compulsory mechanism for listing of
the companies in the stock market and also it is essential to the corporate sectors who want to
raise capital with the help of issue of fixed deposits, commercial papers and other short-term
instruments. Credit rating in India begins from 1988. At present there are four credit rating
agencies very popular in rating.
Objectives of Credit Rating

These are the important objectives of the credit rating:
 To impose a healthy discipline on borrowings
 To lend greater belief to financial and other representations
 To facilitate formulation of public guidelines on institutional investment
 To help merchant bankers, brokers and regulatory authorities
 To encourage the information disclosure, better accounting standards, etc.
 To reduce interest cost for highly rated company
Basis for Credit Rating

Credit rating agencies consider the following important informations for granting the rating
symbol to the borrowing company
 Historical background of the company
 Track record of the company
 Financial efficiency and profitable position
 Operational efficiency
 Market share of the company
 Labour efficiency and their turnover
 Future prospects
1. Credit Rating Information Service of India Limited (CRISIL)

Credit Rating Information Service of India Limited was the first credit rating agency in India, in
January 1988 jointly by ICICI, UTI, LIC, GIC and ADB. The following are the major objectives of
the Credit Rating Information Service of India Limited.
 To rate companies debentures, fixed deposits programmes, short-term instruments etc.
 To provide corporate reports to business concern.
 To conduct industry studies
Credit Rating Symbols of CRISIL
Long-term Medium-term Short-term Remarks

Instrument Instrument Instrument
AAA FAAA P1 Highest Safety
AA FAA P2 High Safety
A FA P3 Adequate Safety
BBB - - Moderate Safety
BB FB P4 Inadequate Safety
B FC - Risk Prone
C - - Substantial Risk
D FD P5 Default

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2. Investment Information and Credit Rating Agency of India Limited (ICRA)

Investment Information and Credit Rating Agency is one of the largest credit rating service
providers next to Credit Rating Information Service of India Limited. It was established mainly
for the purpose of rating of short-term, medium-term and long-term debt instruments of the
corporate and banking companies. It was set up in the year 1991 by the leading banking and
financial institutions.
Credit Rating Symbols of ICRA

LAAA MAAA A1 Highest Safety
LAA MAA A2 High Safety
LA MA A3 Adequate Safety
LBBB - - Moderate Safety
LBB MB A4 Inadequate Safety
LB MC - Risk Prone
LC - - Substantial Risk
LD MD A5 Default
3. Credit Analysis and Research Limited (CARE)

Credit Analysis and Research Limited was set up by Industrial Development Bank of India in
November 1993, Credit Analysis and Research Limited also provides rating to long-term,
medium-term and short-term instruments.
Credit Rating Symbols of CARE

CARE AAA CARE AAA PR1 Highest Safety
CARE AA CARE AA PR2 High Safety
CARE A CARE A PR3 Adequate Safety
CARE BBB CARE BBB - Moderate Safety
CARE BB CARE BB PR4 Inadequate Safety
CARE B CARE B - Risk Prone
CARE C CARE C - Substantial Risk
CARE CARE PR5 Default
---------------------

90
CHAPTER 16
INFRASTRUCTURE FINANCING
An infrastructure is defined as the basic physical systems of a business or nation. Therefore

any credit facility in whatever form extended by lenders i.e. banks, FIs or NBFCs to an
infrastructure facility as specified below falls within the definition of infrastructure financing.
In other words, a credit facility provided to a borrower company engaged in:
1. Developing, or
2. Operating and maintain, or
3. Developing, operating and maintaining
4. Any infrastructure facility that is a project in any of the following sectors:
o A road including toll road, a bridge or a rail system
o A highway project including housing or other activities being an integral part of
the highway project
o A port, airport, inland waterway or inland port or navigational channel in the
sea
o A water supply project, treatment system, irrigation project, sanitation and
sewerage system or solid waste management system
5. Telecommunication services whether basic or cellular, including radio paging, domestic
satellite service, network of trunking, broadband and network and internet services
6. An industrial park or special economic zone
7. Generation or generation and distribution of power
8. Transmission or distribution of power by laying a network of new transmission or
distribution lines
9. Any other infrastructure facility of similar nature
All the activities undertaken in the financing of infrastructure development is known as

infrastructure financing. According to RBI, infrastructure financing refers to any credit facility
extended by banks and FIs for developing, operating and maintaining any infrastructure
facility.
Characteristics of infrastructure finance

Infrastructure projects differ in a very significant way as compare to manufacturing or
expansion or modernization projects. Some of the special features of infrastructure financing
are:
 Longer maturity
 Larger amount
 Higher risk
 Fixed and low return
Issues in infrastructure financing

 Funding gap
 Fiscal burden
 Allocation efficiency
 Fiscal prudence
Financial feasibility
Following factors are important while making a financial appraisal of projects for the purpose
of infrastructure financing
 Due Diligence
 Special skills
 Screening committees
 Joint financing

91
Financing options
There are two major options that could be thought of as equitable risk-sharing arrangements in
the financing of infrastructure projects. These are as follows:
1. Concession approach – Under this approach, the concessionaire who is thereafter

granted a franchise to operate the project for a specific period, builds the project. Costs
and returns will be recovered by the franchisee from the operations of the project. This
approach works under various modes as described below:
 BOT – Build, Operate and Transfer
 BOLT – Build, Operate, Lease and Transfer
 BOOT – Build, Own, Operate and Transfer
 BOO – Build, Own and Operate
 BOOS – Build, Own, Operate and Sell
2. Structured financing option - SFO generally assumes two forms as described below:
 Non-recourse financing – Under this option, the cashflows generated by the project
secure the debt instrument or the collateral value of the specific assets financed by
the instrument. In the event of default on the structured instrument, the debt
holders‘ recourse would be limited to the underlying assets only and would not
extend to general reserves and assets of the company.
 Limited recourse financing – Under this option, in addition to project assets, the
parent company attaches other assets/revenue streams for servicing the instrument
to improve its creditworthiness. Thus, the lenders have limited recourse to the
assets of a company sponsoring the project. The methods available under this
alternative are Special Purpose Vehicle (SPV), General Purpose Vehicle (GPV) and
Financial Guarantee (FG)
Sources of infrastructure financing

 Public funding
 Multilateral and bilateral development banks
 Capital markets
 Regional infrastructure companies for financing specific sectors
 Sovereign wealth fund
 Industrial development bonds
 Taxes
 Grants
 Current funds
Instruments of infrastructure financing

 Asset-Backed Securitization (ABS)
 Municipal Bonds
 Syndicated Loans
 Convertible Bonds
RBI guidelines for infrastructure financing

Banks/FIs are free to finance technically feasible, financially viable and bankable projects
undertaken by both public sector and private sector undertakings subject to the following
conditions:
 The amount sanctioned should be within the overall ceiling of the prudential exposure
norms prescribed by RBI for infrastructure financing.
 Banks/ FIs should have the requisite expertise for appraising technical feasibility,
financial viability and bankability of projects, with particular reference to the risk
analysis and sensitivity analysis.
 In respect of projects undertaken by public sector units, term loans may be sanctioned
only for corporate entities (i.e. public sector undertakings registered under Companies

92
Act or a Corporation established under the relevant statute). Further, such term loans
should not be in lieu of or to substitute budgetary resources envisaged for the project.
The term loan could supplement the budgetary resources if such supplementing was
contemplated in the project design. While such public sector units may include Special
Purpose Vehicles (SPVs) registered under the Companies Act set up for financing
infrastructure projects, it should be ensured by banks and financial institutions that
these loans/investments are not used for financing the budget of the State
Governments. Whether such financing is done by way of extending loans or investing in
bonds, banks and financial institutions should undertake due diligence on the viability
and bankability of such projects to ensure that revenue stream from the project is
sufficient to take care of the debt servicing obligations and that the
repayment/servicing of debt is not out of budgetary resources. Further, in the case of
financing SPVs, banks and financial institutions should ensure that the funding
proposals are for specific monitorable projects. It has been observed that some banks
have extended financial assistance to State PSUs which is not in accordance with the
above norms. Banks/FIs are, therefore, advised to follow the above instructions
scrupulously, even while making investment in bonds of sick State PSUs as part of the
rehabilitation effort.
 Banks may also lend to SPVs in the private sector, registered under the Companies Act
for directly undertaking infrastructure projects which are financially viable and not for
acting as mere financial intermediaries. Banks may ensure that the bankruptcy or
financial difficulties of the parent/ sponsor should not affect the financial health of the
SPV.
Types of financing by banks

In order to meet financial requirements of infrastructure projects, banks may extend credit
facility by way of working capital finance, term loan, project loan, subscription to bonds and
debentures/ preference shares/ equity shares acquired as a part of the project finance package
which is treated as "deemed advance‖ and any other form of funded or non-funded facility.
 Take-out financing arrangement

Take-out financing structure is essentially a mechanism designed to enable banks to
avoid asset-liability maturity mismatches that may arise out of extending long tenor
loans to infrastructure projects. Under the arrangements, banks financing the
infrastructure projects will have an arrangement with IDFC or any other financial
institution for transferring to the latter the outstanding in their books on a pre-
determined basis. This arrangement would enable banks to avoid asset-liability
maturity mismatches that may arise out of extending long tenor loans to infrastructure
projects
 Liquidity support from IDFC

As an alternative to take-out financing structure, IDFC and SBI have devised a product,
providing liquidity support to banks. Under the scheme, IDFC would commit, at the
point of sanction, to refinance the entire outstanding loan (principal+ unrecovered
interest) or part of the loan, to the bank after an agreed period, say, five years. The
credit risk on the project will be taken by the bank concerned and not by IDFC.
 Inter-institutional Guarantees
Banks are permitted to issue guarantees favouring other lending institutions in respect
of infrastructure projects, provided the bank issuing the guarantee takes a funded
share in the project at least to the extent of 5 per cent of the project cost and
undertakes normal credit appraisal, monitoring and follow-up of the project.

93
REFERENCES

2. Financial Management – I M Pandey

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MUMBAI UNIVERSITY QUESTION PAPER
Nov. 2015

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98
Nov. 2016

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IES Management College and Research Centre
STUDY MATERIAL
(Financial Management)
(MFM/MMM/MIM – II Year, Semester : III)
By
(Ms. Gazia Sayed)

Academic Year (2017-18)
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(Ms. Gazia Sayed)

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IES MCRC Ms. Gazia Sayed Financial Management

REVISED SYLLABUS BY MUMBAI UNIVERSITY ................................................................................................ 1

IES MCRC Ms. Gazia Sayed Financial Management

IES MCRC Ms. Gazia Sayed Financial Management

REVISED SYLLABUS BY MUMBAI UNIVERSITY

SL. No Particulars Sessions

1 Objective of Financial Management 2 Sessions

IES MCRC Ms. Gazia Sayed Financial Management

IES MCRC Ms. Gazia Sayed Financial Management

Indian Education Society

Program: MFM/MMM/MIM – II Year Semester : III

Subject: Financial Management

Faculty Name: Ms. Gazia Sayed

Contact No. 9819852124 Email ID: gazia.sayed@ies.edu

Methodology: Lecture, Discussion and exercise solving

Sr. Topic Details No. of Teaching Actual

2 Analysis of Financial Statements

3 Financial performance appraisal

IES MCRC Ms. Gazia Sayed Financial Management

4 Financial Performance Appraisal

5 Financial Performance Appraisal

6 Financial Performance Appraisal

7 Working Capital Management

IES MCRC Ms. Gazia Sayed Financial Management

8 Working Capital Management

12 Long Term Investment Decision

IES MCRC Ms. Gazia Sayed Financial Management

14 Sources of Finance, Financing

15 Capital Structure Planning

16 Divided Policy / Bonus - Theory

IES MCRC Ms. Gazia Sayed Financial Management

Indian Education Society

Total Marks: 100

IES MCRC Ms. Gazia Sayed Financial Management

FINANCIAL MANAGEMENT – AN OVERVIEW

Scope of Financial Management

1. Financial Management and Economics

2. Financial Management and Accounting

3. Financial Management or Mathematics

IES MCRC Ms. Gazia Sayed Financial Management

4. Financial Management and Production Management

5. Financial Management and Marketing

6. Financial Management and Human Resource

Objectives of Financial Management

IES MCRC Ms. Gazia Sayed Financial Management

Role of Financial Management

2. In making investment decisions : Financial management plays an very important role

3. In making financing decisions : Financial management again plays an vital role in

Functional Areas of Financial Management

1. Investment Decision : The investment decision relates to the selection of assets in

2. Financing Decision : The second major decision involved in financial management is

IES MCRC Ms. Gazia Sayed Financial Management

Advantages of Financial Benchmarking

1. Identifying Relative Strengths and Weaknesses: Identifying relative strengths and

2. Developing a Framework for Managing Change: It creates a structured, widely

IES MCRC Ms. Gazia Sayed Financial Management

This is contrasted to catch-as-catch-can ad hoc reports that are seldom updated or

4. Prioritising Improvement Actions: It ensures that improvement targets are based on