 Liquidity Ratios

•Liquidity refers to the ability of a firm to meet its short-term financialobligations when and as they

fall due.
•The main concern of liquidity ratio is to measure the ability of the firms to meet their short-term
maturing obligations. Failure to do this will result in the total failure of the business, as it would be
forced into liquidation.

A. Current Ratio
The Current Ratio expresses the relationship between the firm’s current assets
andits current liabilities. Current assets normally include cash, marketable securities,
accounts receivable and inventories. Current liabilities consist of accounts payable, short term notes
payable, short-term loans, current maturities of long term debt, accrued income taxes and other
accrued expenses (wages).
Current Ratio = Current assets/Current liabilities

Significance:
It is generally accepted that current assets should be 2 times the current liabilities. Ina sound
business, a current ratio of 2:1 is considered an ideal one. If current ratio is lower than 2:1, the short
term solvency of the firm is considered doubtful and it shows that the firm is not in a position to
meet its current liabilities in times and when they are due to mature. A higher current ratio is
considered to be an indication that of the firm is liquid and can meet its short term liabilities on
maturity. Higher current ratio represents a cushion to short-term creditors, “the higher the current
ratio, the greater the margin of safety to the creditors”.

Interpretation:
As a conventional rule, a current ratio of 2:1 is considered satisfactory. This rule is based on the logic
that in a worse situation even if the value of current assets becomes half, the firm will be able to
meet its obligation. The current ratio represents the margin of safety for creditors. The current
ratio has been decreasing year after year which shows decreasing working capital. From the above
statement the fact is depicted that the liquidity position of the Emami limited is unsatisfactory
because after the year 2010 the current ratio has being decreasing below the standard ratio 2:1.

B. Quick Ratio
Measures assets that are quickly converted into cash and they are compared
withcurrent liabilities. This ratio realizes that some of current assets are not easily convertible to
cash e.g. inventories. The quick ratio, also referred to as acid test ratio, examines the ability of
the business to cover its short-term obligations from its “quick “assets only (i.e. it ignores stock). The
quick ratio is calculated as follows
Quick Ratio = Quick assets / Current liabilities

Significance:
The standard liquid ratio is supposed to be 1:1 i.e., liquid assets should be equal to current liabilities.
If the ratio is higher, i.e., liquid assets are more than the current liabilities, the short term financial
position is supposed to be very sound. On the other hand, if the ratio is low, i.e., current liabilities
are more than the liquid assets, the short term financial position of the business shall be deemed to
be unsound. When used in conjunction with current ratio, the liquid ratio gives a better picture of
the firm’s capacity to meet its short-term obligations out of short-term assets.

Interpretation:
As a quick ratio of 1:1 is considered satisfactory as a firm can easily meet all currentclaims. It is a
more rigorous and penetrating test of the liquidity position of a firm. Butthe liquid ratio has been
decreasing year after year which indicates a high operation of the business.From the above
statement, it is clear that the liquidity position of the Emami limited is satisfactory. Since the entire
five years liquid ratio is not below the standard ratio of 1:1

C. Cash ratio:
This is also known as cash position ratio or super quick ratio. It is a variation of quick ratio. This ratio
establishes the relationship between absolute liquid assets and current liabilities. Absolute liquid
assets are cash in hand, bank balance and readily marketable securities. Both the debtors and the
bills receivable are excluded from liquid assets as there is always an uncertainty with respect to their
realization. In other words, liquid assets minus debtors and bills receivable are absolute liquid assets.
The cash ratio is calculated as follows 
Cash Ratio =Cash in hand & at bank + Marketable securities/ Current liabilities

Significance:
This ratio gains much significance only when it is used in conjunction with the first
tworatios. The accepted norm for this ratio is 50% worth absolute liquid assets areconsidered
adequate to pay Rs.2 worth current liabilities in time as all the creditors are not expected to demand
cash at the same time and then cash may also be realized from debtors and inventories. This test is a
more rigorous measure of a firm’s liquidity position. This type of ratio is not widely used in practice.

Interpretation:
The acceptable norm for this ratio is 50% or 1:2. But the cash ratio is below the accepted norm. So
the cash position is not utilized effectively and efficiently.

 Activity Ratio:
If a business does not use its assets effectively, investors in the business would rather take their
money and place it somewhere else. In order for the assets to be used effectively, the business
needs a high turnover. Unless the business continues to generate high turnover, assets will be idle as
it is impossible to buy and sell fixed assets continuously as turnover changes. Activity ratios are
therefore used to assess how active various assets are in the business.

A. Average Collection Period:

The average collection period measures the quality of debtors since it indicates the speed of their
collection.
•The shorter the average collection period, the better the quality of debtors, as a short collection
period implies the prompt payment by debtors.
•The average collection period should be compared against the firm’s credit terms and policy to
judge its credit and collection efficiency.
•An excessively long collection period implies a very liberal and inefficientcredit and collection
performance.
•The delay in collection of cash impairs the firm’s liquidity. On the other hand, too low a collection
period is not necessarily favourable, rather it may indicate a very restrictive credit and collection
policy which may curtail sales and hence adversely affect profit.
Average collection period = 360 days/Debtor’s turnover ratio 

Significance:
Average collection period indicates the quality of debtors by measuring the rapidity or slowness in
the collection process. Generally, the shorter the average collection period,the better is the quality
of debtors as a short collection period implies quick payment
bydebtors. Similarly, a higher collection period implies as inefficient collection performance which, in
turn, adversely affects the liquidity or short term paying capacity of a firm out of its current
liabilities. Moreover, longer the average collection period, larger is the chances of bad debts.

Interpretation:
The shorter the collection period, the better the quality of debtors. Since a
shortcollecti on period implies the prompt payment by debtors. Here, collecti on periodi
ncreased in 2010-2011 and decreased in the year 2011-2012. Therefore the average collection
period of Emami ltd for the five years is satisfactory. Since the number of days have decreased.

B. Inventory Turnover Ratio:

This ratio measures the stock in relation to turnover in order to determine how often the stock turns
over in the business. It indicates the efficiency of the firm in selling its product. It is calculated by
dividing he cost of goods sold by the average inventory.
Turnover Ratio = Cost of goods sold Inventory/Average Inventory

Significance:
This ratio is calculated to ascertain the number of times the stock is turned over during the periods.
In other words, it is an indication of the velocity of the movement of the stock during the year. In
case of decrease in sales, this ratio will decrease. This serves as a check on the control of stock in a
business. This ratio will reveal the excess stock and accumulation of obsolete or damaged stock. The
ratio of net sales to stock is satisfactory relationship, if the stock is more than three-fourths of the
net working capital. This ratio gives the rate at which inventories are converted into sales and then
into cash and thus helps in determining the liquidity of a firm.

Interpretation:
A higher turnover ratio is always beneficial to the concern. In this the number of times the inventory
is turned over has been decreasing from one year to another year.
This decreasing turnover indicates average sales. And in turn activates production process
and is responsible for further development in the business. This indicates theinventory policy of the
company should be
improved.Thus the stock turnover ratios of Emami Limited, for the five years areunsatisfactory.

C. Working capital turnover ratio:

 This ratio shows the number of times the working capital results in sales. In other words, this ratio
indicates the efficiency or otherwise in the utilization of short term funds in making sales. Working
capital means the excess of current assets over current liabilities. In fact, in the short run, it is the
current assets and current liabilities
which pay a major role. A careful handling of the short term assets and funds will mean areduction i
n the amount of capital employed, thereby improving turnover. The following formula is used to
measure this ratio:
Working capital turnover ratio = Sales/Net Working Capital

Significance:
This ratio is used to assess the efficiency with which the working capital has been utilized in a
business. A higher working capital turnover indicates either the favorable turnover of inventories
and receivables and/or the inadequate of net working capital accompanied by low turnover of
inventories and receivables. A low ratio signifies either the excess of net working capital or slow
turnover of inventories and receivables or both. This ratio can at best be used by making of
comparative and trend analysis for different firms in the same industry and for various periods.
Interpretation:
The Working Capital Turnover Ratio is decreasing year after year. It can be noted that the change is
due to the fluctuation in sales or current liabilities. These lower ratios are indicators of higher
investment of working Capital and less profit. Thus, Working Capital Turnover ratios for the five
years are unsatisfactory.

D. Fixed Assets Turnover Ratio:

The fixed assets turnover ratio measures the efficiency with which the firm has been using its fixed
assets to generate sales. It is calculated by dividing the firm’s sales by its net fixed assets as follows:
Fixed Assets Turnover =Sales/Net fixed assets

Significance:
This ratio gives an ideal about adequate investment or over investment or
under investment in fixed assets. As a rule, over-investment in unprofitable fixed assetsshould be
avoided to the possible extent. Under-investment is also equally bad affecting unfavourably the
operating costs and consequently the profit. In manufacturing concerns, the ratio is important and
appropriate, since sales are produced not only by use of working capital but also the capital invested
in fixed assets. An increase in this ratio is the indicator of efficiency in work performance and a
decrease in this ratio speaks of unwise and improper investment in fixed assets.

Interpretation:
The fixed assets turnover ratio is decreasing year after year. The overall lower ratio indicates the
inefficient utilization of the fixed assets. Thus the fixed assets turnover ratios for the five years are
not satisfactory.

 Financial Leverage (Gearing) Ratios

•The ratios indicate the degree to which the activities of a firm are supported by creditors’ funds as
opposed to owners.
The relationship of owner’s equity to borrowed funds is an important indicator of financial strength.
•The debt requires fixed interest payments and repayment of the loan and legal action can be taken
if any amounts due are not paid at the appointed time. A relatively high proportion of funds
contributed by the owners indicates a cushion(surplus) which shields creditors against possible
losses from default in payment. 

A. Proprietary Ratio:
This ratio is also known as ‘Owners fund ratio’ (or) ‘Shareholders equity ratio’ (or)‘Equity ratio’ (or)
‘Net worth ratio’. This ratio establishes the relationship between the proprietors’ fund and total
tangible assets. The formula for this ratio may be written as follows.
Proprietary Ratio =Proprietors’ funds /Total tangible assets

Significance:
This ratio represents the relationship of owner’s funds to total tangible assets, higher the ratio or the
share of the shareholders in the total capital of the company better is the long term solvency
position of the company. This ratio is of importance to the creditors who can ascertain the
proportion of the shareholders’ funds in the total assets employed in the firm. A ratio below 50%
may be alarming for the creditors since they may have to lose heavily in the event of company’s
liquidation on account of heavy losses.
Interpretation:
This ratio is particularly important to the creditors and it focuses on the general financial strength of
the business. A ratio of 50% will be alarming for the creditors. As such the proprietary ratio of the
five years is above 50%.Therefore it indicates relatively little danger to the creditors, etc and a
better performance of the company.

B. Debt to Equity ratio

This ratio indicates the extent to which debt is covered by shareholders’ funds. It reflects the relative
position of the equity holders and the lenders and indicates the company’s policy on the mix of
capital funds. The debt to equity ratio is calculated as follows:
Debt to Equity Ratio = Total debt/Total Equity

Significance:
The importance of debt-equity ratio is very well reflected in the words of Weston and brigham which
are reproduced here: “Debt-equity ratio indicates to what extent the firm depends upon outsiders
for its existence. For the creditors, this provides a margin of safety. For the owners, it is useful to
measure the extent to which they can gain
the benefits of maintaining control over the firm with a limited investment:” The debt-equity ratio
states unambiguously the amount of assets provided by the outsiders for every one rupee of assets
provided by the shareholders of the company.

Interpretation:
The debt to equity ratio is decreasing year after year. A low debt equity ratio is considered
favourable from management. It means greater claim of shareholders over the assets of the
company than those of creditors. For the company also, the servicing of debt is less burdensome and
consequently its credit standing is not adversely affected. Therefore debt to equity ratio is
satisfactory to the company.

C. Interest coverage ratio

The times interest earned shows how many times the business can pay its interest bills from profit
earned. Present and prospective loan creditors such as bondholders, are vitally interested to know
how adequate the interest payments on their loans are covered by the earnings available for such
payments. Owners, managers and directors are also
interested in the ability of the business to service the fixed interest charges onoutstanding debt. The
ratio is calculated as follows:
Interest Coverage Ratio =EBIT/Interest charges

Significance:
It is always desirable to have profit more than the interest payable. In case profit is either equal or
lesser than the interest, the position will be unsafe. It will show that there this nothing left for the
shareholders and the position of the lenders is also unsafe. A high ratio is a sign of low burden of
dept servicing and lower utilization of borrowing capacity. From the points of view of creditors, the
larger the coverage, the greater the ability of the firm to handle fixed charges liabilities and the more
assessed the payment of interest to the creditors. In contrast the low ratio signifies the danger the
signal that the firm is highly dependent on borrowings and its earnings cannot meet obligations fully.
The standard for this ratio for an industrial undertaking is 6 to 7 times.

Interpretation:
The Interest coverage ratio is increasing year after year. A high ratio is a sign of low burden of dept
servicing and lower utilization of borrowing capacity. Therefore this ratio is satisfactory to the
company.
  Profitability Ratios
Profitability is the ability of a business to earn profit over a period of time. Although the profit figure
is the starting point for any calculation of cash flow, as already pointed out, profitable companies
can still fail for a lack of cash.
•A company should earn profits to survive and grow over a long period of time.
•Profits are essential, but it would be wrong to assume that every action
initiated by management of a company should be aimed at maximizing profits, irrespective of social
consequences. The ratios examined previously have tendered to measure management efficiency
and risk.

A. Gross Profit Margin

• Normally the gross profit has to rise proportionately with sales.
•It can also be useful to compare the gross profit margin across similar  businesses although there
will often be good reasons for any disparity.
Gross Profit Margin = Gross profit/ Sales*100

Significance:
The gross profit ratio helps in measuring the results of trading or manufacturing operations. It shows
the gap between revenue and expenses at a point after which an enterprise has to meet the
expenses related to the non-manufacturing acti viti es, like marketing, administration,
finance and also taxes and appropriations. The gross profit shows the gap between revenue and
trading costs. It, therefore, indicates the extent to which the revenue has a potential to generate a
surplus. In other words, the gross profit reveals the mark up on the sales. Gross profit ratio reveals
profit earning capacity of the business with reference to its sale. Increase in gross profit ratio will
mean reduction in cost of production or direct expenses or sale at a reasonably good price and
decrease in the will mean increased cost of production or sales at a lesser price. Higher gross profit
ratio is always in the interest of the business.

Interpretation:
In the year 2007, the Gross Profit Ratio was 61% but then it decreased to 58%, which shows a low
profit earning capacity of the business with reference to its sales. But in the year 2010, it increased
to 62% which may be due to increase in sales. But thereafter, for the succeeding two years, it has
increased considerably, which indicates that the cost
of production has reduced. Therefore the Gross Profit Ratio for the five years reveals asatisfactory
condition of the business.

B. Net Profit Margin

This is a widely used measure of performance and is comparable across companies in similar
industries. The fact that a business works on a very low margin need not cause alarm because there
are some sectors in the industry that work on a basis of high turnover and low margins, for examples
supermarkets and motorcar dealers. What is more important in any trend is the margin and whether
it compares well with similar businesses. 
Net Profit Margin = Earnings after interest and taxes / Net Sales *100

Significance:
An objective of working net profit ratio is to determine the overall efficiency of
the business. Higher the net profit ratio, the better the business. The net profit ratioindicates the
management’s ability to earn sufficient profits on sales not only to cover all revenue operating
expenses of the business, the cost of borrowed funds and the cost of merchandising or servicing, but
also to have a sufficient margin to pay reasonable compensation to shareholders on their
contribution to the firm. A high ratio ensures adequate return to shareholders as well as to enable a
firm to with stand adverse economic conditions. A low margin has an opposite implication.

Interpretation:
 In the year 2007 the Net Profit is 16%, but in the year 2008-2009 it was decreased to14% which may
due to excessing selling and distribution expenses. But thereafter for the succeeding years it has
been increasing which indicates a better performance of the company. Therefore the performance
of the management should be appreciated. Thus
an increase in the ratio over the previous periods indicates improvement in theoperational efficiency
of the business.

C. Return on Investment (ROI)

Income is earned by using the assets of a business productively. The more efficient the production,
the more profitable the business. The rate of return on total assets indicates the degree of efficiency
with which management has used the assets of the enterprise during an accounting period. This is
an important ratio for all readers of financial statements. Investors have placed funds with the
managers of the business. The managers used the funds to purchase assets which will be used to
generate returns. If the return is not better than the investors can achieve elsewhere, they
will instruct the managers to sell the assets and they will invest elsewhere. The managers lose their
jobs and the business liquidates.
Return on Investment =Operating profit/Capital Employed 

Significance:
Return on capital employed shows overall profitability of the business. At first minimum return on
capital employed should be determined and then the actual rate of return on capital employed
should be determined and compared with the normal return. The return and capital employed is a
fair measure of the profitability of any concern with the result that even the result of dissimilar
industries may be compared.

Interpretation:
This ratio indicates that how much of the capital invested is returned in the form of net profit. This
ratio is increasing year after year which indicates the capital employed is returned in the form of net
profit. In the same manner, returns from capital employed for the succeeding years are good. Thus,
the Return on Investment ratio for the five years shows the efficiency of the business which is
very much satisfactory.

D. Return on Equity (ROE)

This ratio shows the profit attributable to the amount invested by the owners of
the business. It also shows potential investors into the business what they might hope to receive as a
return. The stockholders’ equity includes share capital, share premium, distributable and non-
distributable reserves. The ratio is calculated as follows:
Return on Equity =Net profit after taxes and preference dividend/Equity capital

Significance:

This ratio measures the profitability of the capital invested in the business by equity shareholders. As
the business is conducted with a view to earn profit, return on equity capital measures the business
success and managerial efficiency. It reveals whether the firm has earned a reasonable profit to its
equity shareholders or not by comparing it with its own past records, inter-fi rm comparison
and comparison with the overall industry average. This ratio is of significant use in the ratio
analysis from the stand point of the owners of the firm.
Interpretation: 

In the year 2008, the return on equity ratio is 32% but in the year 2009 it decreased to 29%, which
may due to capital investment. And in the year 20011-2012 it increased to 37%. Therefore the
return on equity ratio for the five years reveals a satisfactory condition of the business.

E. Return on Total assets

This ratio is also known as the profit-to-assets ratio. This ratio establishes
therelationship between net profits and assets. As these two terms have conceptualdifferences, the
ratio may be calculated taking the meaning of the terms according to the purpose and intent
of analysis. Usually, the following formula is used to determine the return on total assets ratio.
Return on total assets = (Net profit after taxes and interest / Total assets) * 100

Significance:

This ratio measures the profitability of the funds invested in a firm but do not reflect on the
profitability of the different sources of total funds. This ratio should be compared with the ratios of
other similar companies or for the industry as a whole, to determine whether the rate of return is
attractive. This ratio provides a valid basis for inter-industry comparison.

Interpretation:
The return on total assets ratio had decreased earlier but again the trend is increasing year after
year. This increasing ratio indicates the effective funds invested. Therefore the return on Total Assets
ratio for the five years reveals a satisfactory condition of the business.

F. Earnings per share:

This ratio explains to this point deal with the performance and financial condition of the company.
These ratio’s provide information for the managers (who are interested in evaluating the
performance of the company) and for creditors (who are interested in the company’s ability to pay
its obligations). We will now take a look at ratios that focus on the interests of the owners –
Shareholder ratios. These ratios translate the overall results of operations so that they can be
compared in terms of a share of stock. Usually, the following formula is used to determine the
Earnings Per Share. 

Earnings per share = NPAT- Pref. Dividend/Number of Equity Shares

Interpretation:

The return on Earning Per Share had decreased during the period of 2008-2009 to 13.77. However
the company performed well after the same. The Earnings Per Share increased year after year to
16.97 in 2011-12.
 Comparative Balance Sheet
Comparative study of financial statement is the comparison of the financialstatement of the
business with the previous year’s financial statements and with the performance of other
competitive enterprises, so that weaknesses may be identified and remedial measures applied.
Comparative statements can be prepared for both types of financial statements i.e., Balance sheet
as well as profit and loss account. The comparative profits and loss account will present a review of
operating activities of the business. The comparative balance
shows the effect of operations on the assets and liabilities that change in the financial position
during the period under consideration. Comparative analysis is the study of trend of the same items
and computed items into or more financial statements of the same business enterprise on different
dates. The presentation of comparative financial statements, in annual and other reports, enhances
the usefulness of such reports and brings out more clearly the nature and trends of current changes
affecting the enterprise. While the single balance sheet represents balances of accounts drawn at
the end of an accounting period, the comparative balance sheet represent not nearly the balance
of accounts drawn on two different dates, but also the extent of their increase or decrease between
these two dates. The single balance sheet focuses on the financial status of the concern as on a
particular date, the comparative balance sheet focuses on the changes that have taken place in one
accounting period. The changes are the direct outcome of operational activities, conversion of
assets, liability and capital form into others as well as various interactions among assets, liability and
capital.
The comparative balance sheet of the company reveals during 2008, that there has been an
increase in the fixed assets of Rs. 1,000.54 lakhs, which indicates purchase of fixed assets. The cash
or funds paid for purchase of fixed assets have decreased the cash balance of the company. This
limited cash balance is utilized for the repayment of loan, which is increased from Rs. 5,352.26 lakhs
to Rs. 15,267.63 lakhs for meeting out current liabilities and provision and also
for making investment, which has been increased from Rs. 7,817.91 lakhs to Rs. 10,083.63 lakhs. The
investment has increased from Rs. 7,817.91 lakhs to Rs. 10,083.63 lakhs, which indicates the
investment has been properly made.
The overall financial position of the company for the year (2007-2008) issatisfactory.

Interpretation:
The comparative balance sheet of the company reveals during 2009, that
therehas been an increase in the fixed assets of Rs. 55,798.23 lakhs, which indicates purchase of fixe
d assets. The cash or fund paid for purchase of fixed assets hasdecreased the cash balance of the
company. The current assets have decreased by Rs. (2,062.81) lakhs; this indicates firm’s better
credit policy. Further the current liability also increased by Rs. 5,349.48 lakhs, it indicates that firm
do not have good liquidity position therefore they are not able to pay liabilities within stipulated
period. The fact depicts that the policy of the company is to pay all liabilities both in current and
long-term liabilities within the stipulated period using both current assets and fixed assets. The
investment has decreased from Rs. 10,083.63 lakhs to Rs. 3,707.58 lakhs, which indicates the
investment is not been properly
made.The overall financial position of the company for the year (2008-2009) isunsatisfactory.

 Conclusion:
1. The study is made on the topic financial performance using ratio analysis with five years data in
Emami Limited.
2. The current and liquid ratio indicates the short term financial position of Emami Ltd. whereas debt
equity and proprietary ratios shows the long term financial position.
3. Similarly, activity ratios and profitability ratios are helpful in evaluating the efficiency of
performance in Emami Ltd.
4. The current ratio is above 1 in all the five years. The level of current assets and current liabilities
must be improved.
5. The liquid ratio is increasing year after year. Though the ratio is above 1 in all the five years, it
is preferable to improve upon the situation. This may be due to the fact that the stock is major
composition of current assets, which excludes liquid assets. The firm should try to clear the stocks.
6. The cash ratio is increasing year after year. So it shows that the cash position is utilized effectively
and efficiently.
7. The average collection period is decreasing year after year so it shows the better is the quality of
debtors as a short collection period and implies quick payment by debtors.
8. The inventory turnover ratio for the five years indicated an improvement in inventory policy and
efficiency of business operations of the company.
9. The working capital turnover ratio has been decreasing during the five years,
which indicates that there is higher investment of the working capital and average profit.
10. The proprietary ratio in all the five years is above the satisfactory level, that is, 50%. It indicates
the creditors are in a safer side and there is no pressure from them.
11. The debt to equity ratio is decreasing year after year, which indicates, theservicing of debt is less
burdensome and consequently its credit standing is not adversely affected.
12. The Net Profit for the five years has been increasing which shows that
theselling and distribution expenses are under control and there is a good operational efficiency of
the business concern.
13 It can be stated that the working capital management of the company seems to be satisfactory.
But in certain years there is decrease in working capital, which is due to higher amount of current
liabilities especially, increasing in provision for dividend and taxation and creditors. The company
should try to decrease the current liabilities and provision by making timely payment. The financial
performance of the company for the five years is analysed and it is proved that the company is
financially sound.
Profit maximisation
Profit maximization is the short run or long run process by which a firm may determine
the price, input, and output levels that lead to the greatest profit. To obtain the profit maximizing
output quantity, we start by recognizing that profit is equal to total revenue (TR) minus total cost
(TC). Given a table of costs and revenues at each quantity, we can either compute equations or plot
the data directly on a graph. The profit-maximizing output is the one at which this difference reaches
its maximum.

In the accompanying diagram, the linear total revenue curve represents the case in which the firm is
a perfect competitor in the goods market, and thus cannot set its own selling price. The profit-
maximizing output level is represented as the one at which total revenue is the height of C and total
cost is the height of B; the maximal profit is measured as the length of the segment CB. This output
level is also the one at which the total profit curve is at its maximum.
If, contrary to what is assumed in the graph, the firm is not a perfect competitor in the output
market, the price to sell the product at can be read off the demand curve at the firm's optimal
quantity of output.

Importance of cash flow forecasting

The key reasons why a cash flow forecast is so important:

 Identify potential shortfalls in cash balances in advance—think of the cash flow forecast as
an "early warning system". This is, by far, the most important reason for a cash flow forecast.
 Make sure that the business can afford to pay suppliers and employees. Suppliers who don't
get paid will soon stop supplying the business; it is even worse if employees are not paid on
time.
 Spot problems with customer payments—preparing the forecast encourages the business to
look at how quickly customers are paying their debts. Note—this is not really a problem for
businesses (like retailers) that take most of their sales in cash/credit cards at the point of sale.
 As an important discipline of financial planning—the cash flow forecast is an
important management process, similar to preparing business budgets.
 External stakeholders such as banks may require a regular forecast. Certainly, if the business
has a bank loan, the bank will want to look at the cash flow forecast at regular intervals.
Factors affecting working capital
(1) Nature of Business
(2) Scale of Operations
(3) Business Cycle
(4) Seasonal Factors
(5) Production Cycle
(6) Credit Allowed
(7) Credit Availed
(8) Operating Efficiency
(9) Availability of Raw Material
(10) Growth Prospects

Payback period
Payback period in capital budgeting refers to the period of time required to recoup the funds
expended in an investment, or to reach the break-even point. The time value of money is not taken
into account. Payback period intuitively measures how long something takes to "pay for itself." All
else being equal, shorter payback periods are preferable to longer payback periods. Payback period
is popular due to its easePayback period as a tool of analysis is often used because it is easy to apply
and easy to understand for most individuals, regardless of academic training or field of endeavor.
When used carefully or to compare similar investments, it can be quite useful. As a stand-alone tool
to compare an investment to "doing nothing," payback period has no explicit criteria for decision-
makingThe payback period is considered a method of analysis with serious limitations and
qualifications for its use, because it does not account for the time value of money, risk, financing, or
other important considerations, such as the opportunity cost.

Discounted cash flow

In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company,
or asset using the concepts of the time value of money. All future cash flows are estimated
and discounted by using cost of capital to give their present values(PVs). The sum of all future cash
flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value of the
cash flows in question. Discounted cash flow analysis is widely used in investment finance, real
estate development, corporate financial management and patent valuation. The most widely used
method of discounting is exponential discounting, which values future cash flows as "how much
money would have to be invested currently, at a given rate of return, to yield the cash flow in
future." Other methods of discounting, such as hyperbolic discounting, are studied in academia and
said to reflect intuitive decision-making, but are not generally used in industry.
The discount rate used is generally the appropriate weighted average cost of capital (WACC), that
reflects the risk of the cash flows.
The discount rate reflects two things:

1. Time value of money (risk-free rate) – according to the theory of time preference, investors
would rather have cash immediately than having to wait and must therefore be
compensated by paying for the delay
2. Risk premium – reflects the extra return investors demand because they want to be
compensated for the risk that the cash flow might not materialize after all

Profitability index
Profitability index (PI), also known as profit investment ratio (PIR) and value investment ratio (VIR),
is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking projects
because it allows you to quantify the amount of value created per unit of investment.
The ratio is calculated as follows:

 Profitability index=PV of future cash flows/Initial investment

Assuming that the cash flow calculated does not include the investment made in the project, a
profitability index of 1 indicates breakeven. Any value lower than one would indicate that the
project's present value (PV) is less than the initial investment. As the value of the profitability
index increases, so does the financial attractiveness of the proposed project.
Rules for selection or rejection of a project:

 If PI > 1 then accept the project

 If PI < 1 then reject the project
For example:

 Investment = $40,000
 Life of the Machine = 5 Years

CFAT Year CFAT

1 18000
2 12000
3 10000
4 9000
5 6000

Calculate Net present value at 10% and PI:

Year CFAT PV@10% PV

 1 18000 0.909 16362
2 12000 0.827 9924
3 10000 0.752 7520
4 9000 0.683 6147
5 6000 0.621 3726
Total present value 43679
(-) Investment 40000
NPV 3679

PI = 43679/40000 = 1.091 > 1 ⇒ Accept the project

Weighted average cost of capital

The weighted average cost of capital (WACC) is the rate that a company is expected to pay on
average to all its security holders to finance its assets. The WACC is commonly referred to as the
firm's cost of capital. Importantly, it is dictated by the external market and not by management. The
WACC represents the minimum return that a company must earn on an existing asset base to satisfy
its creditors, owners, and other providers of capital, or they will invest elsewhere. Companies can
use WACC to see if the investment projects available to them are worthwhile to undertake.

Cost of equity
In finance, the cost of equity is the return (often expressed as a rate of return) a firm theoretically
pays to its equity investors, i.e., shareholders, to compensate for the risk they undertake by
investing their capital. Firms need to acquire capital from others to operate and grow. Individuals
and organizations who are willing to provide their funds to others naturally desire to be rewarded.
Just as landlords seek rents on their property, capital providers seek returns on their funds, which
must be commensurate with the risk undertaken.
Firms obtain capital from two kinds of sources: lenders and equity investors. From the perspective of
capital providers, lenders seek to be rewarded with interest and equity investors
seek dividends and/or appreciation in the value of their investment (capital gain). From a firm's
perspective, they must pay for the capital it obtains from others, which is called its cost of capital.
Such costs are separated into a firm's cost of debt and cost of equity and attributed to these two
kinds of capital sources.
While a firm's present cost of debt is relatively easy to determine from observation of interest rates
in the capital markets, its current cost of equity is unobservable and must be estimated.

Types of dividend
A dividend is generally considered to be a cash payment issued to the holders of
company stock. However, there are several types of dividends, some of which do not involve
the payment of cash to shareholders. These dividend types are:
 Cash dividend. The cash dividend is by far the most common of the dividend types used.
On the date of declaration, the board of directors resolves to pay a certain dividend amount in
cash to those investors holding the company's stock on a specific date. The date of record is the
date on which dividends are assigned to the holders of the company's stock. On the date of
payment, the company issues dividend payments.
 Stock dividend. A stock dividend is the issuance by a company of its common stock to its
common shareholders without any consideration. If the company issues less than 25 percent of
the total number of previously outstanding shares, then treat the transaction as a stock
dividend. If the transaction is for a greater proportion of the previously outstanding shares,
then treat the transaction as a stock split.  To record a stock dividend, transfer from retained
earnings to the capital stock and additional paid-in capital accounts an amount equal to the fair
value of the additional shares issued. The fair value of the additional shares issued is based on
their fair market value when the dividend is declared.
 Property dividend. A company may issue a non-monetary dividend to investors, rather
than making a cash or stock payment. Record this distribution at the fair market value of the
assets distributed. Since the fair market value is likely to vary somewhat from the book value of
the assets, the company will likely record the variance as a gain or loss. This accounting rule
can sometimes lead a business to deliberately issue property dividends in order to alter their
taxable and/or reported income.
 Scrip dividend. A company may not have sufficient funds to issue dividends in the near
future, so instead it issues a scrip dividend, which is essentially a promissory note (which may
or may not include interest) to pay shareholders at a later date. This dividend creates a note
payable.
 Liquidating dividend. When the board of directors wishes to return the capital originally
contributed by shareholders as a dividend, it is called a liquidating dividend, and may be a
precursor to shutting down the business.  The accounting for a liquidating dividend is similar to
the entries for a cash dividend, except that the funds are considered to come from the
additional paid-in capital account.

Commercial paper
Commercial paper, in the global financial market, is an unsecured promissory note with a
fixed maturity of not more than 364 days.
Commercial paper is a money-market security issued (sold) by large corporations to obtain funds to
meet short-term debtobligations (for example, payroll), and is backed only by an issuing bank or
company promise to pay the face amount on the maturity date specified on the note. Since it is not
backed by collateral, only firms with excellent credit ratings from a recognized credit rating
agency will be able to sell their commercial paper at a reasonable price. Commercial paper is usually
sold at a discount from face value, and generally carries lower interest repayment rates
than bonds due to the shorter maturities of commercial paper. Typically, the longer the maturity on
a note, the higher the interest rate the issuing institution pays. Interest rates fluctuate with market
conditions, but are typically lower than banks' rates.
Commercial paper is a lower-cost alternative to a line of credit with a bank. Once a business
becomes established, and builds a high credit rating, it is often cheaper to draw on a commercial
paper than on a bank line of credit. Nevertheless, many companies still maintain bank lines of credit
as a "backup".
Advantages of commercial paper:

 High credit ratings fetch a lower cost of capital.

 Wide range of maturity provide more flexibility.
 It does not create any lien on asset of the company.
 Tradability of Commercial Paper provides investors with exit options.
Disadvantages of commercial paper:

 Its usage is limited to only blue chip companies.

 Issuances of commercial paper bring down the bank credit limits.
 A high degree of control is exercised on issue of Commercial Paper.
 Stand-by credit may become necessary

Letter of credit
A letter of credit (LC), also known as a documentary credit or bankers commercial credit, is
a payment mechanism used in international trade to provide an economic guarantee from a
creditworthy bank to an exporter of goods. A letter of credit is extremely common within
international trade and goods delivery, where the reliability of contracting parties cannot be readily
and easily determined. Its economic effect is to introduce a bank as underwriting the credit risk of
the buyer paying the seller for goods. A letter of credit is an important payment method in
international trade. It is particularly useful where the buyer and seller may not know each other
personally and are separated by distance, differing laws in each country, and different trading
customs.[7]It is a primary method in international trade to mitigate the risk a seller of goods takes
when providing those goods to a buyer. It does this by ensuring that the seller is paid for presenting
the documents which are specified in the contract for sale between the buyer and the seller. That is
to say, a letter of credit is a payment method used to discharge the legal obligations for payment
from the buyer to the seller, by having a bank pay the seller directly. Thus, the seller relies on the
credit risk of the bank, rather than the buyer, to receive payment.
Financial Management- Meaning, Scope, Objectives
Financial Management means planning, organizing, directing and controlling the financial activities
such as procurement and utilization of funds of the enterprise. It means applying general
management principles to financial resources of the enterprise.
Scope:
Investment Decisions– Includes investment in fixed assets (called as capital budgeting). Investment
in current assets is also a part of investment decision called as capital decisions.

Financial Decisions– They relate to the raising of finance from various resources which will depend
upon the type of sources, the period of financing, the cost of financing and the return thereby.

Dividend Decision– The finance manager has to take the decision with regard to the net profit
distribution. Net Profit is generally divided into two:

 The dividend for Shareholders- Dividend and the rate of it had to be decided.
 Retained Profit- Amount of retained profit has to be finalized which will depend upon
expansion and diversification plan of the enterprise.
Objective of Financial Management:

The financial management is generally concerned with procurement, allocation, and control of
financial resources of a concern. The objective can be:

1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate return to the shareholders this will depend upon the earning
capacity, the market price of the share, expectations of the shareholders.
3. To ensure optimum fund utilization. Once the funds are procured, they should be
utilized.