Sources of Finance

Finance is the provision of money at the time when it is required. Adequate firance is
inevitable one for every business organisation irrespective of size, nature and scale of
operation. Hence, it is rightly said that finance is the life blood of every business
organisation. Every business organisation needs finance mainly for two purposes
i. to facilitate production facilities, and
ii. to carry out day-to-day operations
Finance needed to support production facilities is termed as long term finance of fired capital
and finance needed for day to day operations are referred as the mo finance or working
capital.
Long Term Sources
Long term sources refer to raising of finance normally for a period beyond one year It is
composed of raising of funds through shares, debentures, bonds, retained earnings.
financial institutions, sale of fixed assets etc. The financing through shares, debentures and
bonds is known as security financing
I.Issue of Shares
Financing through shares is the important source used by companies for raising capital.
Equity shares and preference shares are the different types of shares issued by the
companies
A.Financing through Equity Shares
Equity shares are the foundation of the financial structure of the company. They are also
known as ordinary shares or common shares representing ownership capital Equity shares
are those shares which have no preferential right for getting dividend and repayment of
capital at the time of winding up.
Characteristics of Equity Shares
1.Maturity: Equity shares provide permanent capital to the company and cannot be
redeemed during the lifetime of the company.
2.Claim on income: Equity shareholders have a residual claim on the income of the
company. They have a claim on income left after paying dividend to preference
shareholders.
3.Claim on assets: Equity shareholders have a residual claim on ownership of company's
assets.
4.Right to control or voting right: Equity shareholders are the real owners of the company.
They have voting right in the meeting of the company and have a control over its working.
5.Pre-emptive right: When a company makes subsequent issue of capital, it must be first
offered to the existing shareholders.
6.Limited liability: Limited liability means that the liability of a shareholder is limited to the
extent of the face value of shares
Advantages of Equity Shares
1.Equity share capital is a permanent source of fund.
2.Equity shares do not create obligation to pay a fixed rate of dividend
3.Fresh issue of equity shares provides flexibility to the capital structure as funds are
obtained without creating any charge over the assets of the company
4.By mawing right shares, it is possible to raise additional funds without diluting the control of
existing shareholders.
5.Equity shareholders have voting rights.
Disadvantages of Equity Shares
1.Cost of equity capital is the highest of all sources.
2.Payment of dividend will attract Corporate Dividend Tax which is an additional burden to
the company.
3.Additional issue of equity shares will reduce earning per share.
4.If only equity shares are issued, the company cannot take the advantage of trading on
equity.
5.There is no assurance on dividend on equity shares.
B. Preference Shares
Preference shares form an important source for raising long term capital. Preference shares
are those shares which have preferential rights for geming dividend and repayment of capital
at the time of winding up.
Types of Preference Shares
1.Cumulative Preference Shares: Cumulative Preference Shares are those shares which
carry the right to cumulative dividends. If the company fails to pay the dividend in a particular
year, due to insufficiency of profes, such dividend is payable even out of future profits.
2.Non-Cumulative Preference Shares: These are the Preference Shares which do not carry
the right to receive arrears of dividend. If the company fails to pay dividend in a particular
year, that dividend need not be paid out of future profits.
3.Participating Preference Shares: Participating preference shares are those shares which
have the right to participate in the surplus profits and assets of the company after paying the
equity shareholders, in addition to their fixed rate of dividend and return of capital
4.Non-participating Preference Shares: Preference shares which have no right to participate
on the surplus profits and assets of the company are called Non-participating Preference
Shares
5.Redeemable Preference Shares: Redeemable preference shares are those shares which
can be redeemed after the expiry of a fixed period.
6.Irredeemable Preference Shares: These are shares which are redeemed (repaid) only on
winding up of the company.
7.Convertible Preference Shares: These are the shares which are converted into equity
shares after a specified period. The holders of the shares may be given a right to convert
their holdings into equity shares
8.Non-convertible Preference Shares: Preference Shares which are not convertible imo
equity shares after a fixed period are called Non-convertible Preference Shares.
Features of Preference Shares
1.As per the terms of issue and Articles of Association, a fixed rate of interest is paid on
preference shares
2.Preference shares get some preference over equity shares in respect of dividend and
repayment of capital at the time of winding up.
3.Preference shareholders do not enjoy voting rights
4.Preference shares have fixed maturity date and will have so repay after the fined period.
5.Preference shares are hybrid form of security as it includes some features of equity and
debt.
Advantages of Preference Shares
1.Preference shares add to the equity hase of the company by strengthen its financial
position
2.Preference shares save the company from paying higher rate of interest.
3.Issue of preference shares doesn't create any sort of charge against assets of the
company.
4.Preference shares will not affect existing control of the company as the preference
shareholders have voting rights only on the matters affecting their interest.
5.Financing through preference shares is cheaper than that of equity financing.
6.It is useful to investors who want to get higher rate of return with low risk.
7.Preference shareholders have a prior claim on the assets of the company on liquidation.
Disadvantages of Preference Shares
1.Preference dividend is not deductible as an expense for taxation purposes out of the
profits of the company
2.In case of cumulative preference shares, arrears of dividend have to be declared before
anything can be paid to the equity shareholders of the company
3.Preference shares dilute the claim of equity shareholders over the assets of the company.
4.Compulsory redemption of preferences shares on maturity will lead to substantial outflow
of cash.
5.The cost of capital of preference shares is higher than cost of debt.
2.Issue of Debentures
A company may raise long term finance through public borrowings. The publ borrowing is
done through the issue of debentures. Debenture is an acknowledgement debt. It is only a
written document issued by a company as an evidence of its debt capital.
A debenture is "an instrument in writing acknowledging a debt under the seal of the
company, usually secured by a fixed or floating charge on the assets of the company bearing
a fixed rate of interest and repayable within or after a specified period of irredeemable during
the existence of the company"
Kinds of Debentures
i. On the basis of Transferability
a. Registered Debentures: These are debentures registered in the books of the company
b. Bearer Debentures: If the names and other details of the debenture holders are not
recorded in the "Register of Debentures of the company, they are called bearer debentures.
ii. On the basis of Security
a. Secured or Mortgage Debentures: These are debentures which are secured by a fixed or
floating charge on the assets of the company.
b. Simple or Unsecured Debentures: These debentures carry no security with regard to
repayment of principal and interest. They are also called 'naked debentures'.
iil. On the basis of permanence (Redeemability)
a. Redeemable Debentures: Redeemable debentures are those debentures which are
redeemed after a specified period of time or after maturity period.
b.Irredeemable Debentures: Debentures, which are not repayable during the life time of the
company are called irredeemable debentures. They are also called perpetual debentures.
iv. On the basis of convertibility
a. Convertible debentures: Convertible debentures are those debentures which can be
converted into shares of the same company at the option of the holders.
b. Non-convertible Debentures: Debentures which are not convertible into shares of a
company are called non-convertible debentures.
v. Priority
a. First Mortgage Debentures: These debentures are payable first out of the property
charged.
b.Second Mortgage Debentures: These debentures are payable after satisfying the first
mortgage debentures.
Characteristics of Debentures
1.A Fixed rate of interest is payable on debentures.
2.Debentures create charge against assets of the company. The charge may either fixes or
Boating charge.
3.Interest paid on debentures is tax deductable expense, while computing taxable profia of
the company
4.Most of the debentures are redeemable at maturity.
5.Debenture interest is a charge against the profit of the company.
6.Debenture holders have option for converting their holdings into equity shares.
7.Debt financing does not result into dilation of control in the management of the company
Advantages of Debentures
1.It provides long term finance to the company
2.The rate of interest payable is less than the rate of dividend on shares.
3.Interest on debenture is a tax deductible expense
4.Debt financing does not result in the dilution of control.
5.Debenture capital provides the benefits of trading on equity.
5.Debentures provide fixed, stable and regular source of income to the investors.
Disadvantages of Debentures
1.It is a permanent burden on the company to repay the principal on maturity.
2.Charge on assets of the company restricts it from the use of debenture financing.
3.The increased use of debt financing usually increases the financial risk. The increased
financial risk may lead to financial distress and liquidation.
4.Cost of raising finance through debentures is high because of high stamp duty.
5.It is not desirable to issue debentures by a company having irregular earnings
6.Debenture holders do not have any controlling power over the management of the
company because they do not have any voting rights.
3.Issue of Bonds
A bond is an instrument, whereby, one person binds himself to another for payment of a
specified sum of money on a specified date.
Types of Corporate Bonds
1.Bearer Bonds: In this type of bonds, the amount is payable to the holders of the
instruments at the time of maturity.
2.Registered bonds: In this case, the amount is payable to the person, whose name is
mentioned in the register of the company.
3.Zero coupon bonds or deep discount bonds: This is a new type of bond which has no
periodic interest payment.
4.Sinking fund bonds: In the case of sinking fund bonds, the issuing company redeems a
fraction of the issue every year.
5.Junk bonds: Junk bonds are corporate bonds that are high risk and high return bonds
developed in USA. These are high yield bonds with higher risk of default and other adverse
credit events
6.Privately placed bonds: These are privately placed bonds and are not negotiable These
are usually issued to institutional investors.
7.Bunny bonds: These are the bonds issued with the right to reinvest the income inte the
bonds with the same terms and conditions of the host bond.
8.Secured Premium Notes (SPN): These instruments are issued with detachable warrants
and are redeemable after a notified period, normally 4 to 7 years.
4.Retained Earnings
A company does not generally distribute the entire earnings amongst its shareholders as
dividend. A portion of divisible profit is retained in the business for future use. The portion of
profit retained in the business for future use is known as retained earnings. The process of
retaining a portion of profit for reinvestment in the business is known as ploughing back of
profit. It is an internal source of financing or self-financing.
Need for Ploughing Back of Profit
1.For the replacement of old assets.
2.For the expansion and growth of the business.
3.For meeting fixed and working capital requirements.
4.For improving the efficiency of various assets.
5.For enabling company to become self-dependent.
6.For redemption of loans and debentures.
Factors determining Ploughing Back of Profits
1.Earning capacity: The amount of net profit earned is an important determinant of internal
savings. Higher the net profit earned by a company, the greater is its capacity to plough back
profits.
2.Age of the company: The age of the company also influences the amount of retained
earnings. New companies are generally unable to retain much profits due to their desire to
satisfy the shareholders.
3.Future Financial Requirements: The future plans of the company regarding modernisation
and expansion also affect the amount of retained earnings. A company with more expansion
plans may retain major portion of the earnings to finance such projects.
4.Dividend Policy: The dividend policy of a company determines the extent to which the
profits can be retained for reinvestment in the business. If a company follows a liberal and
regular dividend policy, it may end up retaining lesser profits.
5.Taxation Policy: If the rate of tax is high, then the company may have lesser amount of
internal savings. If the corporate income tax is low and tax on dividend is high, the company
may resort to retain a major part of its profit for future.
5.Institutional Finance
Institutional finance is a source of finance which is provided by the specialized financial
institutions.
i. The Industrial Finance Corporation of India (IFCI)
The IFCI was established in 1948 under an Act of Parliament with the basic object of
providing industrial finance (medium and long-term credit) to industrial concerns, especially
to small scale industries in India.
ii. The Industrial Credit and Investment Corporation of India (ICICI)
ICICI was established in 1955, as a private sector Development Bank with the primary
objective to provide development finance to enterprises in the private sector. The main
purpose for which financial assistance is extended by ICICI is for the purchase of capital
assets such as land, building and machinery.
iii. Industrial Development Bank of India (IDBI)
The Industrial Development Bank of India (IDBI) was established on 1st July, 1964, under
the Industrial Development Bank of India Act, 1964, as a wholly owned subsidiary of the
Reserve Bank of India. In terms of the Public Financial Institutions Laws (Amendment) Act,
1975, the ownership of IDBI has been transferred to the Central Government with effect from
February 16, 1976.
v. National Bank for Agriculture and Rural Development (NABARD)
NABARD is the apex institution that provides all types of credit to various sectors in the rural
economy, such as, agriculture, small scale industries, tiny and cottage industries,
handicrafts, in an integrated way for rural development. It came into existence on July 12,
1982.
iv. Small Industries Development Bank of India (SIDBI)
In order to ensure larger flow of financial and non-financial assistance to the small scale
sector, the Government of India set up the Small Industries Development Bank of India
(SIDBI), under a special Act of the Parliament in October 1989 as a wholly owned subsidiary
of the IDBI. The Bank commenced its operations from April 2, 1990, with its head office in
Lucknow.
6.Sale of fixed assets
Sale of fixed assets like land and building, lease hold premises which are not in use form a
long term source of finance to corporations.
7.Innovative Sources
i.Hire purchase financing
It is a new development of finance mechanism in certain selected sectors of Indian
Industries. Under the hire purchase financing the organisations are able to use high value
msets with minimum capital. It is an agreement between buyer and seller of the property.
ii.Lease Financing
Leasing is an agreement between the owner of the property and the user of the same,
whereby, the owner of the property provides exclusive right to the user to use the asset
without owning the same for a periodical payment called lease rentals.
iii. Venture Capital
Venture capital is a long-term risk capital to finance high technology projects which Involve
risk but at the same time has strong potential for growth.
Iv. Indian Depository Receipts (IDR)
An Indian Depository Receipt (IDR) enables foreign companies to raise funds from the
Indian securities market. IDR is an instrument denominated in Indian Rupees in the form of a
domestic depository receipt against the underlying equity shares of foreign Issuing company.
v. Euro Issues
Euro issue means an issue made abroad through instrument denominated in foreign
currency and listed on European Stock Exchange. But the subscription for it may come from
any part of the world other than India.
Short-term Sources
1.Trade Credit
Sellers or suppliers of different kinds of products or raw materials provide credit to deir
customers. The credit offered by the seller or supplier is known as trade credit or hillis
payable. It is a very important source of short-term finance
2.Bank Credit
Banks provide short-term finance in the form of over draft, cash credit, discounting of trade
bills and letters of credit to its customers.
3.Public Deposit
Firms may mobilise savings from the general public and it is termed as 'public deposit. It is a
very old system of financing.
4.Inter-corporate Deposits
A deposit made by one company in another company is known as inter corporate deposit. It
is an important short-term source of finance for firms in India.
5.Advances from Customers
Usually, sellers or producers receive whole or part of the amount of goods in advance and
such advance remains with them till the supply of goods. Normally, no interest is paid on this
amount
6.Commercial Paper (CP)
Commercial paper is a short-term money market instrument. It is a promissory note which is
negotiable by endorsement and fit for delivery with a fixed maturity period between one
month to one year. It helps to raise short-term deal at attractive rates.
7.Factoring
Factoring is a business activity in which a financial intermediary called factor takes the
responsibility of collecting the debtors or receivables of a manufacturing or trading concern.
 CAPITAL STRUCTURE
The term capital structure refers to the relationship between various long term form of
financing such as equity capital, preference share capital and debenture capitalis qualitative
aspect of financial planning. It refers to the proportion or mix of owners funds or equity and
borrowed funds or debts in the total capital of the firm.
According to Gerestenberg, "Capital structure of a company refers to the composition or
make-up of its capitalisation and it includes all long term capital resources Viz: loans,
reserves, shares and bonds"
Factors Determining Capital Structure Decision
1.Size of the firm
The size of a firm influences the capital structure decisions. If the firm is small, it prefers to
raise funds through the issue of equity shares and also depends on retained earnings.
2.Stage of the firm
The life cycle stage is also an important factor for capital structure decisions. If the firm is in
the initial or declining stage, it may depend more on equity.
3.Nature of Business
Capital structure decision differs according to the operational characteristics of the firm.
Merchandising firms operate on a small margin and so relies more on equity.
4.Stable earnings
Firms having stable and regular earnings can have more debt capital in their capital
structure. The capital structure of firms having unstable earnings is more conservative and
they do not use more debt capital.
5.Growth and Stability of Sales
The capital structure of a company is highly influenced by the growth and stability of its
sales. If the growth and stability of sales are more, the larger may be the use of debt.
6.Control
Equity shareholders are the owners of the company having complete control over it. At the
time of designing capital structure, it should be ensured that the control of the existing
shareholders over the affairs of the company is not adversity affected.
7.Cost of capital
Overall cost of capital of the firm is also an important factor that influences the capital
structure decision. If the existing cost of capital is already high, then the firm w go for low
cost sources of funds.
8.Flexibility
The desire to keep flexibility in the capital structure also influences the financing decision.
Flexibility means that, if need arises, the amount of capital in the business could be
increased or decreased easily.
9.Floatation Costs
Floatation costs are those expenses which are incurred while issuing securities. These
include commission of underwriters, brokerage, etc. The capital structure should provide
minimum floatation cost.
10.Capital Market Conditions
The capital market conditions prevailing in the economy do not remain same forever.
Sometimes, there may be boom in the market, while at other times there may be depression.
The capital structure decision is also influenced by the prevailing capital market conditions.
11.Corporate Tax Rate
The corporate tax rate also influences the capital structure decision. If the corporate tax rate
is high, debt financing is preferable than equity as interest paid on debt is tax deductible
while computing taxable profit.
12.Purpose of Finance
The purpose for which the required fund is mobilised is another consideration for capital
structure decision. If funds are required for a productive purpose, debt financing is suitable.
13.Period of Finance
The period for which the finance is required is another factor that determines capital
structure decision. If funds are required for a limited period, debentures or redeemable
preference shares should be preferable.
14.Regulatory Framework
Capital structure is also influenced by government regulations. For instance, banking
companies can raise funds by issuing share capital alone.
15.Attitude of the Management
Attitude of the management and the personal consideration also influence the determination
of capital structure. Well experienced management has to use more debt for raising capital.
Principles of Capital Structure Decisions
1.Cost Principle
This principle states that an ideal capital structure is one that leads to minimisation of the
overall cost of capital.
2.Risk Principle
This principle suggests that the rak associated with source of finance is analyse separately
and the pattern of capital structure that has minimum risk is to be selected.
3.Control Principle
This principle clearly states that the pattern of security used in capital structure don not
adversely affect the controlling position of the existing equity shareholders.
4.Flexibility Principle
According to this principle, the capital structure of a company should be designed in soch a
manner that the management have an option to raise capital from various alternatives as
and when situation demands.
5.Timing Principle
This principle states that the capital structure is designed in such a manner that it can take
advantages of opportunities in the capital market.
Capital Structure Theories
In financial management, capital structure theory refers to a systematic approach to
financing business activities through a combination of equities and liabilities.
assumptions of capital structure theories are as follows.
i.There are only two sources of finance in capital structure, debt and equity.
ii. Corporate taxes do not exist
iii The operating income (Earning Before Interest and Tax / EBIT) is assumed to be constant.
iv. The business risk is assumed to be constant.
V.The total assets of the firm do not change.
vi.The life of the firm is perpetual.
vii.The total assets of the firm do not change.
I.Net Income (NI)
Theory Net income theory was developed by David Durand. This theory proposes that there
is a direct relationship between capital structure and the value of the firm According to this
theory, a firm can maximise its value and minimise overall cost of capital by employing more
debt in its capital structure.
This theory is based on the following assumptions.
a.The cost of debt is lower than cost of equity.
b. The risk perception of investors is not changed by the increased use of debt.
C.There are no corporate taxes.
II.Net Operating Income Theory
Net Operating theory was also developed by David Durand. Net Operating Income theory is
just opposite to the Net Income theory. According to the Net Operating Income theory,
change in the capital structure of a company does not affect the market value of a firm and
overall cost of capital remains constant irrespective of the method of financing.
The following are the assumptions of net operating income theory.
a.The overall capitalisation rate remains constant irrespective of the degree of leverage.
b.The value of the firm is calculated by capitalizing the operating earnings (EBIT) of the firm.
C.Overall cost of capital remains constant
d.Corporate taxes do not exist.
III. The Modigliani -Miller(MM) Theory /Approach
The theory advocates that capital structure or combination of debt and equity is irrelevant in
the determination of value of the firm. The theory argues that cost of capital is independent
of the degree of leverage.
MM theory is based on certain assumptions.
a.There is perfect capital market. b.Investors are free to buy and sell securities.
c.All information are available to investors at low cost.
d. Investors behave rationally.
e.The expected earnings of all the firms are identical.
F. Investors can trade without restrictions and can borrow or lend funds on the same terms
as the firms do.
G.All earnings are distributed to the shareholders.
H.The firms may be grouped into homogeneous risk classes.
I. Personal leverage is the perfect substitute of corporate leverage, f det hich
J.No corporate taxes.
IV. Traditional Theory
According to this theory, the firm can increase its value initially or reduce cost f capital by
employing more and more debt capital in capital structure as debt is a cheape source of
finance.The advantage of cheaper debt at this point of capital structure is exactly offset by
increased cost of equity . Thus, according to this theory optimal capital structure can be
achieved by a proper mix of debt and equity.
Leverage
In financial management, the term leverage is used to describe the ability of a firm to use
fited cost assets or funds to magnify the return to its owners. The fixed cost assets/ funds act
as the base of the leverage.
According to James Horne "leverage is the employment of assets or funds for which the
firms pays a fixed cost or fixed return".
Types of Leverage
1.Operating leverage
Operating leverage simply means the presence of fixed costs components in the total cost of
a firm.
Importance of Operating Leverage Analysis
a.Useful for financial planning: Analysis of favourable and unfavourable impacts o operating
leverage is essential before taking any decision relating to fixed cos commitments.
b.Useful for planning capital structure: Operating leverage analysis reveals the effen of
changes in sales on EBIT of a firm. The degree of operating leverage reflects the capacity of
a firm to support its fixed costs.
c. Useful for risk analysis: The degree of operating leverage and degree of risk are directly
correlated. Therefore, the degree of operating leverage can be used as a good yardstick to
analyse the extent of risk.
2.Financial Leverage or Trading on Equity
The use of fixed interest/dividend bearing securities such as debt capital and preference
capital along with the equity capital in the total capital structure of the company is described
as financial leverage.Financial leverage or trading on equity is defined as, "the use of fixed
charge sources of funds along with equity capital to magnify the return of ordinary
shareholders".
Importance
a. Helps in profit planning: Without financial leverage analysis, it is impossible to arrive at the
capital structure which maximises the EPS. The different levels of sales and the volume of
profit resulting therefrom, surplus left after paying fixed charges are all taken into
consideration in financial leverage analysis.
b. Helps in capital structure planning: Optimum capital structure is highly essential for the
survival and growth of any business firm. Capital structure focuses on raising of long term
funds from shareholders and creditors.
C.Helps in profit maximisation: Favourable financial leverage will bring more income to the
equity shareholders which will result in appreciation of the market value of shares.
3.Combined Leverage (Composite Leverage)
Combined leverage expresses the relationship between sales and the taxable income. It is
the product of operating leverage and financial leverage.
 DIVIDEND POLICY/DIVIDEND DECISION
Dividend
The term dividend refers to that part of profit of a company that can be legally distributed to
its shareholders.
According to the Institute of Chartered Accounts of India, dividend is "a distribution
shareholders out profits of or reserves available for the purpose".
Dividend policy/decision
Dividend policy / decision refers to the policy of management concerning the quantum of
profits to be distributed among the shareholders and how much to be retained in the
business for reinvestment.
Dividend decision is defined as, "the policy that the management of a company formulates in
regard to its earnings for distribution us dividends amongst its shareholders".
Forms/Types of Dividend
1.Cash dividend: Cash dividend is a type of dividend in which dividend is paid in form of
cash. Payment of dividend in cash results in outflow of funds and shareholders get an
opportunity to invest the cash in a manner as they desire.
2.Scrip or Bond dividend: A scrip dividend is a type of dividend which promises pay dividend
to the shareholders at a future date. Scrip dividend is used in a situation in which the
company does not have sufficient funds to pay dividend in cash.
3.Property Dividend: Property dividend is a form of dividend in which dividend are paid in the
form of some assets other than cash. This may be in the form certain assets which are not
required by the company or in the form of company's products.
4.Stock Dividend: Stock dividend is a type of dividend paid in the form of shares of the
company through bonus issue.
Types of Dividend Policies
1.Regular Dividend Policy
Regular dividend policy is a type of dividend policy in which dividend is paid at usual rate
regularly. Regular dividend policy is beneficial to many investors such as retired persons,
widows and other economically weaker sections of the community, who consider dividend as
a means of their livelihood. A regular dividend policy offers the following advantages.
a.It establishes a profitable record of the company
b.It helps to improve the confidence of the investors.
c.It helps firms in easy mobilisation of its fund requirements.
d.It helps to stabilise the market price of the shares.
2.Stable Dividend Policy
The term stability means consistency or lack of variability in the stream of dividend
payments.
a.Constant dividend per share: According to this policy, the company pays a certain fixed
dividend per share year after year irrespective of their level of earnings. This policy is most
suitable to those companies whose earnings are expected to remain stable over a number of
years.
b.Constant pay out ratio: Constant payout ratio means payment of fixed percentage of net
earnings as dividend every year. In constant payout ratio, the amount of dividend is not fixed
but it fluctuates in direct proportion to the earnings of the company.
c. Stable rupee dividend plus extra dividend: In this policy, the firms usually pay constant low
dividend per share every year plus an extra dividend in the years of high profits. This policy
is suitable to those firms whose earnings are fluctuating from year to year.
Advantages of stabile dividend policy
1.Investors normally expect regular income.
2.A stabile dividend policy helps to attract fresh investors.
3.Brings stability in market value of shares.
4.Increases confidence of the shareholders in the company and its management
5.Increases goodwill and credit worthiness of the company.
6.Mobilisation of funds for new projects becomes easy.
3.Irregular Dividend Policy
It is a dividend policy followed by companies whose earnings are uncertain, busines
operations often become unsuccessful and also suffer from liquidity.
4.No Dividend Policy
No dividend policy is a type of dividend policy in which company pays no dividend presently
because of its unfavourable working capital position or on account of future financial
requirements.
Factors Determining Dividend Policy
1.Legal Provisions: It is an important factor to be considered while formulating a dividend
policy. Legal provisions relating to dividend policy is laid down in the various provisions of
the Companies Act, 2013,
2.Nature of Earnings: The amount and trend of earnings are important aspects of dividend
policy.
3.Nature of Industry: The nature of industry in which the company is engaged is another
factor is to be considered while determining the dividend policy.
4.Age of the Company: The age of the company is another important factor which influences
the dividend policy of the firm.
5.Desire and type of Shareholders: Desire and type of shareholders also influence the
dividend policy of an organisation. Desires of shareholders depend on their economic status.
6.Future Financial Requirements: Future financial requirements of the concern form an
important factor to be taken into account while formulating dividend policy.
7.Economic Policy of the Government: The economic policy of the Government is an
important consideration of dividend policy. The dividend policy of the firm has to be adjusted
according to the changing economic policy of the Government.
8.Control Objectives: When a company pays high dividend out of its earnings, it may result
in the dilution of both control and earnings of the existing shareholders. If company follows
high dividend pay out ratio, the retained earnings are insignificant and the company will have
to issue new shares to raise funds to finance future requirements.
9.Taxation Policy: The taxation policy of the Government also affects the dividend decision of
a firm. A high or low rate of taxation affects the net earnings of a company
10.General State of Economy: General state of economy is the major factor that determines
the dividend policy of the company.
Models of Dividend Policy
1.Walter's Model
James E Walter developed a model for dividend policy in which he strongly argue that
dividend decisions are relevant and affect the value of the firm. According to him, the firm's
internal rate of return and cost of capital is very significant in determining the dividend policy
and serve the basic objective of wealth maximization of shareholders.
Assumptions of Walter model
1.The investments of the firm are financed through retained earnings only and the firm does
not use any external source of finance.
2.Internal rate of return (r) and cost of capital (k) of the firm are constant.
3.The firm has a very long life.
4.Earnings and dividend do not change while determining the value.
Criticism of Walter's Model
1.Financing of the investments through retained earnings is not true in practice
2.The internal rate of return does not remain constant
3.The cost of capital will not remain constant.
II. Gordon's Model
Myron Gordon developed a model for dividend decision in line with James E Walter. In this
model, he argues that dividend policy of a firm is relevant and the dividend decision affects
the market value of shares.
Assumptions of Gordon's Model
Gordon's model of dividend decision is based on certain assumptions.
1.The firm has only equity capital.
2.No external financing is available or used.
3.The rate of return on investment is constant
4.The retention ratio, once decided upon is constant.
5.The cost of capital of the firm remains constant.
6.The firm has perpetual life.
7.Corporate taxes do not exist.
Implications of Myron Gordon's basic model
1.When the rate of return on investment is greater than the cost of capital (r>k). market price
of shares increase as the dividend payout ratio decreases.
2.When the rate of return on investment is equal to the cost of capital (r=-k), the marts price
of share is unaffected by the dividend policy.
3.When the rate of return on investment is lower than the cost of capital (r<k), market price
of share increases as the dividend payout ratio increases.
III. Gordon's Revised Model
The Gordon revised his basic model by considering the elements of risk a uncertainty. In his
revised model, Gordon suggested that even in the case of normal fim (r=k), dividend policy
affects the market value of shares on account of risk and uncertain of future. In this model,
Gordon argues that shareholders discount future dividend at higher rate than they discount
near dividend, i.e., the value of a rupee of dividend income more than the value of capital
gain.
IV.Modigliani and Miller (MM) Model
Modigliani and Miller developed a theory of dividend policy in which they have expressed
most comprehensive manner to support the theory of irrelevance. They argue dat dividend
decision has no effect on the market value of the shares and market value of the firm.
Modigliani and Miller hold that the splitting of earnings between dividend and retention has
no effect on the market price per share.
Assumptions of Modigliani and Miller Theory
1.There exists perfect capital market conditions.
2.Investors behave rationally.
3.Information about company is available to all without any cost.
4.There is no transaction and flotation cost.
5.Taxes do not exist.
6.There is no tax rate applicable to dividend income and capital gain.
7.The firm has a rigid investment policy.
 Working capital management
Working Capital Management refers to all aspects of managing current assets and current liabilities
Working capital management is defined as, "the managerial strategy designed to monitor and utilize
the components of working capital, to ensure the most financially efficient operation of the company".
Working Capital Management Working Capital Management involves management of different
components of working capital such as cash, receivables, and inventories. Thus, the major areas of
working capital management are the following.
1.Cash Management
2.Receivables Management
3.inventory Management
I.Cash Management
Cash management means management of cash and cash equivalents, so as to maintain an optimum
cash balance and at the same time avoid idle cash balance. It aims at maintaining equilibrium
between liquidity and profitability for maximising the profit of the enterprise.
Techniques of Cash Management
1.Cash planning and control
Cash planning and control refer to forecast of the cash receipts and arrangement of payments
accordingly. It helps to ascertain the cash surplus or deficit through the inflows and outflows of cash.
i.Cash flow analysis: In this method, the estimated cash flows from various activities namely investing
activities, financing activities and operating activities are ascertained, for a definite period of time.
ii.Cash budget: Cash budget is an estimate of cash receipts and disbursements of cash during a
future period of time.
iii.Ratio analysis: Ratio analysis is an important method used for cash planning and control. Ratios like
cash turnover ratio, daily cash payment ratio, cash position ratios, cash flow coverage ratios, etc. can
be used for cash planning control.
iv.Cash management models: Experts in the field of cash management have prepared certain models
for determining optimum cash balance which shall enable the firms for the determination of
appropriate cash balance.
2.Managing cash flows
After estimating the cash flows, efforts should be taken by the organisation to adhere to the estimate
of receipts and payment of cash. Cash management is effective only when there is a proper
management of cash flow.
Methods of cash flow
A. Accelerating cash collections
i. Prompt billing and cash discount: One method of getting immediate payment from customers is to
prepare pare invoices and bills promptly. Computerised bills and self- addressed envelope can be
used to convey customers for immediate and prompt payment.
ii. Reduction in deposit float: There is a time lag between cheque issued to a customer and time of
depositing it in to the bank for collection. This time gap has three components. (1) time taken by the
post office in sending the cheque from the customer to receiver. This is known as postal float, (2)time
taken for processing the cheque before it is deposited in to bank, which is known as lethargy or
processing float and (3) time taken by the bank in collecting the amount of cheque to the customer's
account is called bank float. Postal float, processing float and bank float, taken together is known as
deposit float.
iii. Decentralised collections: In decentralized collections, a number of collection centres are opened in
different areas and instructions are given to their clients to deposit the payment to the collection
centres.
iv.Lock-box system: Lock box system is used to reduce processing float, bank float as well as postal
float. Under this system, the enterprise hires a post office box on rent in each important trading
centres.
V.Internal control: The enterprise may increase the spread of cash inflows by imposing some kind of
control over internal transfer of cash. This is to prevent unnecessary Jocking up of funds in different
departments or sections of the enterprise.
vi.Reduction in number of bank accounts: If an enterprise has different accounts in various banks
operating in the same phase it is better to eliminate the various bank accounts and opening only one
account.
B. Decelerating cash payments
i.Payment of last date: The cash payments can be delayed by making the payments on the last due
date only
ii.Payment through cheques or drafts: A company can delay the payment by making all the payments
through cheques or drafts. It will help the firm to avail the benefit of deposit float.
iii.Adjusting payroll funds: Some companies use payroll adjustments for delaying the payments It is
done by reducing the frequency of payments.
iv.Centralised payments: The payments should be centralised and is made in the form of cheque and
drafts.
3.Determination of optimum cash balance
An enterprise should strike a balance between liquidity and profitability For this, the cash balance
maintained should be optimum. Some of the methods for maintaining optimum cash balance are
discussed below:
a. Cash cycle model: The flow of cash in a business passes through various channels
b. Baumol Model: This is based on economie order quantity model of inventory management. Under
this model a balance is made between two types of cost-cost of holding the cash and the transaction
cost.
C.Miller orr model: Miller-orr model is basically an application of control limits theory to the cash
management. For the purpose, two control limits -upper and lower are determined.
4.Investment of surplus funds
Cash balance in excess of required amount is invested in short-term or marketable securities, so that
some incomes can be earned on that excess cash balance.
i. Default risk
Default risk arises when there is no possibility of getting back principal amoun well as interest. The
magnitude of such risk is dependent on the credit worthiness and behaviour of the issuer of securities.
ii.Maturity
On maturity, the investor has the right to receive the principal amount and interes on securities.
However, it is important to makes a study of money-rate risk from maturity point of view. Changes in
interest rates affect market rate of securities.
iii. Marketability
From the liquidity point of view the selected securities must possess the quality of marketability.
Marketability involves:
(i) how much net proceeds will be available on the sale of securities and
(ii) how much time will be required for selling these securities.
iv. Avenues of investments
The following are the important avenues available for investment of surplus funds
a. Treasury Bills.
b. Certificates of Deposits.
C.Units Schemes of Mutual Funds.
d. Inter Corporate Deposits.
e.Bills Discounting.
f. Investment in Marketable Securities.
g. Money Market Mutual Funds.
II. Receivables Management (Debtors Management)
Receivable management is concerned with all the processes adopted for maintaining the amount of
receivables at the optimum level, considering the requirements of the customers at one end, and the
credit sanctioning capacity of the firm at the other.
Factors affecting the size of receivables
1.Nature of Business: The size of investment in receivables is determined by the nature of business.
The size of investment in receivables is low in public utility concerns as most of the transactions are
on cash basis.
2.Level of credit sales: The quantum of credit sale is the most important factor which determines the
size of receivables. If an organisation follows cash sales only, there will be no receivables.
3.Credit policies: Credit policy refers to a policy of the organisation towards debtors that influences the
amount of trade credit i.e., amount invested in receivables.
4.Credit terms: The size of the receivables is also influenced by the terms of credit offered by the
organisation. Credit terms specify the repayment terms of credit customers or receivables.
5.Credit collection efforts: Credit collection efforts involve procedures for collecting accounts
receivables when they are due. If the customers fail to pay their dues on time, they should be
immediately informed.
6.Habits of customers: Certain customers have the habit of delaying payment even though they are
financially strong. In this situation, the organisation should frequently be in touch with such customers
in order to collect the dues and avoid delay in payment.
7.Business cycles: The size of investment in receivables fluctuates with business cycles In the
depression period, the size of receivables will be more due to collection difficulties.
Techniques of receivables management
1.Credit analysis: No enterprise can sell goods on credit blindly to every customer. It hat to evaluate
and examine the ability of customers to make payment on time, Therefore, an analysis of those risks,
which may arise on account of non-payment of late payment, must be undertaken before granting
credit facilities to customers.
2.Credit standards: A credit standard provides a base for deciding whether to gram credit to a
customer or not. Credit standards may be in a strict manner or in liberal manner.
3.Credit terms: The firm has to determine the terms and conditions on which trade credit will be made
available to customers. A credit term has three variables namely: (1) credit period, (2) cash discount
and (3) cash discount period.
4.Collection policy: Collection policy is basically concerned with the procedure to be followed in
collecting the amount due from the receivables. The type of effort and the degree of collection efforts
are issues related to collection policy.
5.Control and monitoring: After setting the credit standards credit terms and collection policies, the
financial manager has to control and monitor the effectiveness of collections.
6.Ageing schedule techniques: This technique classifies the debtors at a given point of time in to
different age groups. Usually greater the age of receivables, greater is the level of credit sales.
7.Control of average collection period: Many concerns, now-a-days have adopted this method to
control the percentage of those very likely to make late payments. For computing average collection
period, the firms computes two ratios namely: (1) Debtors turnover ratio and (2) Debt collection
period.
8.Factoring: A factor is a financial institution which offers services relating to management and
financing of debts arising out of genuine credit sales.
III.Inventory Management
Inventory management is defined as "planning and devising procedures to maintain an optimum level
of inventories, so that, smooth flow of activities is assured and cost control and cost reduction is made
possible".
Techniques and Tools of Inventory Management
I.ABC Analysis
Always Better Control technique, popularly known as ABC analysis is a system of inventory control
based on the relative economic importance of different categories of materials. It is based on the
principle that more care and control are necessary for costly items of materials.
i.Provides better means of material control: Grouping of materials into well defined groups on the
basis of their value and quantity provides a better means of material cost control.
ii.More attention on costly items: As the materials are categorised on the basis of their value, more
attention and care can be given on those materials.
iii. Less attention to less costly items: Under ABC analysis C category items are larger in quantity with
very less value. Such items require only routine care and attention.
iv.Reduction in investment: Under ABC analysis, group A materials are purchased only to the
minimum requirement, so that the capital investment in those items are kept at the minimum.
5.Low carrying cost: Care and attention given to materials are on the basis of their value as well as
quantity.
6.Strict control: Under ABC analysis, strict control can be exercised to the materials in group A that
have higher value.
II.VED Analysis
Vital Essential and Desirable Analysis, popularly known as VED analysis is a material control device
applied on the basis of relative importance of availability of certain materials It is mainly intended for
control of equipments and spare parts. On the basis of the relative importance, spare parts may be
classified into 3 categories viz., Vital, Essential and Desirable. Vital spare parts are those items of
parts whose non-availability may lead to stoppage of production.Production may not be interrupted
due to the non-availabiliry of 'Essential' spares for some hours, beyond which production will be
stopped and thus these items are essential. Desirable spare parts are those spares which are needed
bu their absence for certain days may not lead to stoppage of production.
III. FSN Analysis
FSN analysis is a method of categorising items of stores of materials on the basis of their speed of
movement from the store. The inventories are classified into Fast moving. Slow moving and Non
moving items.
i. Fast moving items: These are the materials which are very rapidly consumed, so that the stocks are
to be replenished very frequently.
ii. Slow moving items: These are materials which are not frequently required for consumption and
these stocks are not to be replenished so frequently.
iii.Non-moving items: Non moving or Dormant Stocks are the items of stock which are not moving
currently, but its movement is expected in future.
IV.Just-In-Time Inventory (JIT) System
Just-In-Time (JIT) is a modern technique of inventory control. It aims at minimising he stock of raw
materials, work-in-progress and finished products IIT refers to Just-In- Time purchasing of materials.
JIT producing of goods and JIT delivering of materials and finished goods.
V. Economic Ordering Quantity (EOQ)
Economic ordering quantity refers to that quantity of materials to be purchased at a time to optimise
the costs thereon, where by, the ordering cost and carrying cost taken together per unit will be the
lowest. It is also known by different names like "optimuon quantiry", "economic lot quantity", "ideal
quantiry', 'ordering quantity, etc.
VI.Stock levels of materials
One of the objectives of material control is to maintain the stock of raw material as low as possible
and to ensure the availability of material as and when required. Overstocking leads to unnecessary
blocking up of working capital and understocking may interrupt production. The object of fixing stock
levels is to maintain required quantity of materials in the store and thereby reducing the stores
expenses to the minimum.
1.Minimum stock level (safety stock)
Minimum stock level is the minimum quantity or minimum number of units of material to be available
in the store at any time. Material should not be allowed to fall below this level. If the stock goes below
this level, production may be held up for want of materials This stock is also known as safety stock
level.
2.Maximum stock level
Maximum stock level is that level of stock above which the stock in hand should never be allowed to
exceed It is the largest quantity of a particular material which may be held in the store at any time.
3.Reorder stock level
Reorder level is the stock level at which the stores department issues purchase requisition and the
purchasing department places order for fresh supply of materials. It is fixed somewhere between
maximum and minimum levels, in such a way that, fresh supplies are received only just before the
minimum level is reached.
4.Average stock level
Average stock level is the average quantity of materials kept in the store. This is regarded as the
average of maximum and minimum stock levels.
5.Danger level
Danger stock level is the level set below the minimum stock level, at which, the stores department is
cautious in issuing materials, but issues are made under special instructions.
VII. Stock turnover/Inventory turnover
Inventory turnover is one of the important methods of material control. The objective of stock turnover
is to ensure the availability of all types of materials required and to avoid over or under investment in
materials stock turnover establishes the relation between each item of material consumed and
average quantity of material kept in the store during the period. It indicates the rate of speed at which
materials are consumed.
VIII. Aging Schedule of Inventories
Classification of inventories according to their holding period (age) helps the organisation to locate
slow moving inventories. Identification of slow moving inventories helps in effective control and
management of inventories.
IX. Inventory Reports
For effective inventory control, the management should be informed with the latest stock position of
different items. This is done through the preparation of inventory reports. Inventory report is a report
which contains all the information regarding materials, which enables the organisation to take
necessary managerial actions.
X. Maintaining Stores Records
To exercise proper control over the materials kept in the store, certain documents of records are to be
maintained. There are two important inventory records, viz, Bin Card and Stores Ledger.
Bin card is a card attached to each bin showing the quantitative details of materials received, issued
and the balance of quantity in the bin.
Stores ledger is the stores record kept in the costing department showing the quantity, price and value
of materials received, issued and the balance in stock.
 Financial Management
Financial management refers to the process of planning, organizing, controlling and
monitoring financial resources with a view to achieve organisational goals and objectives
According to I. M. Pandey, "Financial Management is the managerial activity which is
concerned with the planning and controlling of the firm's financial resources"
Scope of Financial Management
1.Financing Decisions: Financing decision refers to the decision regarding the amount of
finance to be raised and identifying the various available sources for raising the finance.
Managers make decisions pertaining to raising finance from long-term sources and
short-term sources. It includes:
i. Financial Planning decisions which relate to estimating the sources and application of
funds.
ii.Capital Structure decisions which involve identifying sources of funds.
2.Investment Decisions: The investment decision relates to the decision made by the
investors or the top level management with respect to the amount of funds to be deployed in
the investment opportunities.
i.Long-term investment decisions or Capital Budgeting mean committing funds for a long
period of time, mainly in fixed assets.
iiShort-term investment decisions or Working Capital Management means committing funds
for a short period of time, mainly in current assets.
3.Dividend Decisions: Dividend decision refers to the policy of management concerning the
quantum of profits to be distributed among the shareholders and how much to be retained in
the business for reinvestment.
scope of financial management includes the following:
i.Anticipation: Financial management estimates the financial needs of the company.
ii. Acquisition: it collects finance for the company from different sources.
iii. Allocation: It uses the collected finance to purchase both fixed and current assets for the
company.
iv. Appropriation: It divides the company's profits among the shareholders, debentureholders,
etc. It also retains a part of the profit.
v. Assessment: It also controls all the financial activities of the company.
Importance of Financial Management
1.Aids in financial planning: Finance manager of an organisation has to estimate financial
needs with the help of cash flow statements, cash budgets, etc.
2.Facilitates financial decision making: Any financial decisions make an immediate and
direct effect on the business, which in turn will affect the profitability.
3.Helps in acquiring financial resources: Financial Manager has to initiate steps in tapping
potential sources of funds and raising them at low cost for meeting the financial needs of the
company.
4.Assists in optimal allocation of funds: There should be optimum allocation and deployment
of funds to various assets in order to achieve maximum return.
5.Helps to analyse financial performance: Inorder to get maximum return on investments, the
cost and benefit of each financial decision must be analysed.
6.Helps in accounting and reporting: The financial manager of an organisation should supply
information about the financial performance to the top management.
7.Helps in cost control: Application of various tools of financial management enables the
financial manager to bring costs under control.
8.Aids in estimation of profit: Profit levels have to be forecasted from time to time to
strengthen the organisation.
Objectives of Financial Management
The major objectives of financial management are as follows
1.Profit Maximisation
2 Wealth Maximisation
1.Profit Maximisation
Profit earning is the main aim of every economic activity.Profit maximisation is the basic
objective of financial management, through which, profit is maximised by undertaking those
activities which increase profit and avoiding those which reduce profit.
Arguments advocated by experts in favour or profit maximisation objective
1.Efficient allocation of resources; To maximise profits, financial managers often shift funds
from less profitable projects to more profitable ones.
2.Rationality: When a person performs an economic activity in the rational way, he derives
maximum utility from the activity. The utility for the activity is measured in terms of profits
obtained from it.
3.Maximising social welfare: Profit maximisation enables a firm to make it healthier to meet
its social responsibilities. But profit maximisation should not be at the social cost.
4.Measurement of efficiency: Profit is the test of economic performance and its efficiency A
firm can earn profit only through efficient production, sales and performance.
5.Profit acts as a source of incentive: It is the profit which creates competition and without
competition business becomes stagnant. Enterprises try to be more efficient to maximise
profit
Criticisms against profit maximisation objective
i. Ambiguity: The term profit is not clearly defined. It may be gross profit, net profit or profit
before tax or after tax Again, it may be in terms of profitability as return on capital employed,
return on shareholders' equity or return on sales.
ii.Ignores time value of money: The goal ignores the time value of money. It is an accepted
principle that the value of one rupee tomorrow is lower than the value of one rupee today or
earlier is better.
iii. Ignores risk factor: Profit maximisation objective does not take into consideration the risk
associated with its future earnings.
iv.Social considerations: Profit maximisation objective fails to consider social values and
social considerations. According to this concept, these activities which lead to the
maximisation of profits can be adopted by the firm.
2.Wealth Maximisation
Wealth maximisation is the concept of increasing the value of a business, inorder to
increase the value of the shares held by its stock holders. It is concerned with the
maximisation of shareholders' wealth.
Arguments in favour of Wealth Maximisation
1.Protection of interest of shareholders: The basic aim of investing money in a business to
increase one's wealth.
2.Continued growth: A business is established on the concept of perpetual succession For
the purpose, there should be continued increase in wealth.
3.Considers time value of money: Wealth maximization objective takes ints consideration the
time value of money.
4.Considers risk factor: Wealth maximisation objective considers the risk associated with the
prospective earnings stream.
Criticism / Objections to Wealth Maximisation Goal
1.Social point of view: Wealth maximisation may lead to concentration of wealth in few
hands. Wealth concentration in few hands leads to widening the gap between the rich and
the poor.
2.Undesirable fluctuations: With the objective of increasing wealth and for becoming more
richer, there will be some undesirable manipulations in financial market.
3.Leads to conflicts: In corporate organisations, there is separation of management from
ownership. Management is always interested in improving the health of the organisation,
whereas, ownership is interested in increasing their wealth.
4.Prescriptive idea: Wealth maximisation is a prescriptive idea. The objective of wealth
maximisation is not descriptive of what the firm actually does.
Key Decisions of Financial Management
1.Investment Decisions
Investment decision is concerned with decision as to investment of funds of the business in
different assets. It relates to the determination of long term as well as short term assets to be
held in the firm, its composition and probable risk associated with such investments.The long
term investment decision refers to capital budgeting and short term investment decision
refers to working capital management.
2.Financing Decisions
Once firm has decided its investment in long term assets and short term assets, it has to
design ways and means of financing them. Financing decision is concerned with the
decision as to the amount of finance to be raised and identifying the various sources
available for it. The firm's financing decision is related to the capital structure of the business.
3.Dividend Decisions
Dividend Decision is concerned with decision as to disbursement of divisible profits as
dividend to shareholders of the business and retaining a portion of the profit for future
growth. The decision may be based on factors such as preference of the shareholders.
future expansion opportunities and investment opportunities for the firm.
 Working Capital
Working capital refers to that part of capital which is required for meeting or financing short
term or current assets of the business such as cash, inventories, debtors and marketable
securities.
In the words of Shubin "Working capital is the amount of funds necessary to cover the cost
of operating an enterprise"
Importance/Advantages of Adequate Working Capital
1.Smooth running: A concern require adequate working capital to carry on its day to day
operations smoothly and efficiently
2.Prompt payment: It enables a firm to pay its current obligations promptly and take
advantage of cash discounts.
3.Maintains reputation/goodwill: It ensures the maintenance of a company's credit standing
and reputation.
4.Maintains inventory at the optimum level: It enables maintaining inventory at the optimum
level to serve the needs of customers.
5.Extends favourable credit terms: It enables a company to extend favourable credit terms to
its customers.
6.Easy loan: Adequate amount of working capital builds a sound credit worthiness of the
firm.
7.Efficient operation of the business: It enables a company to operate its more efficiently
because there is no delay in obtaining materials, payment of wages, etc. businesses
8.Provides adequate fund: It provides a firm with adequate funds for meeting unforeseen
contingencies in the future.
9.Increase in liquidity and solvency position: Adequate working capital enhances the liquidity
and solvency position of the business concern.
10.Efficient utilisation of resources: It helps to utilise the maximum available resources
11.Stable dividend policy: It helps a firm to follow a stable dividend policy due to the timely
availability of working capital.
Types of Working Capital
Permanent working capital Permanent working capital is the minimum amount of investment
in all currers assets which must be kept inorder to carry on the business. It is the investment
in current assets which is permanently locked up in the business. Therefore, permanent
working capital is also known as fixed or regular working capital.
Temporary working capital (Variable working capital) Temporary or Variable working capital is
the working capital which is needed over and above the fixed working capital. Variable
working capital can also be called as fluctuating working capital. It is the extra working
capital needed to support the changing production and sales activities.
Concepts of Working Capital
i.Gross Working Capital
Gross working capital is the sum total of investment in current assets in a company Current
assets are those assets which can be converted in to cash within an period of one year. It is
the total of the components of current assets like,
(a) Cash and bank balance,(b) Short-term investments, (c) Trade debtors, (d) Bills
receivable, (e) Stock of raw materials, work-in-progress and finished goods, (f) Prepaid
expenses, and (g) Consumable stores.
ii. Net Working Capital
Net working capital is the excess of current assets over current liabilities. Curren liabilities
are those claims of outsiders, which are expected to mature for payment within a period of
one year. 21 The components of current liabilities are: (a) Short term borrowings. (b)
Advances received from customers, (c) Bank over draft, (d) Sundry creditors and bills
payable, (e) Outstanding expenses, etc.
The net working capital may be positive or negative.
a.Positive working capital: A positive working capital is one where the curren assets exceed
current liabilities.
b.Negative working capital: A negative working capital is a position where the current assets
are less than current liabilities.
iii. Zero Working Capital
Zero working capital is a modern concept developed in working capital management. It is a
situation where current assets are equal to current liabilities.
Sources of Working Capital
1.Trade Credit: Sellers or suppliers of different kinds of products or raw materials provide
credit to their customers. The credit offered by the seller or supplier is known as trade credit
or hills payable.
2.Bank Credit: Banks provide short-term finance in the form of over draft, cash credit,
discounting of trade bills and letters of credit to its customers. Overdraft facilities are allowed
to customers having current account balance upto a limit.
3.Public deposit: Firms may mobilise savings from the general public and it is termed as
'public deposit' It is a very old system.
4.Inter corporate deposits: Deposits made by one company in another company is known as
inter corporate deposit. It is an important short-term source of finance for firms in India.
5.Advances from customers: Many times, sellers or producers receive whole or part of the
amount of goods in advance and such advance remains with them till the supply of goods.
6.Commercial paper (CP): Commercial paper is a short-term money market instrument. It is
a promissory note which is negotiable by endorsement and fit for delivery with a fixed
maturity period between one month to one year.
7.Convertible debentures: For raising funds for working capital along with long term purpose,
the issue of convertible debentures is considered a popular method.
8.Factoring: Factoring is a business activity in which a financial intermediary called factor
takes the responsibility of collecting the debtors or receivables of a manufacturing or trading
concern.The main advantages of factoring are:
i.Reduces the operating cycle by providing liquidity.
ii.Credit risk is transferred from seller of goods to factor.
iii.Cash flow from credit sales is assured.
iv.Sales administration is taken over by factors.
Determinants of Working Capital
1.Nature of business: Nature of business influences the magnitude of working capital. The
working capital requirement of a firm basically depends upon the nature of the business.
2.Size of the business: The working capital requirements of the firm is directly influenced by
the size of the of business and is measured in terms of scale operations.
3.Volume of sales: The volume of sales and size of working capital is maintained to support
operational activities which result in sales.
4.Terms of purchase and sales: If a firm has allowed very liberal credit terms to its
customers, more funds will be tied in book debts and working capital needs will be high.
5.Inventory turnover: If the inventory turnover is high, the working capital requirement will be
low. With a better inventory control a firm is able to reduce its working capital requirements.
6.Receivables turnover: A prompt collection of receivables and good facilities for settling
payables result into low working capital requirements.
7.Production cycle: The time taken to convert raw materials into finished products is referred
to as the production cycle. The longer the production cycle, the greater is the requirement of
working capital.
8.Working capital cycle: An important factor which influences the working requirements of
the firm is working capital cycle.
9.Business cycle: Business expands during period of prosperity and declines during the
period of depression.
10.Value of current assets: A decrease in real value of current assets as compared to their
book value reduces the size of working capital.
11.Credit control: Credit control includes such factors as the volume of credit sales terms of
credit sales, collection policy, etc.
12.Liquidity and profitability: If a firm gives more importance to liquidity, it is interested in
maintaining a larger amount of working capital.
13.Inflation: As a result of inflation there may be a better inflow of cash and consequently the
working capital is increased.
14.Seasonal fluctuations: For seasonal firms the size of working capital fluctuates with
seasonal variations. The size of working capital is large during busy seasons than slack
seasons
15.Changes in technology: Technological development related to the production process
have an impact on working capital.
Estimation of Working Capital Requirements
1.Operating Cycle Method (Cash working capital method)
The working capital requirement of a firm in a period is determined with reference length of
net operating cycle and the volume of cash needed to meet the operation penses for the
period. In this method, the speed or time duration required to complete one cycle determines
the requirements of the working capital.
2.Estimation of current assets and current liabilities (Working Capital Budget Method)
Since working capital is the excess of current assets over current liabilities, its estimate can
be made by making the estimates of the amount of each component of working capital.
3.Cash Forecasting Method
This method is otherwise called cash budget method, in which an attempt is made to
estimate cash surplus or deficiency. For this purpose, receipts and payments expected Now
during future period are estimated and their difference show surplus or deficiency.
4.Projected Balance Sheet Method
Under this method, various items of assets and liabilities (long-term and short-term) are
estimated. On the basis of these assets and liabilities a projected balance sheet prepared
and then working capital estimate is made by taking the difference between current assets
and current liabilities.
5.Profit and Loss Adjustment Method
According to this method, estimated profit is calculated first on the basis of transactions
likely to take place in future. It is a technique to ascertain cash flow from various activities
namely cash from operational activities, cash from investing activities and cash from
functioning activities.
6.Percentage of Sales Method
This method of estimating working capital requirement is based on the assumption that the
level of working capital for any firm is directly related to its sales volume. If past experience
indicates a stable relationship between the amount of sales and working capital, then this
basis may be used to determine the requirements of working capital for future period.
7.Regression Analysis Method
This method of forecasting working capital requirements is based upon the statistical
technique of estimating or predicting the unknown value of a dependent variable from the
known value of an independent variable.
 Capital Budgeting
Capital budgeting is the process of making decisions to invest the available funds most
efficiently in long term activities against an anticipated flow of future benefits over a number
of years.
According to Charles T. Horngren Capital budgeting is "long-term planning for making and
financing proposed capital outlay".
Decisional areas of Capital Budgeting (Scope of capital budgeting)
1.Launching of a new business: A firm has to invest heavily in building, plant and machinery
and other fixed assets when it commences its activities.
2.Replacement: When the fixed assets become worn-out or outdated on account of new
technology, its replacement becomes necessary.
3.Expansion: A firm has to make additional investment when it decides to expand its
activities to meet increased demand for its products and services.
4.Diversification: A business may reduce its risk by operating in several markets, rather than
in a single market.
5.Research and development: Research cost is the cost incurred for seeking or searching
for improved or new products, new or improved methods, etc. Development cost is the
additional cost incurred inconnection with development of a new product or the manufacture
of a product under improved method.
6.Statutory requirements: Capital budgeting is needed for meeting the statutory
requirements.
Methods of capital budgeting
A. Traditional Methods
Traditional methods are methods employed for evaluating investment proposals is which
various investment proposals are ranked without considering the time value of money. The
various methods used under traditional methods are:
1.Pay Back Period
Pay back period is otherwise called as pay out period method or pay off period method. Pay
back period is the time period required to recover or recoup the initial investment invested in
a project. It refers to the time required for generating sufficient cash inflows for the recovery
of investment made in a project.
Advantages of Pay back period
1.Easy and simple: Pay back period is easy to compute and simple to understand.
2.Save costs: It saves cost since the time and effort required for computation are less.
3.Reduces loss by obsolescence: In the dynamic world of changing technology, the chance
of obsolescence is large. This method reduces the chance of loss by obsolescence as the
original investment is recovered at an early date.
4.Enhances the liquidity position: As there is early realisation of original investment, this
method enhances the liquidity position of the firm.
5.Quick realisation of investment: This method ensures quick realisation of investment and
hence suitable to the firms which experience shortage of funds.
Disadvantages of Pay back period
1.Ignores the cash inflow beyond the pay back period: This method ignores the cash inflow
beyond the pay back period and hence, the profitability of the project is not considered.
2.Does not take time value of money: This method does not take time value of mo Cash
inflows occurring at different periods are treated alike
3.Ignores cost of capital: Cost of capital is a very important aspect in my Investment
decisions. This is altogether ignored in this method.
4.Difficulty in determination of payback period: In the process of evaluation of single project
(where there is no ranking) determination of minimum acceptable pa back period is rather
difficult
5.Ignores returns en capital employed: This method places undue emphasis on liquidity and
ignores return on capital employed
6.Ignores risk differences: The pay back period also fails to consider any thi differences.
2.Improvement to Pay Back Period
a.Posts Pay Back Profitability Indes One of the serious limitations of pay back period method
is that it does not take imo account the cash inflows earned after pay back period and hence,
true profitability of the project cannot be assessed.
b. Posts Pay Back Reciprocal Method Posts Pay Back Reciprocal Method is employed to
estimate the Internal Rate of Return generated by the project.
c.Past Pay Back Period Method
Post pay back period method takes into account the period beyond the pay back period. This
method is otherwise termed as Surplus life over pay back period.
d. Discounted Pay Back Period
One of the serious limitations of pay back period method is that it does not consider the time
value of money
3.Average Rate of Return Method
Rate of Return Method is a traditional method of evaluating long term investment proposals,
where the investment proposals are ranked according to their returns on investments.
Advantages of Average Rate of Return Method
1.Easy and simple: ARR is easy to calculate and simple to understand.
2.Considers the entire earnings: It takes into account the entire earnings of the project during
its economic life.
3.Based on the concept of net earnings: This method is based on the concept of net
earnings, i.e., earnings after tax and depreciation.
4.Importance to profitability: This method gives importance to profitability rather than liquidity.
It gives a clear picture of the profitability of a project.
5.Considers the accounting concept of profit: This is the only method that considers the
accounting concept of profit for calculating rate of return.
6.Satisfies the interest of the owners: This method satisfies the interest of the owne as they
are much interested in return on investment.
7.Measures the current performance: This method is useful to measure the curre
performance of the firm.
Disadvantages of Average Rate of Return Method
1.Ignores the time value of money: This method ignores the time value of money Profit
earned at different points of time are given equal weights.
2.Not suitable to all projects: It is not suitable where investment in a project is to te made in
parts
3.Ignores the life span: It ignores the life span of various investments. A proje which gives
20% return in 15 years may be preferred to one which gives 19% in 4 years.
4.Does not consider cash inflows: It takes into account only the accounting profit and not
cash inflows which are also important for project evaluation.
5.No uniformity: There exist different concepts about earnings and as such there is no
uniformity in approach.
B. Modern Methods (Discounted Cash Flow Methods)
One of the serious limitations of traditional methods is that they do not take into
consideration the time value of money. It led to the development of time adjusted cash flow
methods. The time adjusted cash flow methods consider the time value of money for
evaluating the profitability of investment proposals.
1.Net Present Value Method
The Net Present Value Method is a time adjusted method of capital budgeting which tates
into consideration the time value of money. Net present value is the difference between
present value of cash inflows and present value of cash out flows.
Advantages of Net Present Value Method
1.It considers time value of money.
2.It considers the earnings over the entire life of the project and the true profitability the
investment proposals can be evaluated.
3.It takes into consideration the objective of maximum profitability.
Disadvantage of Net Present Value Method
1.Computation of net present value is rather a difficult process.
2.Life of the asset is totally ignored. There is chance of choosing a long period rish project
rather than accepting a less risky project even though net present value m be slightly less.
3.It may not give good results while comparing projects with unequal investmen because net
present value is expressed in absolute terms.
4.It is not easy to determine appropriate discount rate.
2.Internal Rate of Return (IRR) Method
Internal Rate of Return Method is a modern technique of capital budgeting which takes into
account the time value of money. Internal rate of return is the rate at which NPV become
zero. Internal rate of return is otherwise called trial and error method because of the reason
that the rate of interest which equates the present value of cash inflows with present value of
cash out flows are not given.
Advantages of Internal Rate of Return
1.Considers time value of money: IRR method takes time value of money into account and
hence it can be profitably employed in cases where there is irregular inflow of cash.
2.Considers entire earnings: It takes into account the entire earnings over the economie life
of the asset.
3.Considers cost of capital: Cost of capital is considered for decision making. B
determination of cost of capital is not a pre-requisite as under NPV method.
4.Uniformity: As IRR is expressed as a percentage, ranking of the proposals is mak on a
uniform basis.
Disadvantages of Internal Rate of Return
1.Difficulty in computation: The process of computation of IRR is rather difficult.
2.Not realistic: The basic assumption that the earnings are reinvested at the IRR is tet
realistic.
3.Variations not considered: It does not consider the variation in the life span of assets.
4.Ignores liquidity: The method ignores the aspect of liquidity.
3.Profitability Index Method (Benefit Cost Method)
Profitability index method is also a time adjusted method for evaluating investment
proposals. Profitability index is also known as benefit cost method or desirability factor This
is a variant of the net present value method. Profitability Index is the relationship between
present value of cash inflows and present value of cash outflows.