Bank Lending Decision Criteria: The practice of private banks

The application of CAMPAIR in lending decision in the Ethiopian private banks

Locating Sources of Financing

I. Internally generated funds: These are the most frequently and easily employed sources.
They are needed to generate short term funds and can come from several sources.
 Personal savings
 Funds from friends, relatives, and local investors
 Selling used assets
 Collecting bills (accounts receivables) quickly.
 Leasing an item that allows another party to use in exchange for regular payments
 Issuing bonds. Bonds are certificate of indebtedness that is sold to raise funds. Each bond
has denominations or amount of loan represented on it. They can be secured which are
backed by specific property that will be passed the bondholders, unsecured or debentures
that are not backed by collateral but on the general good name and earning power of the
issuer that the bonds will be paid at the maturity date, subordinate debentures that the
bond holder is honored to claim against the issuing firms assets as a second option in the
event of default.

Secured bonds can also be classified as: Mortgage bonds backed by buildings,
equipment, and land in the agreement that are less risky. Income bonds on which the
issuing firm is required to pay the interest only when the firm earns enough money. If it
does not earn the money to pay the interest, none is paid until the next year. Industrial
development bonds issued by the state and local governments to raise money for
industrial projects that will the local economy as stated in the objective of the project.
 Sale of capital stock (equity) which is made available in two forms: (1) Private placement
–This is selling the firm’s capital stock to selected individuals who are most likely to be
the firm’s employees, local residents, customers, suppliers, and owner’s acquaintances or
to private investors who might be families, friends, or wealthy individuals who frequently
require advice in making investment decisions. Some investors want take an equity
position in the firm and can influence the nature and direction of the business. Others
play an advisory role in the direction and day-to-day operation of the venture and want to
share in its profits. (2) Public sale - making capital stock available for sale to the general
public.

There are two classes of stock: Common stock which gives ownership title to investors
who purchase a share/stock. They are entitled to get a stock certificate that signifies
ownership of the company/firm. Preferred stock gives certain special
privileges/preferences to its holders than common stock holders such as paying dividends
to them before paying to common stock holders and the rights to receive their share to
whatever asset left if the firm fails after the firm’s debts like for bondholders have been
paid.
 Reducing the working capital such as inventory, cash, and other short term assets.
 Profits: Plowing all the profits back into the venture before any outside investors expect
payback in the early years.
II. External sources of financing: External sources of financing required can be influenced by
the length of time the funds are required, the costs or the prevailing interest rate involved, and
the amount of company’s control over them. They fall in one of the two categories: debt
financing or equity financing.
 Debt financing is a financing method involving on interest bearing loan, the payment for
which is only indirectly related to the sells & profits of the new venture. It requires some
assets such as car, house, machine, or land as collateral. Thus, it is secured loan for the
creditor.
 Equity financing does not require collateral and offers the investor some form of
ownership positions in the venture. The investors share in the profits of the venture and
on any disposition of assets.

Frequently, the entrepreneur’s financial needs are met by employing a combination of debt and
equity financing. They more frequently used sources of funds include
1. Bank loans
2. Trade credits
3. Small business administration loans
4. Research & Development limited partnerships
5. Government grants
6. Venture capital

1. Bank loans: Banks frequently provide secured or unsecured loans. When they provide
secured loans, they require tangible assets such as land, equipment, building/a house, car, stock
or bonds of the entrepreneur &/or the assets of the consigner who will guarantee that the loan
will be repaid. The unsecured loans are offered based on cash flow of the venture.

(a) The asset based loans

 Accounts receivables provide a good basis for pledging short term loans, especially if
the customer base is solid and credit worthy. But banks do not provide 100% of the
accounts receivable. Banks and others sometimes purchase accounts receivables at a
value below the face value of the sell and collects the money directly from the
account/customer. This process is known as factoring.
 Inventory is often a basis for a loan particularly when the inventory can be sold
easily. Finished goods inventory such as automobiles and appliances can be financed.
 Used/new equipment is used to secure longer term financing. The amount of loan
depends on the salability of that equipment secured.
 Real estate such as land, plant, or building is used to secure mortgage loans.
(b) Cash flow financing loans
 Lines of credit financing: The borrower pays a commitment fee at the start to ensure
that the bank will make the loan when requested and then pays interest on any
outstanding funds borrowed from the bank. Frequently, the loan must be repaid on a
periodic basis.
 Installment loans obtained based on track records of sales and profits. They are short-
term funds used to cover working capital needs.
 Long term loans: These are loans used to finance long-term programs and repaid
according to a fixed interest and scheduled period.
 Character /personal/ loans: These are loans secured when the business itself does not
have the assets to support a loan. They are consigned by another individual.
Thus, banks make lending decisions based on the 5 C’s: character, capacity, capital, collateral
& conditions. Bankers also use CAMPAIR as a framework for making lending decisions which
means.

1. Character: What is the business track record of the persons credit history, honesty &
integrity which are difficult to judge.
2. Ability (Capacity): How able is the owner manager to make the plan happen? This is
about their managerial, financial and business ability.
3. Management: Is the management team adequate? The quality of management can be
judged by the relevant business experience, education, training and proven luck record.
4. Purpose: What is the purpose of the loan? Is it consistent with bank policy? Is it legal? Is
it in the best interest of the business?
5. Amount (capital): Is the amount requested correct? Have all associated costs for the
project been included? Has the borrower put some money in themselves? Is there a
contingency?
6. Insurance (Collateral): Is security necessary? Is the security properly valued? Is
personal and business collateral required?
7. Repayment: Will the business generate sufficient cash to make the interest payments and
repay the capital? Is the repayment term realistic?

2. Supplier’s credit (trade credits): Most suppliers are willing to offer credits to their business
customers. Buyers purchase products on credit and take few more days to pay their bills. In
effect, the supplier finances the buyer.

3. Small Business Administration (SBA) loans: SBA guarantees a certain percent of the
amount loaned to the entrepreneur’s business to the bank if the company (entrepreneur) cannot
make payment. This guarantee allows the bank to make a higher risk loan to a business than it
would otherwise make. This procedure is the same as that securing a regular loan, except that
appropriate government forms and documentation are also needed. The forms are used to
minimize the time involved in the government’s processing and approving the loan. Both long
and short term loans can be guaranteed by the SBA.

SBA Loan Application Procedure

1. Assemble the information outlined below.
2. Take it to your bank and ask your banker to review the information and loan proposal. It
will be necessary for you to locate a bank that is willing to participate with SBA and
make the loan since direct loan funds from SBA are quite limited and an unreliable
source of financing.
3. If the bank is willing to participate, ask the bank to forward the information to us for our
review, along with their comments.

Information Needed for Loan Review

1. Brief resume of business.
2. Brief resume of management, prior business experience, technical training, education,
age, health, etc.
3. Itemized use of loans:
Working capital ____________
Land ____________
 Building ____________
Furniture and fixtures ____________
Machinery and equipment ____________
Automotive equipment ____________
Other ____________
Total ____________
4. Current business balance sheet and profit/loss statement.
5. Year-ending balance sheets and profit/loss statements for the last three years or, if the
business has been in existence less than three years, furnish the financial statements for
each year it has been in operation. Copies of the financial statements submitted with the
income tax returns are adequate.
6. If the business is not in existence but is proposed, furnish a projected balance sheet of the
business showing its proposed assets, liabilities, and net worth upon commencement of
operations, together with projected annual operating statements for the first three years of
operation.
7. Furnish a separate personal balance sheet showing all assets owned and liabilities owed
outside of the business.

4. Research and Development (R&D) Limited Partnerships

These are additional possible sources of funds for entrepreneurs in a high-technology area.
Instead of using debt from lenders, equity from owners, or cash from internal operations, this
method of financing provides funds from investors looking for tax shelters. A typical R & D
partnership arrangement involves a contract between the sponsoring company to develop the
technology and the limited partner to provide the funds. This kind of financing sources is good.
This is because:
 Small entrepreneurial companies locking access to capital markets.
 When the project involves a high degree of risk and shares the risks and rewards together.
 When the new venture requires significant amount of expense in doing R&D.
 It can increase business and make available flexible financial plan by providing
alternative sources of funding.

5. Government Grants: Sometimes entrepreneurs can obtain grant money to develop and
launch their innovating idea from the government. A program of particular interest can be
designed for the small business. The program provides an opportunity for small businesses to
obtain R&D money but provides a uniform method by which each participating agency solicits,
evaluates and selects the research proposals for funding.

6. Venture Capital: This is one of the least understood areas in the entrepreneurial process. It is
an alternative form of equity financing for small businesses. It focuses on high risk
entrepreneurial businesses by providing start-up capital (seed money) to new ventures. It is
necessary at the early stages of financing relatively small firms. It is provided for ventures that
need capital for acquisition and technologically growing companies. Thus, it is a development
fund to businesses.
Other principal investors in the venture can be capital limited partnerships, pension funds,
endowment funds, and foreign investors that are managed by a general partner (venture
capitalists).

Preparing a Financial Proposal

Once the type, quantity and the most likely sources of capital needed is determined,
entrepreneurs must develop a financial proposal consisting of the following sections after
collecting and properly analyzing the needed information and discussing the problems that are
likely to face the proposed business.
(1) Initial financial requirement
(2) Profit and loss forecast
(3) Cash flow forecast
(4) Break-even analysis
(5) Projected sources of finance
(6) Estimated balance sheet
(7) Ownership interest
(8) Risks & contingency plans

7.1. Capital Requirements for Small Businesses

To accurately determine the capital requirements for small businesses, the owner should first of
all clearly understand the different types of capital including working capital, fixed capital,
promotional expense capital, and funds for personal expenses.
Working Capital
The term “working capital” is often used to refer to a firm’s total current assets. It is defined
precisely as the excess of current assets over current liabilities. Circulating capital, a term which
is sometimes applied to working capital, emphasizes its constant change from cash to inventory
to receivables to cash, and so on. Working capital includes cash, receivables, inventories, and
marketable securities. Since the latter is readily converted to cash, only the first three items will
be discussed here.

Cash. Every firm must have the cash essential for current business operations. A reservoir of
cash is needed because of the uneven flows of funds into the business (as income) and out of the
business (expense). The size of this reservoir is determined not only by the volume of sales but
also by the regularity of cash receipts and cash payments. Uncertainties also exist because of
unpredictable decisions by customers as to when they will pay their bills and because of
emergencies calling for substantial cash outlays. If an adequate cash balance is maintained, the
firm can phase such unexpected developments and irregularities in stride.

Accounts & Notes Receivable. The firm’s accounts receivable consist of payments due from its
customers. If the firm expects to sell on a credit basis—and in many of business this is virtually
imperative—provision must be made for financing receivables. The firm cannot wait until its
customers pay to restock its shelves. Of course, the proportion of cash and credit sales
significantly affects the size of receivables, as do the terms of sale offered to credit customers.
The size of the receivables is likewise affected by seasonality of sales and by changes in business
conditions which influence promptness of payment by many customers.
Inventories. Although their relative importance differs considerably from one type of business
to another, inventories often constitute a major part of working capital. Factors affecting the size
of the minimum inventory include the seasonality of sales and production. Retail stores, for
example, may find it desirable to carry a larger-than normal inventory during the Christmas
season.

Fixed Capital
Fixed assets are the relatively permanent assets that are intended for use in the business rather
than for sale. For example, a delivery truck used by a grocer to deliver merchandise to customers
is a fixed asset. In the case of an automobile dealer, however, a delivery truck to be sold would
be a part of the inventory and thus a current asset. The types of fixed assets needed in a new
business may include the following:
1. Tangible fixed assets. These include assets like building, machinery, equipment, and
land-including mineral rights, timber, and the like.
2. Intangible fixed assets—including patents, copyrights, good will. Many new firms have
no intangible fixed assets.
3. Fixed security investments. These include stocks of subsidiaries, pension funds, and
contingency funds. In most case, a new business has no fixed security investments.
The nature and size of the fixed asset investment are determined by the type of business
operation. A modern beauty shop, for example, may be equipped for around $40,000, whereas a
motel sometimes requires fifty or more times that amount. In any given kind of business,
moreover, there is a minimum quantity or assortment of facilities needed for efficient operation.
It would seldom be profitable, for example, to operate a motel with only one or two units. It is
this principle, of course, that excludes small business from automobile manufacturing and other
types of heavy industry. A firm’s flexibility is inversely related to its investment in fixed assets.
Investments in land, buildings, and equipment involve long-term commitments. Equipment is
typically specialized, and substantial losses and delays often occur underscores the importance of
a correct evaluation of fixed asset needs.

Promotional Expense Capital

Those who expend time and money establishing or promoting a business expect repayment of
their personal funds and payment for their services. Payment of the promoter may take the form
of a cash fee or of an ownership interest in the business. Of course, many new businesses come
into being as sole proprietorships, with the entrepreneur acting as the promoter. In this case the
proprietor must have sufficient funds to pay all necessary out-of-pocket promotional costs.

Funds for Personal Expenses

In the truly small business, financial provision must also be made for the personal living
expenses of the owner during an initial period of operation. Technically this is not a part of the
business capitalization, but it should be considered in the business financial plan. Inadequate
provision for personal expenses will inevitably lead to diversion of business assets and departure
from the financial plan.
7.2. Estimating Capital Requirements
If the business is to be an entirely new venture, the entrepreneur quickly feels the need for a
“crystal ball” to use in making forecasts. If an established business is being taken over, the
uncertainties are reduced, but they are by no means eliminated.

As a first step in estimating capital requirements, the volume of sales should be estimated. One
approach to sales prediction is to select a desired profit figure and to work backward from that to
sales. Suppose that the proposed business is a job printing shop and that the prospective
entrepreneur hopes to earn annual profits of $30,000. If the industry standard ratio shows that job
printers typically earn 5 percent on sales, the prospective entrepreneur must then achieve sales of
20 times the proposed profit, or $600,000.

The $600,000 sales figure now constitutes the minimum sales one must secure to make the
venture sufficiently attractive. It does not prove, however, that the proposed business will
guarantee this amount of sales. In fact, this figure should be cross-checked in as many ways as
possible. In an existing business, past sales records should be compared with the estimated sales
figure. In a new business, the sales records of other, somewhat similar firms may provide a
bench mark for checking.

Having arrived at a sales estimate as objectively as possible, the next step is to compute the
amount of assets necessary for that particular sales volume. The prospective entrepreneur may
use the double-barreled approach of applying industry standard rations and cross-checking by
empirical investigation. Bankers, trade associations, and other organizations compile industry
standard ratios for numerous types of business. If no standard data can be located, then
estimating inevitably involves educated guesswork.

Estimating Inventory Requirements

Suppose a retailer’s estimated sales is $600,000 and the standard sales-to-inventory ratio is 6.
This means that the retailer would need a $100,000 inventory to keep up with the industry ratio
of 6 ($600,000÷6 = $100,000).

In analyzing inventory requirements, the specific type and quantities of items to be kept in
inventory must be considered. In the case of a clothing retailer, for example, the entrepreneur
must make a distribution by sizes and styles of items to be sold to customers. The cost in
stocking this merchandise can then be computed by reference to prices quoted by suppliers. A
prospective manufacturer identifies the types and quantities of raw materials to be kept on hand,
considering the rate of usage, location of suppliers, and the time required to replenish. Schedules
may also be prepared showing the labor and material costs going into the production process so
that adequate provision is made for both finished goods inventory and work-in-process
inventory.

Estimating Accounts Receivable

The average collection period is the average length of time that a firm must wait after making a
sale before it receives cash. It measures the turnover of accounts receivable. This period is
computed in two steps:
1. Divide annual sales by 360 to get the average daily sales.
2. Divide accounts receivable by daily sales to find the number of days’ sales tied up in
receivables.
Using the same retailer as an example, suppose that the average collection period for the industry
is 36 days. The level of accounts receivable that the retailer must maintain to conform to the
industry standard may be calculated as follows:
Step 1: $600,000 = $1,666 average daily sales
360
Step 2: Accounts receivable = 36 days
1,666
Accounts receivable =36×1,666 =60,000

Estimating Cash Requirements

For a new business, the standard amount of cash that is specified by the industry may be too
small. It is customary and desirable therefore, to provide cash reserves to meet anticipated
expenditures as well as unexpected contingencies. Anticipated payments for labor, utilities, rent,
supplies, and other expenses following initiation of the firm must be studied. And a generous
amount of cash must be set aside for unexpected expenses.

In many types of business, a cash balance adequate to pay one or two months’ expenses is
desirable. But the prospective entrepreneur should realize that much subjective judgment is
needed in estimating the desired cash balance for a particular business.

Estimating Fixed Assets Requirements

The fixed asset turnover is defined as the ration of sales to fixed assets. It measures the extent to
which plant and equipment are being utilized productively. Again using the same retailer with
estimated sales of 600,000 as an example, suppose that the industry fixed asset turnover is 4.
This indicates that the retailer would require 150,000 in fixed assets to conform to the industry
standard (600,000÷ 4=150,000).

It is possible that firms beginning operation may differ somewhat from existing small firms in
the sources of capital which they use. Unfortunately completely adequate data are not available.
It is probable that personal savings are more important for the beginning business than for the
existing firm.
The sources of funds discussed in this chapter are particularly important in establishing the
original financial structure of the new firm. Of course, these and other sources of funds are used
both in initial financing and in the subsequent day- to-day financing of business operations.

7.3. Sources of Funds for Initial Financing

Initial capital consists of owner capital and creditor capital. Traditionally it is said that owner
capital in a new firm should be at least two thirds of the total initial capital. If the venture
involves a total initial capital of $12,000 for example, the owner should invest $8,000 from
personal funds. The balance of $4,000 would then be supplied by creditor capital in the form of
bank loans, loans from individuals, trade credit, or credit from equipment suppliers. This “two
thirds” dictum is quite conservative, and many small businesses are started with ownership
equities that are smaller. However, many small firms fail every year due to inadequate ownership
equity. In the following few sections, we briefly describe the different sources of initial finance
for small businesses.

Personal Savings
Although stock may occasionally be sold to outsiders, the ownership equity for a beginning
business must typically come from personal savings. It is not only difficult but also hazardous to
borrow venture capital. The requirement of fixed interest charges and definite dates of repayment
means results in failures if prospects fail to materialize exactly as expected. It is for this reason
that two thirds ownership equity was recommended earlier in this chapter.

Commercial Bank Loans

Although commercial bankers tend to limit their lending to working capital needs of going
concerns, some initial capital does come from this source. If the small firm is adequately
financed in terms of equity capital and if the entrepreneur is of good character, the commercial
bank may loan on the basis of signature only. Of course, this is less likely for the beginning firm
than for the established one. In any event, collateral and/or personal guarantees are often
required.

Trade Credit
Credit extended by suppliers is of unusual importance to the beginning entrepreneur. In fact,
trade (or mercantile) credit is the small firm’s most widely used source of short-term funds.
Trade credit is of short duration—30 days being the customary credit period. Most commonly,
this type of credit involves an unsecured, open-book account. The supplier (seller) sends
merchandise to the purchasing firm and sets up an account receivable. The buying firm sets up
an account payable for the amount of the purchase.

In considering the use of trade credit, attention should be given to the pertinent cost. There may
be a cost of not using trade credit if payment is made before the permissible date for lowest cash
payment. By paying early, the firm commits funds that might have been used for other purposes.
The more critical cost, however, is the cost involved in failure to take an offered cash discount.
Normally both bank loans and trade credit should be used only for working capital. Other use of
such credit is risky to both parties.

Equipment Loans and Lease

Some small businesses—restaurants, to take only one example—utilize equipment that may be
purchased on an installment basis. A down payment of 25 to 35 percent is ordinarily required,
and the contract period normally runs from three to five years. The manufacturer or supplier
typically extends credit on the basis of a conditional sales contract. During the loan period, this
equipment cannot serve as collateral for a bank loan.

There is a danger in contracting for so much equipment that it will be impossible to meet
installment payments. It is a mark of real management ability to recognize the desirable limits in
borrowing of this type.

Equipment leasing, a practice that has grown rapidly in recent years, provides an occasionally
attractive alternative to equipment purchase. Cars, trucks, business equipment, and machinery
used in manufacturing are examples of assets that may be obtained in this way. Possible
advantages of leasing equipment include the greater flexibility of investment and the smaller
capital requirement made possible by leasing. Offsetting these advantages is the typically higher
total cost of leasing rather than purchasing.

Funds from Friends, Relatives, and Local Investors

At times, loans from friends or relatives may be the only available source of new small business
financing. However, friends and relatives who provide capital loans may tend to feel that they
have the right to interfere in the management of the business. If they are indeed the only
available source, it is desirable that the initial financial plan provide for repayment within the
first six months of operation.

Local capitalists—for example, lawyers, physicians, or others who wish to invest funds—are
better sources. But the small firm must compete with other investment opportunities for the
resources of such financial “backers.” Local capitalists are not inclined to invest money in risky
small business ventures unless there is the prospect of a significantly better rate of return than is
available elsewhere. The entrepreneur must also surrender some degree of control in this type of
financing. For these reasons, such equity sources are used less frequently than other sources and
are typically arranged as a last resort by the promoter.

The need for additional funds varies with a firm with a firm’s age and stage of development. A
new business typically has strained finances, and its resources are used fully. Its working capital
is often too little. But, as the business matures under sound management, available assets become
more clearly compatible with the firm’s operating needs. Under these conditions capital
resources also become more plentiful due to the farm’s history of successful operations. It is the
new, rapidly expanding firm; therefore, that experiences the most serious shortages of long-term
funds.

7.4. Sources of Funds for the Going Concern

As the business matures under sound management, available assets become more clearly
compatible with the firm’s operating needs. Under these conditions capital resources also
become more plentiful due to the firm’s history of successful operations. It is the new, rapidly
expanding firm; therefore, that experiences the most serious shortages of long term funds. The
sources of fund for the going concern are debt and equity.

I. Sources of Funds for the Long-Term Capital Needs

The source of funds for launching a new business discussed before may continue to provide
capital after the business is under way. In this section we are concerned with other sources of
funds for long term capital needs of the going business.

Retained Earnings
Realized profits that are plowed back into the business, or retained earnings, constitute a major
source of funds for financing small business expansion. Such internally generated funds may be
invested in physical facilities or used to expand the firm’s working capital. It is likely that the
majority of small firms experience an annual growth in net worth as a result of retained earnings.

In using retained earnings, the rate of expansion is limited by the amount of profits generated by
the business. In the case of a rapidly expanding small firm, these funds are often insufficient to
meet the heavy capital needs. Financing through retained earnings provides a conservative
approach to expansion. The dangers of over expansion or expansion that is too rapid are largely
avoided. Because the additional funds are equity, the firm has no creditors threatening
foreclosure and no due dates by which repayment must be made.

The lack of an interest charge on funds secured in this way may create the impression that there
is no cost involved in their use. Even though there is no out-of pocket cost, there is a definite
opportunity cost involved. This opportunity cost is the dividend foregone by stockholders.
Presumably the stockholders could have reinvested their dividends in other income-generating
opportunities.

Sale of Capital Stock (Shares)

A second source of expansion capital is available through the sale of capital stock to outsiders.
This involves, of necessity, a dilution of ownership, and many owners are reluctant to take this
step for that reason. Whether the owner is wise in declining to use outside equity financing
depends upon the long-range prospects. If there is an opportunity for substantial expansion on a
continuing basis and if other sources are inadequate, they decide logically to bring in other
owners. Owning part of a larger business may be more profitable than owning all of a smaller
business.

Shares are of two types-equity shares and preference shares. Equity shares represent the
permanent or basic capital of a company. Equity capital is repaid last and dividend on equity
shares is payable only after paying all other interests and dividends. Preference shares carry
preferential rights. Dividends and capital are payable before equity shares. Such shares may be
cumulative or no cumulative, convertible or non-convertible, participating or non-participating.

Debentures
Debentures represent loans and debenture-holders are creditors of a company. Borrowed capital
has several advantages. First, the cost of such capital is generally lower than that of equity.
Secondly, the owner can retain full control over the enterprise. Thirdly, the money can be repaid
as and when not required in business. Lastly, the benefits of trading on equity can be obtained.
On the other hand, ownership capital is permanently available. No fixed burden of interest is
created and there is no charge on the assets of the enterprise.

Debentures can be of several types, e.g. registered or bearer, convertible or non-convertible, etc.
Registered debentures are payable only to the person or business registered as the creditor. On
the other hand, bearer debentures are the ones payable to whoever have the certificate.

Convertible debentures are the debentures, which entitle their holders to get these converted
wholly or partly into shares. Such debentures are usually converted into equity shares as
opposed to non-convertible ones which cannot be converted under any situation. Once converted
into shares, these cannot be converted back into debentures. In case of partly convertible
debentures, a part of the debenture value is converted into shares. The no converted portion is
paid back after the stipulated period. Fully convertible debentures are wholly converted into
shares. The terms of conversion are stimulated at the time of issue of convertible debentures.
The terms include:
(a) The time period over which the debentures can be converted into shares.
(b) The ratio of exchange between debentures and shares

The issue of convertible debentures is permitted under the Companies Act, subject to the
following conditions:
(i) The terms of issue of convertible debentures must be approved by a special resolution
passed by the company in a general meeting, before the issue of debentures.
(ii) The terms should be in conformity with the rules framed by the Government in this
regard.
(iii) If the conversion results in issue of shares at a discount, formalities under the Companies
Act must be compiled with and the sanction of the Company Law Board must be
obtained.
Advantages of Convertible Debentures: - As a source of raising finance, convertible
debentures offer the following benefits:
1. The rate of interest payable on convertible debentures is usually lower than that payable
on non-convertible debentures. Therefore, the cost of raising funds is reduced.
2. When the market for equity shares is dull, convertible debentures can be issued to raise
funds successfully.
3. Interest on debentures is allowed as an expense for calculating taxable income.
Therefore, cost of capital is lesser as compared to that of equity shares.
4. Issue of convertible debentures unlike that of equity shares does not immediately dilute
earnings per share.
Convertible debentures usually appeal to investors who want to make capital gains without
taking the risks involved in direct purchase of equity shares.

II. Sources of Funds for the Short Term Funds

Permanent part of the working capital should be financed through long-term funds. The various
sources of long term funds e.g. shares, debentures, term loans, retained earnings, etc., have been
explained already. The variable part of working capital is funded through short-term funds. The
main sources of short-term finance are as follows:
1. Trade credit
2. Bank credit
3. Public deposits
4. Accrual accounts
5. Advances from customers
6. Factoring

Trade Credit
Trade credit is the credit extended by the seller of goods to the buyer as incidental to sale. It is
also known as mercantile credit. It arises out of transfer of ownership of goods. Trade credit is
available in the ordinary course of business without any security. The volume of trade credit
available to a firm depends upon the reputation of the buyer, financial position of the seller,
volume of purchase, terms of credit, degree of competition in the market, etc.

Trade credit may take two forms: (a) an open account credit arrangement, and (b) acceptance
credit arrangement. In case of open account credit, the buyer has not to sign a formal instrument
of debt. Under acceptance credit, on the other hand, the buyer is required to sign a debt
instrument e.g. a bill of exchange or a promissory note as an evidence of the amount due by him
to the seller. In both the cases, credit is made available to the buyer on an informal basis without
creating any charge on assets.
Merits:
1. Trade credit is easily and readily available because no legal formalities are involved.
2. Credit is available on a continuing and informal basis. The concern is not to approach
anybody and tell that it is short of working capital.
3. No charge is created on the assets of the buyer.
4. Trade credit is a flexible source of working capital. Wherever necessary, the buyer can
delay payment because the seller normally accepts a genuine request. The concern can
earn cash discounts by making payments before the expiry of the credit period.
Demerits:
1) While fixing prices, the seller takes into account the interest, risk and inconvenience
involved in selling goods on credit. Therefore, the cost of trade credit may be very high.
2) Availability of liberal trading which can be harmful.

Bank Credits
Commercial banks are the single largest source of short-term finance for industry. They provide
working funds in the following forms.
1) Loans: Loan is an advance with or without security. A lump sum is given to the
borrower at an agreed rate of interest. The borrower has to pay interest on the total
amount whether he withdraws the full amount of the loan or not. The loan may be repaid
in lump sum or in instalments. Loan may be term loan or demand loan. A 'term loan' is
allowed for a fixed time period whereas a 'demand loan' is payable on demand and is,
therefore, for a short period.
2) Cash credit: It is an arrangement under which the borrower is allowed to borrow money
up to a specified limit. Cash credit limit is fixed after taking into account the paying
capacity and credit worthiness of the client. The credit is given in the form of cash
usually against some security or guarantee. Cash credit is a very flexible source of
working capital. The borrower can withdraw money as and when required. He has to
pay interest on the amount actually withdrawn rather than on thee total unit sanctioned.
3) Overdraft: It is a facility allowed by a bank to its current account holders. The account
holder is allowed to withdraw up to a certain limit over and above the credit balance in
his current account. It is for a very short duration, generally a week and is used
occasionally.
4) Bills Discounted/Purchased: The customer having a bill of exchange arising out of trade
can discount the same with a commercial bank. The term 'discounting of bills' is used
with respect to demand bills.
While sanctioning credit, commercial banks take into account the following factors.
1) Promote, background, managerial competence, creditworthiness and integrity.
2) Technical feasibility of the project in terms of location, size-infrastructure, raw materials,
skilled labor, manufacturing process, etc.
3) Economic viability of the enterprise in terms of future demand and supply position for the
product, marketing arrangements, etc.
4) Financial feasibility and profitability in terms of cost of the project sources of finance,
breakeven point, projected profits, cash flow.
5) Security and guarantee offered.
6) Role of the enterprise in the nation's economy-priority sector or otherwise, employment
generation, export promotion, etc.
Merits
(i) Bank credit is generally a cheaper method of raising working capital
(ii) Bank credit is flexible because banks offer different schemes of financing working
capital.
(iii) Commercial banks serve as a friend, philosopher and guide to their clients in respect of
the most appropriate method of financing and utilization of credit.
(iv) Commercial banks serve as a friend and guide to their clients in respect of the most
appropriate method of financing and utilization of credit.
Demerits
(i) In order to raise funds from commercial banks several documents have to be submitted
and signed. It is a time-consuming and expensive process.
 (ii) Commercial banks generally require hypothecation or pledge of assets for graining credit.
(iii) Commercial banks generally take a very serious view of delay in repayment and interest.

Public Deposits
Many companies invite and accept deposits for short periods from their directors, shareholders
and the general public. This method of raising short-term finance is becoming popular due to
increasing cost of bank credit. Deposits are generally invited for a period ranging from 6
months to five years. Government has to prescribe rules and regulations, which must be
followed by companies inviting public deposits.

Merits
(i) It is a very simple method of financing as very little formalities are involved. A company
has only to advertise and inform the public that it is interested in and authorized to accept
public deposits.
(ii) Public deposits are a relatively less costly source of short-term finance.
(iii) No charge is created against the assets of the company as public deposits are unsecured
loans.
(iv) The rate of interest on public deposits is fixed. Therefore, the company can take
advantage of trading on equity.
Demerits
(i) Public deposits are not a reliable source of finance. It is not available during depression
and financial stringency. Only well reputed firms can raise public deposits.
(ii) This mode of financing can put the company in serious financial difficulties. Even a
rumor that the company is not doing well may lead to a sudden rush of public demanding
premature repayments of deposits.
(iii) Widespread use of public deposits may reduce the supply of industrial scurrilities and
thereby adversely affect the growth of the capital market.

Accrual Accounts
There is a time lag between receipt of income and making payment for the expenditure incurred
in earning that income. During this time large, the outstanding expenses help an enterprise in
meeting some of its working capital needs. For example, wages and taxes become due but are
not paid immediately. Wages and salaries are paid in the first week of the month next to the
month in which services were rendered. Similarly, a provision for tax is created at the end of the
financial year but tax is paid only after the assessment is finalized.

Merits
(i) Accrual accounts are a spontaneous source of finance as these are self-generating.
(ii) Financing through accruals is an interest free method and no charge is created on the
assets.
(iii) As the size of business increases the amount of accruals also increase.
Demerits
(i) An enterprise cannot indefinitely postpone the payment of wages/salaries and taxes.
Therefore, it is not a discretionary source of finance.
(ii) This source should be used only as a matter of last resort.
Factoring
Factoring is an arrangement under which a financial institution (called factor) undertakes the
task of collecting the book debts of its client in return for a service charge in the form of discount
or rebate. The factoring institution eliminates the client's risk of bad debts by taking over the
responsibility of book debts due to the client. The factoring institution advances a proportion of
the value of book debts of the client immediately and the balance on maturity of book debts.
Merits
(i) As a result of factoring services, the enterprise can concentrate on manufacturing and
selling.
(ii) The risk of bad debts is eliminated.
(iii) The factoring institution also provides advice on business trends and other related
matters.
Demerits
(i) A substantial amount of discount or rebate has to be paid to the factoring concern.
(ii) If the factoring institution uses strong-arm tactics to collect money it mill spoil the image
and relations of the firm with its customers.

Advances from Customers

Manufacturers and suppliers of goods that are in short supply usually demand advance money
from their customers at the time of accepting their orders. For example, a customer has to make
an advance at the time of booking a car, a telephone connection etc. Similarly, contractors
constructing buildings, etc. requires an advance from the client. In some businesses it has
become customary to receive advance payment from the customers. This is a very cheap source
of short-term finance because either no interest is payable or the rate of interest payable on
advance is nominal.

7.5. Undertaking Financial Evaluation

Undertaking financial evaluation requires first and foremost accounting records. This is so
because accounting records are designed to summarize the financial results of business
transactions and to portray the firm’s financial condition. As a minimum, the accounting records
should provide information concerning the following:
1. Assets, including real estate, equipment, inventory, receivables, and cash.
2. Liabilities to banks, suppliers, employees, and others.
3. Owner’s equity in the firm.
4. Sales, expenses, and profit for the accounting period.

An accounting system should accomplish the following objectives for small businesses:
1. The system should yield an accurate, thorough picture of operating results.
2. The records should permit a quick comparison of current data with prior years’ operating
results and with budgetary goals.
3. The records should provide suitable financial statements for use by management,
bankers, and prospective creditors.
 4. The system should facilitate prompt filing of reports and tax returns to regulatory and tax
collecting agencies of the government.
5. The system should reveal employee frauds, thefts, waste, and record-keeping errors.

Any accounting system, of course, must be consistent with accepted principles of accounting
theory and practice. This means that a business must be consistent in its treatment of given data
and given transactions. For this reason the services of a public accountant ordinarily are required.
Designing an accounting system is seldom well done by the amateur. Most modern accounting
systems are based on an accrual, rather than a cash, system. In a cash system, the accounts are
debited and credited as cash is received and paid out. In the accrual system, income earned and
expenses incurred are recorded at the time the sale made or the expense is incurred. The use of
the accrual method is preferable because it provides a more nearly accurate and up-to-date
statement of profits.

The major types of accounting records and the financial decisions to which they are related are
briefly described below.
1. Accounts Receivable. Records of receivables are vital not only to decisions on credit
extension but also to accurate billing and to maintenance of good customer relations.
Analysis of these records reveals the degree of effectiveness of the firm’s credit and
collection policies.
2. Accounts Payable. Records of liabilities show what the firm owes, facilitate the taking of
cash discounts, and allow payments to be made when due.
3. Inventory Records. Adequate records are essential to the control and security of inventory
items. In addition, they supply information for use in purchasing, maintenance of adequate
stock levels, and computation of turnover ratios.
4. Payroll Records. The payroll records how the total payments to employees and provide the
base for computing and paying the various payroll taxes.
5. Cash Records. Carefully maintained records showing all receipts and disbursements are
necessary to safeguard cash. They yield a knowledge of cash flow and balances on hand;
such information is essential for the proper timing of loans and for assurance of cash of pay
maturing obligations.
6. Other Records. Among other accounting records which are vital to the efficient operation of
the small business are the insurance register, which shows all policies in force; records of
leaseholds; and records covering the firm’s investments outside of its business.

Typical Financial Statements

The preparation of financial statements is made possible by the existence of accurate and
thorough accounting records. There major financial statements of the YILMA Manufacturing
Company, a hypothetical small corporation, are illustrated in this section. Two of these
statements—the income statement and the balance sheet—will be referred to in the discussion of
financial ratios later in the chapter.

Income Statement: The income statement shows the results of a firm’s operations over a period
of time, usually one year. The income statement of the YILMA Manufacturing Company is
indicated below. A minor variation would be involved in preparing an income statement for a
retailing or wholesaling, rather than a manufacturing, firm. Specifically, the “Cost of Goods
sold” section would make reference to purchases rather than manufacturing costs.
Balance Sheet: The balance sheet is a statement that shows a firm’s financial position at a
specific data. The following figure shows the balance sheet of the YILMA Manufacturing
Company as of June 30, 1979. If this firm were a proprietorship or partnership, the heading
“Stockholders’ Equity” would read “Capital.” The items listed below it would show individual
ownership investments.

Analysis of Financial Statements

A single item from a financial statement has only limited meaning until it is related to some
other item. For example, current assets of 10,000 mean one thing when current liabilities are
5,000 and another when they are 50,000. For this reason ratios have been developed to relate
items to each other & income statement items to balance sheet items.

Ratios Related to Working Capital Position

Adequacy and liquidity of working capital are measured by two ratios: the current ratio & the
acid-test (or quick) ratio.

Current Ratio. The current ratio is computed by dividing current assets by current liabilities.
The “banker’s rule” for this ratio is “at least two to one” for working capital to be judged
adequate. Actually the proper size of this ratio depends upon the type of industry, the season of
the year, and other factors. The current ratio of the YILMA Manufacturing Company is: Current
assets=173,865=3.05
Current liabilities 56,915

For this it appears that the YILMA Manufacturing Company has sufficient cash and other assets
which will be quickly converted into cash to pay all maturing obligations.

Acid-test (Quick) Ratio. A more severe test of adequacy of working capital is provided by the
acid-test, or quick, ratio. It is computed by dividing current assets less inventories by current
liabilities. The exclusion of inventories from current assets is necessary because inventories are
in part a fixed capital investment and are less liquid than other current assets. The YILMA
Manufacturing Company’s acid-test ratio is:
Current assets less inventories=173,865-105,725=1.20
Current liabilities 56,915

The traditional rule of thumb is a minimum of 1 to 1 acid-test ratio. Again it appears that
YILMA Manufacturing Company’s working capital position is sound.
Ratios Related to the Sales Position
Comparisons between the level of sales and the investment in various asset accounts involve the
use of three ratios: inventory turnover, average collection period, and fixed asset turnover. They
indicate the need for a proper balance between sales and various asset accounts.

Inventory Turnover. The inventory turnover rate shows whether or not a company is holding
excessive stocks of inventory. In the previous discussion we used an inventory turnover ratio to
estimate inventory requirements. When computing this ratio for a going concern, two questions
arise:
a) Since sales are at market prices and inventories are usually carried at cost, which is more
appropriate to use as the numerator in the ratio: sales or cost of goods sold? And
b) Which inventory figure should be used: an average inventory or an inventory at one
point in time?

Logic requires computation of inventory turnover by comparing cost of goods sold to inventory.
As a rule, however, it is better to use the ratio of sales to inventories carried at cost because
established compilers of sales during the year. The YILMA Manufacturing Company’s
inventory turnover rate is computed as follows:
Sales =415,100=9.3 times
Average inventory 44,750

If the industry average is 9, for example, it is obvious that the YILMA Manufacturing Company
is not carrying excessive stocks of inventory. Excessive inventories are unnecessary and would
reduce business profits.

Average Collection Period - the average collection period is a measure of accounts receivable
turnover. The two step procedure for finding the average collection is:

Step-1 sales=415,100=1,153 average daily sales

360 360
Step-2 Receivables=39,000=33.8 or 34 days
Average daily sales 1,153

If the industry average collection is 20 days, then it would appear that YILMA Manufacturing
Company is experiencing serious collection problems.
Fixed Asset Turn Over- The fixed asset turnover measures the extent to which plant and
equipment are being utilized. For YILMA Company the fixed asset turnover is:
Sales =415,100=1.58 times
Fixed assets 262,400

If the industry average is 4 times, this means that YILMA’s plant and equipment are not being
used effectively. This should be borne in mind when considering requests for additional
equipment.
Ratios Related to Profitability
Profitability is the net result of a firm’s management policies and decisions. The ratio that may
be used to measure how effectively the firm is being managed are the following:

Profit Margin on Sales- the profit margin on sales gives the profit per dollar of sales. It is
computed by dividing net profit by sales. For the YILMA Manufacturing Company, the profit
margin on sales is:
Net profit = $ 24,450 =0.0589 or 5.89 percent
Sales $ 415,100
If the industry average is 5 percent, YILMA’s slightly higher profit margin indicates effective
management of sales and operations.

Return on Total Assets- the return on total assets, or asset earning power, measure the return on
total investment in the business. It is computed by dividing net profit by total assets. The
YILMA Manufacturing Company’s return on total assets is:
Net profit = $ 24, 450 = 0.527 or 5.27 percent
Total assets $ 463,765
If the industry average is 8 percent, YILMA’s low rate may indicate an excessive investment in
fixed assets even though its profit margin on sales is slightly better than industry’s average.

Return On Net Worth (Return On Equity) - the return on net worth, or equity, measures the rate
of return on stockholders’ investments in the business. It is computed by dividing net profit by
net worth. The return on net worth is computed as follows:
Net profit = $ 24, 450 = 0.0797 or 7.97 percent
Owner’s Equity 306,850
If the industry average is 10 percent, it would appear that YILMA’s return is unsatisfactorily
low. YILMA’s return on net worth may be improved by using by using more debt.
Ratios Related to Debt Position
One of the most critical aspects of financial structure of a firm is the relationship b/n borrowed
funds and invested capital. If debt is unreasonably large when compared with equity funds, the
firm may be in great danger. According to the conservative rule of thumb, two third of the total
capital in business should be owner-supplied. The ratios that may be used to measure the debt
position of a firm are debt to total assets and times interest earned.

Debt to Total Asset Ratio - The debt to total asset ratio is a ratio that measures the percentage of
total funds that have been provided by a firm’s creditors. It is computed by dividing the total
debts (current liabilities and long term liabilities) by total assets. The YILMA Manufacturing
Company’s debt ratio is:
Total debts = $ 156,915 = 0.3383 = 33.83%
Total Assets $ 463,765

It is evident that YILMA manufacturing Company’s debt ratio conforms to the conservative rule
of thumb that YILMA should be able, if desired, to borrow additional funds without first raising
more equity funds.

Times Interest Earned -The times interest earned ratio measures the extent to which a firm’s
earnings can decline without impairing it ability to meet annual interest costs. The YILMA
Manufacturing Company’s times interest earned ratio is computed as follows:
Operating income = $ 44,550 = 8.9 times
Interest charges $ 5,000
If the industry average is 8 times, it is obvious that YILMA’s position is strong and that it can
cover its interest charges even with a substantial decline in its earnings. This reinforces the
previous conclusion that YILMA should have little difficulty if it tries to borrow additional
funds.

7.6. Capital Budgeting and Project Preparation

After assessing the availability of expansion capital the most profitable use of such funds must
be determined by appraising the alternative investment opportunities. This process of planning
expenditures whose returns are expected to extend well into future is called capital budgeting.
Capital budgeting assumes that the firms supply is limited and it should be rationed in such a
way as to provide for best investment proposals.

Importance of Capital Budgeting

The importance of capital budgeting stems from the following three interrelated reasons:
1. Long term effects - the consequences of capital expenditure decision extend far into the
future. The scope of current manufacturing activities of a firm is governed largely by capital
expenditures in the past. Like wise, current capital expenditure decisions provide the
framework for the future activities. Capital investment decisions have an enormous bearing
on the basic charter of a firm.
2. Irreversibility - The market for used capital equipment in general is ill-organized. Further,
for some type of capital equipments, customs made to meet specific requirements, the market
may virtually be non-existent. Once such equipment is acquired, reversal of decision may
mean scrapping the capital equipment. Thus, a wrong capital investment decision often
cannot be revered without incurring a substantial loss.
3. Substantial outlays- Capital expenditures usually involve substantial outlays. An integrated
steel plant, for example, involves an out lay of several thousand millions. Capital costs tend
to increase with advanced technology.

Difficulties of Capital Budgeting

While capital expenditure decisions are extremely important, they also pose difficulties which
stem from three principal sources:
1. Measurement problems – identifying and measuring the costs and benefits of a capital
expenditure proposal tends to be difficult. This is more so when a capital expenditure has a
bearing on some other activities of the firm( liking cutting into the sales of some existing
product) or has some intangible consequences(like improving the morale of workers)
2. Uncertainty- a capital expenditure decision involves costs and benefits that extend far in to
future. It is impossible to predict exactly what will happen in future. Hence, there is usually a
great deal of uncertainty characterizing the costs and benefits of a capital expenditure
decision.
3. Temporal spread- the costs and benefits associated with a capital expenditure decision are
spread out over a long period of time, usually 10-20 years for industrial projects and 20-50
years for infrastructure projects.

Phases of Capital Budgeting

Capital budgeting is a complex process which may be divided into five broad phases: planning,
analysis, selection, implementation, and review.
1. Planning- the planning phase of a firm’s capital budgeting process is concerned with the
articulation of its broad investment strategy and the generation and preliminary screening of
project proposals. The investment strategy of a firm delineates the broad areas or types of
investment the firm is planning to take. This provides the frame work which shapes, guides,
and circumscribes the identification of individual project opportunities. Once the project
proposal is identified, it needs to be examined. To begin with, a preliminary project analysis
is done. This exercise is meant to assess:
i. whether the project is prima-facie worthwhile to justify a feasibility study
ii. what aspects of the project are critical to its viability and hence warrant an in-depth
investigation.
2. Analysis- If the preliminary screening suggests that the project is prima facie worthwhile, a
detailed analysis of the marketing, technical, financial, economic and ecological aspects is
undertaken. The question and the issue raised in such a detailed analysis are described in the
following sections. The focus of this phase of capital budgeting is on gathering, preparing,
and summarizing relevant information about various project proposals which are being
considered for inclusion in the capital budget. Based on the information developed in this
analysis, costs and benefits associated with the project can be defined.
3. Selection-Selection follows, and often overlaps, analysis. It addresses the question –Is the
project worthwhile? A wide range of appraisal criteria have been suggested to judge the
worthwhile ness of a project. They are divided in to two broad categories: non-discounting
criteria and discounting criteria. The principal non-discounting criteria are the payback
period and the accounting rate of return. The key discounting criteria are net present value,
the internal rate of return, and the benefit cost ration.
4. Implementation- the implementation phase for an industrial project, which involves setting
up of manufacturing facilities, consists of several stages: project and engineering designs,
negotiations and contracting, construction, training, and plant commissioning.

Stages Concerned with

Project & engineering site probing and prospecting, preparation of blue prints, and plant design, plant
designs engineering, selection of specific machineries and equipments
Negotiations and negotiating and drawing up of legal contracts with respect to project financing,
contracting acquisition of technology, construction of building and civil works, provision of
utilities, supply of machinery and equipment , marketing arrangements, etc.
Construction site preparation, construction of buildings, erection and installation of machinery and
equipment.
Training training of engineers, technicians, and workers (this can proceed simultaneously along
with the construction work).
Plan commissioning start up the plant (this a brief but commissioning technically crucial stage in the
project development)

5. Review- Once the project is commissioned the review phase has to be set in motion.
Performance review should be done periodically to compare actual performance with
projected performance. A feedback device, it is useful in several ways.
i. It throws light on how realistic were the assumptions underlying the project;
ii. It provides a documented log of experience that is highly valuable in future decision
making;
iii. It suggests corrective action to be taken in the light of actual performance;
iv. It helps in uncovering judge mental biases;
v. It induces a desired caution among project sponsors.

7.7. Methods of Investment Valuation

The manager of a going concern must find time to search for alternative prospective investments
if the business is to grow. In its broadest sense, capital budgeting includes investments of both a
long-range and short-range nature. In this chapter, however, our concern is with long-range
financial commitments; and the discussion that follow deals exclusively with long-range
movements of funds.

Development and introduction of a new product that shows promise but requires additional study
and improvement.
i. Replacement of the company’s delivery trucks with newer models.
 ii. Expansion of sales activity into a new territory.
iii. Construction of a new building.
iv. Employment of several additional salespersons for more intensive selling in the existing
market.
Because capital is insufficient to finance all five investment proposals, the owner-manager must
decide which of them must be postponed or rejected and which must be accepted. Both the cost
of capital and the absolute limit on the volume of available funds require the rejection not only of
proposals that would be unprofitable but also of those that would be least profitable. A ranking
of the alternative investment proposals according to their profitability can be made after each
proposal has been evaluated.

In using either of these methods, only net additions to costs or profits are considered. For
example, if a partially depreciated machine is to be replaced, the book value of the old machine
is ignored except for the purpose of calculating the tax impact of resale at a price differing from
book value. Of course, any salvage or trade-in value of the old machine would be considered in
computing the investment cost. Although they have definite limitations when compared with the
more sophisticated valuation tools described later in this chapter, they are widely used and often
provide satisfactory answers.

Payback Period Method. Suppose that a firm is considering two investment projects, each of
which requires an investment of $100,000. The firm’s cost of capital is 10 percent. The estimated
annual cash flows (profit plus depreciation) from the two projects are as follows:
Economic Life
(Year) Project A Project B
1 50,000 10,000
2 40,000 20,000
3 10,000 30,000
4 10,000 40,000
5 - 50,000
6 - 60,000
The payback period for Project A is 3 years; for Project B, 4 years. If the firm ordinarily sets
three years as its standard payback period, then Project A will be accepted and project B rejected.

Return-on-Investment Method. This method evaluates proposals by relating the expected

annual profit from an investment to the amount invested. This method is expressed in the
following equation:
Rate of return = Annual profit
Investment
If the expected return on an investment of $ 100,000 is $20,000, the rate of return will be 20
percent. Such an investment is justified if more lucrative investments are not available and if a
return of 20 percent is reasonable in view of the risk involved.

Weaknesses of Traditional Methods. The return payback period method are subject to two major
weaknesses. First, they fail to recognize the time value of money. - A theoretically correct
evaluation method must take into account the timing of cash flows and apply the concept to the
time value of money to determine the attractiveness of investment proposals. For example,
suppose Projects C and D, each of which costs $10,000, had net cash flows as follows:
Year Project C Project D
1 $ 5,000 $ 1,000
2 4,000 4,000
3 1,000 5,000

Both projects have a three year pay back, which makes them equally attractive when judged by
this criterion. But we know that a dollar today is worth more than a dollar a year from to day,
because the dollar can earn interest during the year. Therefore, Project C with its faster cash flow
is more desirable.

The second weakness of the traditional methods is their neglect of the economic life the project.
Going back to the annual cash flow from projects A and B before, we note that the payback
period of the project B is a year longer than that of Project A. But Project B’s longer economic
life of 6 years provides $100000 more in total cash flow than Project A. In a similar manner, a
simple rate of return method gives no indication of the length of time during which that rate of
return may be expected to continue.

Net Present Value (NPV) Method-present value means the value of a stream of expected net
cash flows, discounted at an appropriate rate of interest. The NPV method is calculated using the
formula:
NPV= Q1 + Q2 + Qn + S =C
(1+r)1 (1+r)2 (1+r)n (1+r)n
Where V = excess present value over cost
Qt = post cash flow in year t (where t is 1,2,3,4……n)
S = terminal salvage value
r = selected rate of interest
C = cost of the project/asset
n = useful life of the asset/project
Note that the present value figure, V, represents the net of the investment over and above the cost
of the project and the firm’s cost of capital. The selected rate of interest, r, is usually a firm’s cost
of capital. When the net present value is negative, the project should be rejected. When it is
positive, the project should be accepted because the value of the firm increases by the amount of
the net present value of the project.

To illustrate let us calculate the net present value of projects A and B given above. Assume that
neither project has any salvage value. The above formula for calculating the net present value of
project would be used under the following assumptions
V= Q1 + Q2 + Q3 + Q4 -C
(1+r)1 (1+r)2 (1+r)3 (1+r)4

Where Q1 =cash flow in year 1 = 50,000

Q2 =cash flow in year 2 =40,000
Q3 =cash flow in year 3 =10,000
Q4 =cash flow in year 4 =10,000
r =10% C =100,000 n=4 years
V= 50,000 + 40,000 + 10,000 + 10,000- 100,000
1.1 1.21 1.33 1.46
=45,454 +33,057 + 7,518 + 6,849 -100,000= -7,122
When a negative present value of, Birr 7,122, Project A should be rejected. Calculating the net
present value of project B, the formula would be used similarly and results in a positive net
present value of $40,000 for Project B. Thus, Project B should be accepted.

7.8. Breakeven Analysis

Break- even is an activity level at which the firm will make neither profit nor loss. In other
words, break-even is an activity level at which revenue generated from business equals total
costs incurred. Any firm, before it desires to earn a profit, must "break-even". If the firm’s
volume of sales is below the break-even, it will suffer a loss. Therefore, to make profit, the
volume of sales should be greater than the break-even level.

Approaches in Breakeven Analysis

The equation approach
This approach is based on the following equation
Sales = Variable Costs + Fixed Costs + Profits
Sales revenue is a function of the selling price and units of products sold on the market. Thus,
Sales Revenue = Selling Price (SP/U) X Units Sold (Q)
On the other hand, variable costs vary with the number of products made. Thus, total variable
cost can be explained as a function of variable costs per unit and units of product made. Thus,
Variable costs = Unit variable cost X Units products made
As indicated in earlier discussions, at break-even, profits are nil. As a result, the break-even level
can be computed at a point where sales revenue equals total cost. Hence, at break-even
SPXQ = (VC/unit X Q) + fixed costs
Manipulating the equation till Q (sales volume) appears to the left hand- side will result in the
following formula that can be used to calculate a break-even level.
Break-even sales =Fixed costs
Selling price-Unit variable cost
Example. Som Pvt. Ltd. Co. is a small manufacturing firm engaged in the production of molds.
A single mold costs the Company $12 to produce. Moreover, the Company incurs $72,000pa for
rent of building, machineries and other fixed costs. Given the prevailing market situation, Som
charges its customers $18 for each product.
Determine the level of sales volume, both in units and dollars that will generate no loss
and no profit for the company.
Solution: Fixed Costs =72,000 Selling Price =18/mold Variable Cost =12/mold
Break even sales (units)=Fixed costs ___________ =72,000=12,000 molds
(Selling Price/Unit)-(Variable cost/unit)18-12

The company should produce and sell 12,000 molds to break-even. On other hand, the sales
revenue at break-even can be determined by taking the product of break-even sales units and unit
selling price. Hence, Break-even sales revenue =Break-even units x Unit Selling Price=12,000 x
$18= $216,000

Hence, to break-even, Som Company needs to generate sales revenue that amounts to $216,000.
When 12,000 molds are made, variable costs equal $144,000 (12,000x12) making the total costs
$216,000 ($144,000 + 72,000). These bring the total sales revenue and total costs to equality
(hence, break - even)

Carefully note that the difference of unit selling price and unit variable cost produces unit
contribution and this implies that, each unit of product sold contributes certain amount that will
go to cover the uncovered fixed costs. In the example above, a single mold is made at a variable
cost of $12, and sold at $18 producing a contribution of $6 that will go to cover the remaining
uncovered fixed costs.
The contribution approach
This approach is useful especially when unit contribution is given as a percentage of selling
price. Unit contribution is the excess of selling price per unit over unit variable costs. The
break - even sales revenue for example above, can be calculated using the following formula.
Break – even sales revenue = Fixed Costs
Contribution to sales ratio*
* Contribution to sales ratio = (Contribution/Sales) x100
For the example illustrated above, the break-even level of sales can be determined using the
contribution approach as follows. Unit contribution=($18-12/18=33.33%
Break-even sales revenue=($72,000)/33.33%=$216,000
When the unit contribution margin (SP/Unit-VC/Unit) is expressed in terms of percentage it is
referred to as contribution to sales ratio. C/S ratio=Contribution x 100
Sales
Note that contribution to sales ratio is an expression of contribution as a percentage of sales.
Example: Grace Co. Ltd. currently manufactures and sells water tankers to the local community.
Grace incurs $7 for the purchase of materials to be used in the manufacture of a single tanker and
a labor cost of $3 for each tanker. Each tanker is sold at $16 on the market. Fixed costs total to
$132,000 pa.
 Determine the number of water tankers Grace should produce and sell to break-even.
 If Grace aims at generating a profit of $15,000, how much sales revenue would achieve
this?
Solutions
1. Break-even =Fixed costs =132,000=22,000 water tankers should be made & sold to
break-even
Unit Contribution 16-10
2. Volume target=Contribution target=132,000+15,000=147,000=24,500
Unit contribution 16-10 6

The graphic approach

The break-even sales revenue (and units) can also be determined using graphs. A break-even
level of activity (both in sales units and values) can also be determined using a graphic approach.
This approach involves plotting sales and costs on a graph and locating the level of output at
which sales and costs are equal.

The graph, which is alternatively known as a break-even or CVP chart, represents pictorially the
likely profits (losses) at different levels of output and the break-even volume. It also shows the
relationship between variable and fixed costs, the margin of safety and contribution. A break-
even chart depicts costs on the vertical line in relation to volume (activity level) on the horizontal
line.
Revenue/Costs
Sales revenue

Total cost
Variable costs

Break-even Level

Fixed Costs

0 Qe Sales volume
A break-even chart

Since sales and costs equal at break-even, their point of intersection occurs at the break-even
level of sales. This enables one to easily observe the sales revenue that produces a break-even on
the vertical line and the break-even sales (in units) on the horizontal line.
Example. Daisy Plc. is a firm engaged in the manufacture and sell of electronic calculators. The
company usually incurs 96,000 to cover its annual fixed costs and 10 per calculator. Show the
break-even sales volume (both in units and dollars) on a break -even chart if the selling price is
20 per unit.
Solution. Let q represents the number of calculators that can be produced and sold.
Total Costs (TC)=10q + 96,000 Total Revenue (TR)=20q
Revenue/(Costs$'000)

TR
TC
Profit area
192
96 Loss area

0 9.6 q ('000)
A break-even Chart

The break-even chart shown above clearly depicts that Daisy will make neither profit nor loss
when it produces and sells 9,600 units of products. At this level of activity, Daisy could generate
revenue of 192,000 (also shown on the graph) and incur the same amount for costs. Hence the
profit will be nil.

In general, a break-even chart provides a useful way of determining an activity level at which the
firm will break-even. Using the above break-even chart, one can easily read off sales revenue
and costs at each level of activity. Moreover, the graph provides a visual picture of the impact of
every change in the level of activity (sales volume) on the profitability of the firm.

PROJECT WORK
1. Locate the sources and determine the nature of financing new ventures.
2. How do you estimate the amount of capital required for the new venture?
3. Prepare the financial proposal needed to secure funds.

REFERENCES
Broom, Longenecker, and Moore, 1983, Small-Business Management, Six edition,
Southwestern Publishing Co., USA.
Burns, Paul, 2001, Entrepreneurship and Small Business, Palagrave, UK, England.
Desai, Vasant, 1999, Dynamics of Entrepreneurial Development and Management,
Himalaya Publishing House, New Delhi.
Hisrich, Robert D. and Michael P. Peters, 1989, Entrepreneurship: Starting, Developing, and
Managing a new enterprise, USA.
Holt, David H., 1992, Entrepreneurship: New Venture Creation, Prentice-Hall of India, New
Delhi.
Peter Drucker, 1985, Innovation and entrepreneurship: Practice and principles.
Robert R. Reeder, Edward G. Brierty, and Betty H. Reeder, 1987, Industrial Marketing:
Analysis, Planning, and Control, Prentice-Hall editions, USA.