Finance Project

Working Capital Management

GENERAL INTRODUCTION

All business organizations prepare financial statements after every financial

year. The financial statements clearly indicate the financial position of the business

concern. Published financial statements may be of considerable interest to

shareholders, trade organizations, business analyst and many others. Each of these

groups may be interest in different aspects of the business concern according to their

own purposes.

The basis for financial planning, analysis and decision making is the financial

information. Financial information is needed to predict, compare and evaluate the

firm’s earning ability. It is also required to aid in economic decision making

investment and financing decision making. The financial information of an enterprise

is contained in the financial statements or accounting reports.

The financial analysis is the process of analyzing the financial strengths and

weaknesses of the firm by properly establishing the relationships between the items of

the balance sheet and profit and loss account. It is the study of the performance of the

unit and therefore is aimed at financial performance of an individual unit.

This report deals with the financial performance of MEDREICH STERILABS

LIMITED for the financial year 2007 to 2009.

This report briefly explains the subject matter (financial statements analysis)

of the study conducted. The basis for the financial planning, analysis and decision-

making is the financial information. Financial information is needed to predict,

compare and evaluate the firm’s earning ability. It is also required to aid in economic

decision making investment and financing decision making. The financial information

of an enterprise is contained in the financial statements or accounting reports.

The financial analysis is the process of identifying the financial strengths and

weaknesses of the firm by properly establishing relationship between the items of the

SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE 1


balance sheet and profit and loss account. It is the study of the performance of the unit

and therefore is aimed at the financial performance in an individual unit. This is

therefore aimed at analyzing the performance, trend and the areas of strengths and

weaknesses of the firm The objective of the study was to thoroughly analyze the

company’s performance and the financial position over the years i.e., the direction

and the trend in which the company is performing and the various and their uses.

The balance sheet and the income statement of the company provide some

extremely useful information to the extent that the balance sheet mirrors the financial

position on a given date in terms of the structure of assets, liabilities and owners

equity etc. The comparison of the above statements is therefore an important aid in

determining the company’s position and performance over a period of time. The first

task in the analysis is the selection of the information relevant to the decision under

consideration from the total information contained in the financial statements. The

second task is to arrange the information in a way to highlight comparison among

different variables from balance sheet and income statement of different years. The

final step is that of drawing inferences and conclusions.

The best tool used for the purpose of finding out trends of an organization’s

growth over a period of time is Ratio Analysis. The variables in the balance sheet

provides considerable information which is eventually helpful for the organization as

the trends can be studied and it forms the basis of drawing important inferences.

Working Capital is the capital required for the day-to-day operations of the

business It maybe regarded as the life blood of business. Its effective position can do

much to ensure the success of a business, while its inefficient management can lead

not only to loss of profit but also the ultimate downfall the study o f working capital

management is important because of its close relation with the day to day operations

of the business Therefore to keep healthy management of working capital business

needs professionalism and good skill thus the management of working capital varies

from industry to industry.



M\S MEDREICH STERILAB LIMITED has been taken for the case study

to analyze the financial aspects to working capital for the better understanding of

the financial standing of the Company



RESEARCH DESIGN

1) STATEMENT THE OF THE PROBLEM

To study the working capital management and to analyze and evaluate the

financial position M\S MEDREICH STERILAB LIMITED with special reference to

Working Capital Management, Ratio Analysis, and Fund Flow Analysis

2) OBJECTIVES OF THE STUDY

Primary objective is to analyze the financial position of Medreich Sterilab Ltd,

for the year, 2006-2007, 2007-2008 and 2008-2009

To use working capital management, fund flow analysis, ratio analysis as a

tool to identify the liquidity, solvency, profitability and management

efficiency of the company

To compare the financial position for three years and help in financial

control and planning resources

To make suggestions out of the findings of the study

3) DATA COLLECTION

The requisite data for the study is collected from the secondary sources of

information The Secondary data has been obtained from the financial statements of

the company in the form of the Balance Sheet and Profit & Loss accounts. The

analysis and interpretation has been thus derived with the help of secondary data

available there was use of primary data in the case of financing of working capital

through paper work and discussions held with the senior financial manger.



4) PLAN OF ANALYSIS:

The data has been compiled, analyzed and tabulated in various forms. The

tabulated financial data has been further interpreted. These interpretations have been

used to form conclusions and suggest recommendation. Using various financial tools

like fund flow statement, ratios and percentages the analysis was done.

5) RESEARCH METHODOLOGY:

Three Year Balance sheet &Profit & Loss account stated in annual reports

were used for analysis Working Capital &concerned ratios that were used as tools of

analysis based upon the companies financial position, performance was evaluated

suggestions were made. Regarding financing of working capital both the methods

were evaluated by extracting information from balance sheet for three years, then the

best alternative was chosen based on which the companies position regarding the

financing of working capital was known

6) LIMITATIONS OF THE STUDY:

Study makes an extensive use of information provided by financial statements

and if there is window dressing, the findings could be misleading.

As there is no standard formula for ratios, different people may express

different opinions.

No other company in the same sector has been considered to evaluate the ratio

standards.

This being an academic study suffers from time and cost consideration.



CHAPTER SCHEME

The project has been completed in the following chapters:

CHAPTER 1 GENERAL INTRODUCTION

CHAPTER 2 RESEARCH DESIGN

CHAPTER 3 COMPANY PROFILE

CHAPTER 4 WORKING CAPITAL MANAGEMENT

CHAPTER 5 ANALYSIS & INTERPRETATION

CHAPTER 6 FUND FLOW STATEMENT

CHAPTER 7 FINDINGS AND SUGGESTIONS

BIBLIOGRAPHY



PHARMACEUTICAL INDUSTRY

There is general feeling in the country that the Indian pharma industry is doing

extremely well. This is certainly true, particularly in the Indian context.

It is also a fact that several large multi national pharma companies in the world

have taken note of the progress of a few Indian pharma units and are recognizing their

capabilities and track records.

Even under such circumstances, there is some sort of apprehension amongst

the Indian pharma industry as to whether it would be able to sustain the past growth

level in the coming years, in the light of the impending patent regulations and the

liberalized global trade.

A clear analysis of the performance of the Indian pharma industry would

readily indicate the fact that while a few number of organizations such as Ranbaxy,

Dr.Reddys, Orchid, Lupin and others have done extremely well, there have also been

a large number of pharma organizations in the medium and small scale sectors, who

have failed in the past If one would look into total number of pharmaceutical units

(both bulk drug and formulations) that have been set up in India since independence,

it would become clear that at least 40% of the units have closed and withered away.

Obviously, this implies that everything about Indian pharma industry is not so rosy

and promising as projected.

While we recognize the success, we should also investigate the cause for such

failures.



It is generally said that the success of the Indian pharma industries are only

due to its capability in reverse engineering. Such views are uncharitable, as the

success of Indian pharma sector has not been due to reasons as simple as that only.

Indian pharma industry deserves far more credit and praise for its

achievements. It has been able to introduce and practice appropriate marketing

strategies both in the Indian and global market, even in the face of severe competition

from well established multi national companies. By and large, it enjoys excellent

credibility and faith among consumers, particularly in India. Over and above that, it

has also practiced reasonable level of fairness in price fixing and has exhibited

responsible corporate behavior.

It is well-recognized fact in future; the fate and progress of the pharma

industries in any part of the world would be largely guided by the R&D capabilities

and introduction of new molecules appropriate to the requirements of different

regions. This calls for extensive and high level of Research and Development

capabilities amongst the pharma industries.

The question is as to what extent the Indian units have developed such

capabilities.

In the past, most have the turn over and profits for Indian pharma units have

come from the formulation sector and not from the bulk drug sector. Even the export

break through of the Indian units has been largely in the formulation sector.

We all know that the formulation sector is not that R&D intensive to the level

of bulk drug sector. A number of Indian formulation units themselves have been

importing bulk drug for formulation and finished products. This formulation

capability by itself would not be adequate to forge ahead in the future.

The development and introduction of new bulk drug takes any where between

6 to 10 years and cost millions of dollars. The success rate in development of new



molecules has been low and it is said that hardly one or two research exercises are

successful out of around 100 attempts.

Further, there are number of cases in the recent years, where the drugs which

have already been well introduced in the market have to be withdrawn due to

pressures from alert public and environmentalists.

Obviously, all such aspects indicate that Research and Development work in

pharma sector is not only multi million dollar exercise but it is also a calculated risk.

One would wonder as to whether Indian pharma units have necessary turn over and

financial muscle to face such risks in the pharma sector in the coming years.

It appears that in the coming years, the Indian pharma industry would find it

difficult to maintain its market share as bulk drug manufacturer in the global context.

They could find it difficult even to maintain market share in the Indian bulk drug

market in the face of competition from multi national companies operating all over

the world.

In this scenario, it would be appropriate for the Indian pharma sector to

introspect as to whether it should focus more in functions relating to service sector in

the pharma industry instead of manufacturing activity.

The service sector such as data base management, bio-informatics, clinical

trials, testing and analysis, custom synthesis, contract research etc. are of tremendous

importance and have promising future.

With army of technologists and scientists around the country and reasonable

capability level, Indian pharma sector would emerge even stronger in the global

sphere, if it could concentrate in service functions, of which contract research and

custom synthesis could play a major part.

Obviously, there are both adequacies and inadequacies in the Indian pharma

sector. Perhaps, we should look into inadequacies with greater attention and try to

over come the constraints.



MEDREICH STERILABS LIMITED

As the world is shrinking and trade barriers are beginning to come down, the

pharmaceutical industry is constantly in search of ways to reduce cost without

compromising on quality or service; so as to retain a competitive edge in the global

market place.

Medreich Sterilabs Ltd. (Medreich) is an Indian Company and forms part of

the UK Group of companies comprising of Medreich plc. They have an international

focus, and world-class accredited plants that are capable of offering low cost, high

quality out-sourcing solutions for its customers.

They specialize in developing and delivering bespoke solutions for their major

international customers. They have the capability to handle significant complexity and

to produce a wide range of products and dosage forms, in varied packing

presentations.

Medreich strictly adheres to all cGMP requirements and through regular Audit

interactions with International agencies, they are constantly upgrading their plants to

meet the needs of the changing Regulatory scenario, Quality requirements, while

keeping an eye on Environment, Health and Safety.

Medreich plants are certified by the UK MHRA, TGA Australia, and South

Africa MCC as they all are leading multinational and Indian pharmaceutical

companies.

They are committed to setting the best standards in the industry; to build long-

term relationships with their customers, deliver complete satisfaction, while

improving business performance.

They actively seek strategic alliances with growing, dynamic and leading

companies that share their Vision of offering very competitively priced formulations

without compromise on Quality and Service.



COMPANY & ITS AFFILIATES:

Registered office: MEDREICH STERILAB LIMITED

BANASWADI ROAD,

BANGALORE.

WEBSITE: WWW.MEDREICH .COM

DIRECTOR: C.P.BOTHRA

MANAGING DIRECTOR: J.R.VENU

COMPANY SECRETARY: DASARI RAMESH

BANKERS: STATE BANK OF MYSORE

CANARA BANK

KARNATAKA STATE FINANCIAL

CORPORATION

KARNATAKA STATE INDUSTRIAL

INVESTMENT & DEVELOPMENT

CORPORATION

CHARTED ACCOUNTANTS: A. RAM MOHAN & CO



FACILITIES OF THE COMPANY

There are four labs and a research and development center situated in

Bangalore where each lab is dedicated for the manufacturing of certain specific

related medicines.

The company has an in house research and development center for constant

development of new medicines to keep pace with tough competition in the global

market place. It also has a research team working on the packaging of the their

company products for cost reduction and to provide better quality products to their

international clients

The facilities of the company are as follows which are situated in Bangalore

1. Unit one –dedicated manufacturing facility for B-LACTAM capsules, tablets,

by powder suspension

2. Unit two-dedicated manufacturing facility for non-penicillin capsules

3. Unit three-manufacturing facility for tablets, capsules,& pellets

4. Unit four- manufacturing facility for non-penicillin tablets, liquids &dry

powder suspension

5. Unit five-the in house research and development centre

UNIT ONE



FACILITIES AVAILABLE

Capsules

Two automatic capsule filling line equipped with

Check Weighing

Metal Detection System

Dry Powder

Multi-Head Automatic Powder Filling Machine

On-Line Automatic Labeling

Inkjet Printing

Tablet

Tablet manufacturing area with facility for

Dry Granulation

Compression

Auto-coater with PLC controlled

Packaging Lines:

Three Blister Packing

One Strip Packing

One Tropical Blister Packing

Bulk Packing Lines with facility to pack from 10's to 1000's

Auto Cartoner with Camera Sensor, Barcode and Edge code readers.

Adequate Warehousing Space.

The production and packaging areas maintained at required pressures,

temperatures and humidity levels with the help of 14 Independent HVAC Systems.

The facility has independent Site Quality Assurance team, responsible for the final

release of the Product.

The facility has a well-equipped Quality Control Laboratory capable of

carrying out all tests.



UNIT TWO

Facilities available

Capsules

Automatic capsule filling line equipped with

Check Weighing

Metal Detection System

Packaging Lines Blister Packing

Strip Packing with non-fill detection, collation of strips

Bulk Packing Lines with facility to pack from 10’s to 1000’s

Adequate Warehousing Space

The production and packaging areas maintained at required pressures,

temperatures and humidity levels with the help of 14 Independent HVAC Systems.

The facility has independent Site Quality Assurance team, responsible for the

final release of the Product.

The facility has a well-equipped Quality Control Laboratory capable of

carrying out all tests.



UNIT THREE


Three independent and self contained granulation suites. Two suites are

equipped with Glatt Fluid Bed Processor of 800 ltrs. And 250 ltrs. 360 Kgs.

Automatic Coating Systems with Microprocessor Controller and Printer.

Liquid

Automatic Tunnel type bottle washing and monoblock filling and capping

under LAF. Automatic self-adhesive labeling machine with on-line Inkjet printing.

Multimixer with built in homogenizer to manufacture high viscosity suspensions

besides other manufacturing and holding tanks to ensure continuous production.

Dry Powder

Dry Syrup Line is equipped with air jet cleaning system for bottles, blending

equipment, filling equipment and packing equipment.

Packaging Lines

Five blister packing lines.

One strip packing line.

One container packing line.

Auto cartoner with camera sensor, barcode and edge code readers. Hologram,

BOPP wrapping, security seal, collating, shrink-wrapping, Pelletisation facility



UNIT FOUR


TABLETS

Automatic coating pan with PLC control, capabilities to Sugar/Film/Enteric

Coating.

Four tableting machines with large capacity to produce two independent

granulation suites with facility to handle all types of process.

Tablets of any shape and size. The machine is also equipped to produce Bi-

layered tablets.

CAPSULES:

Two fully Automatic capsule filling lines with metal detection system

One 150-T multi station Automatic capsule filling machine to encapsulate

Powder, Pellets and Tablet or combination thereof

One 80-T multi station automatic capsule filling machine to encapsulate

Powder and Pellets or combination thereof

PELLETS:

The facility has the capability to produce immediate release and sustain

release pellets with aqueous and non-aqueous polymeric solution or

suspensions.

Pellets ready to be filled in capsules or compressed into pellets.

PACKAGING LINES:

Ten independent packaging lines with auto conveyors to transfer Packing

materials and finished products

Five 240 EX blister packing machines

One flat bed blister packing machine with capability to handle Alu/Alu

(COLD Forming) blisters

Three container packing lines with facility to pack from 10's to 1000's

One strip packing line

A new Research and Development Center has been commissioned to design and

develop new and innovative oral dosage forms - using robust and reliable



technologies. The Center focuses on the development of products just reaching patent

expiry in the International markets. The target is to deliver Standard Technical Files to

the European and International market place to allow first to market applications to be

made after patent expiry. The Center is run as a strategic business unit, capable of

delivering novel cutting edge technology and supporting applications for Intellectual

Property Rights (IPR). It is fully equipped with a self-sufficient laboratory and

manufacturing area conforming to cGMP

The development process covers:

Conceptualizing and identifying the product profile

Pre-formulations

Formulation and manufacturing method development

Lab scale development

Lab scale development

Analytical method development

Packaging material development including novel packaging

Stability testing protocols

Data management (documentation and IPR)

Installed capability at the Research Center includes:

Conventional or modified release tablets using coated, uncoated, sublingual,

effervescent, bilayered or dispersible technologies.

Conventional or modified release capsules containing powder, pellets,

microgranules or a combination of either of above.

Conventional or modified release granules or pellets ready to be filled into

capsules or compressed into tablets or for sprinkling over food or mixing with

juice.

Syrups and suspensions, as well as dry powder formulations for reconstitution,

designed to be robust, even when using unstable API's.

New drug delivery systems including the conversion of existing molecules

into bio-equivalent novel dosage forms offering more competitive product

profiles.



QUALITY POLICY OF THE COMPANY

Every Unit produced by the Company, will totally conform to the quality

systems & procedures laid down by the company.

Every Unit produced by the Company, will be in accordance with the process,

procedures & controls as laid down by the company.

Every input and component that goes into the product produced, will conform

to all standards laid down by the Co• Every manual, document, certificates,

approvals, will be made to conform to the highest quality standards.

Every human resource available in the Company, while they are directly or

indirectly connected with the production of every Unit will adhere to all

quality systems, controls, & procedure.

Every Unit produced by the Company, will carry the Company’s commitment

to quality & customer satisfaction.

The Company will make constant & continuous endeavors to upgrade &

enhance its procedures, systems & controls to keep up to the latest Quality

Standards in vogue at any given point in time.



GROSS WORKING CAPITAL

NET WORKING CAPITAL

NEGATIVE WORKING CAPITAL

RESERVE WORKING CAPITAL

PERMANENT WORKING CAPITAL

TEMPORARY WORKING CAPITAL

WORKING

CAPITAL

WORKING CAPITAL MANAGEMENT

Introduction:

Working capital is the lifeblood of every business. Its effective provision

ensures success and inefficient provision reduces the profit and results in downfall of

the company. Mismanagement of business failure. A study of working capital is of

major importance to internal and external analysis because of its close relationship

with day-do-day operations of a business.

Definition:

In accounting concept working capital is nothing but, “The difference between

inflow and outflow of cash. It is also known as the difference between current assets

and current liabilities. Current assets consists of cash/bank balance, short from

investments, receivables, stocks advance payments etc., current liabilities include

creditors, bills payables, bank overdraft, short term loans etc.,”



1. Gross working capital:

It is the amount of funds invested in the various components of current assets.

2. Net working capital:

It is the difference between current assets and the current liabilities. The

concept of net working capital enables a firm to determine the exact amount available

at its disposal for operational requirements. It reflects the company’s liquidity

position.

3. Negative working capital:

When current liabilities exceed current assets negative working capital

emerges. Such a situation occurs when a firm is nearing a crisis of some magnitude.

4. Reserve working capital:

It refers to the short term financial arrangement made by the business units to

meet uncertainties. Business firms are always exposed to risks, which may be

controllable or uncontrollable. In the event of happenings of such events, reserve

working capital strengthens the capacity of the company to face the challengers.

5. Permanent working capital:

It means the minimum amount of investment in all current assets which is

regarded at all times to carry on minimum level of business activities. The operating

cycle is a continuous process and therefore, the need for current assets. But, the

magnitude of current assets increases and decreases over time. There is always a

minimum level of current assets required at all times by the firm to carry on its

business operations. The minimum level of current assets is known as permanent

working capital or fixed working capital.



6. Temporary working capital:

This is also called the fluctuating or variable working capital. The amount of

temporary working capital keeps on changing depending upon the changes in

production and sales. For example extra inventory of finished goods will have to be

maintained to support the peak periods of sale and investment in receivable may also

increase during such period. On the other hand investment in raw materials, work-in-

progress and finished goods will decrease. If the market is black. The extra working

capital required to support the changing production and sales activities is known as

temporary working capital.

The figure above shows that the permanent level is fairly constant while

temporary working capital is fluctuating sometimes increasing and sometimes

decreasing in accordance with seasonable demands. In the case of an expanding firm

the permanent working capital line may not be horizontal this is because the demand

for permanent current assets might be increasing or decreasing to support a rising

level of activity.

Both finds working capital are necessary to facilitate the sales process through

the operation cycle. Temporary working capital is created to meet liquidity

requirements that are purely transient nature.

Need for working capital:

The basic objective of financial management is maximizing wealth of

shareholders. This can be achieved when a firm earns sufficient returns from its

operations. The amount of such earnings largely depends upon the magnitude of

sales. There is always a time gap between sales of goods and the final realization of

cash. Current assets are required during time gap in order to sustain the sales activity.

Adequate working capital is required during this period for the purchase of raw

material, payment of images or other expenses required for the manufacturing of

goods to be sold. Working capital is also required to run the business smoothly.



Operating cycle:

The duration of the time required to complete the following cycle of events in

a case of manufacturing firm is called as operating cycle. The operating cycle

consists of the following events.

1. Conversion of cash into raw material

2. Conversion of raw material into work-in-progress

3. Conversion of work-in-progress into finished goods

4. Conversion of finished goods into debtors and bills receivable through sales

5. Conversion of debtors and bills receivable into cash

This cycle will be repeated again and again. This can be shown in the

following chart.

OPERATING CYCLE

Determinants of working capital:

A large number of number of factors influence working capital needs of a

firm. The basic objectives of working capital management are to manage the firm’s

current assets and current assets and current liabilities in such a way that a satisfactory

level of working capital is maintained.

SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE

RAW MATERIAL

CASH WORK-IN-PROGRESS

ACCOUNT RECIEVABLES FINISHED GOODS

22


The following factors determine the amount of working capital.

1. Nature of business:

The composition of current assets is a function of the size of a business and

industry to which it belongs. Small companies have smaller proportion of cash,

receivables and inventory than large corporations. This difference becomes more

marked i.e., large corporations. A public utility concern, for example, mostly

employees fixed assets in its operations, while a merchandising department depends

generally on inventory and receivables. Need for working capital is thus determined

by the nature of an enterprise.

2. Size of business:

The size of business is also an important impact on its working capital needs.

Size may be, measured in terms of scale of operations. A firm with large scale of

operation will need more working capital than a small firm.

3. Length Of The Manufacturing Process:

Larger the manufacturing process, the higher will be the requirement of

working capital and vise versa. This is because of the fact that highly capital-

intensive industries require a large amount of working capital to run their

sophisticated and long production process. On the same principle of trading concern

requires a much lower working capital than a manufacturing concern.

4. Production policy:

The production policies by the management have a significant effect on the

requirement on working capital of the business. The production schedule has a great

influence on the level of inventories. The decision automation etc., will also have an

effect on the working capital requirements.



5. Volume of sales:

This is the most important factor effecting the size and components of working

capital. A firm maintains current assets because they are needed to support the

operational activities which resulting sales. The volume of sales and size of the

working capital are directly related to each other. As the volume of sales increases

there is an increase in the investment of working capital.

6. Terms of purchases and sales:

A Firm, which allows liberal credit to its customers, may enjoy higher sales

but will need more working capital as compared as compared to a firm enforcing strict

credit terms. The working capital requirements are also effected by the credit

facilities enjoyed by the firm.

7. Business cycle:

Business expands during the period of prosperity and declines during the

period of depression; consequently, more working capital is required during the

period of prosperity and less during the period of depression.

8. Growth and expansion:

If a business firm has ambitious plan for expansion, it requires more working

capital, to fulfill such requirements. Growth and expansion in business is more

essential to exploit the available business opportunity and to increase the existing

market share.

9. Fluctuations in the supply of raw materials:

Certain companies have to obtain and maintain large reserve of raw materials

due to their irregular sales and intermittent supply. This is particularly true in case of

companies requiring special kind of raw materials available only from one or two

sources. In such a case a large quantity of raw materials is to be kept in store to avoid



an possibility of the production process coming to a dead halt. Thus, the working

capital requirements in case of such industries would be large.

10. Price level changes:

The increasing shifts in price levels make the functions of financial managers

difficult. He should anticipate the effect of price level changes on working capital

requirements of the firm. Generally, rising price levels will require a firm to maintain

higher amounts of working capital. The same levels of current assets will need

increased investment when prices are increasing.

11. Operating efficiency:

The operating efficiency of the firm relates to the optimum utilization of

resources at a minimum cost. The firm will be effectively contributing to its working

capital if it’s efficient in controlling the operating costs. The use of working capital is

improved and pace of cash cycle is accelerated with operating efficiency.

12. Profit margin:

Firms differ in their capacity to generate profit from business operations.

Some firms enjoy a dominant position, due to quality product or good marketing

management or monopoly power in the market and earn a high profit margin. Some

other firms may have to operate in an environment of intense competition and may

earn low margin of profits.

13. Profit appropriations:

Even if the net profits are earned in cash at the end of the period, whole of it is

not available for working capital purposes. The contribution towards working capital

would be effected by the way in which profits are appropriated. The availability of

cash generated from operations thus depends upon taxation, dividend and retention

policy and depreciation policy.



14. Credit Policy:

A, company which follows a liberal credit policy to its customers, may have

higher sales but will need higher working capital as compared to a company which

has an efficient debt collection machinery and observing strict terms. A company

enjoying liberal credit facilities from its suppliers will need lower amount of working

capital as compared to a company, which does not enjoy such credit facilities.



PRINCIPLES OF WORKING CAPITAL MANAGEMENT:

Principle of risk variation:

Risk here refers to the inability of a firm to maintain sufficient current assets

to pay for its obligations, if working capital is varied relative to ales; the amount of

risk that a firm assumes is also varied and the opportunity for gain or loss is increased.

As the level of working capital relative to sales decreases the degree of risk

increases. When the degree of risk increases the opportunity for gain or loss also

increases. Thus if the level of working capital goes up the amount of risk goes down

and the opportunity for gain or loss is likewise adversely affected. Depending upon

this attitude, the management changes the size of working capital.

Principle of cost of capital:

This principle emphasizes the different sources of finance, for each source has

a different cost of capital. It should be remembered that the cost of capital moves

inversely with risk. Thus additional capital results in the decline in the cost of capital.

Principle of equity position:

Accounting to this principle the amount of working capital invested in each

corporate should be adequately justified by a firm’s equity position. Every rupee

invested in the working capital should be contributed to the net worth of the firm.

Principle of maturity of payments:

A company should make every effort to relate maturity of payments be it flow

of internally generated funds. There should be the least disparity between the

maturities of a firm’s short-term debt instruments and its flow of internally generated

funds because a greater risk is generated with greater disparity. A margin of safety

however should be provided for short-term debt payments.



Sources of working capital:

There are two approaches for sources of finance:

a. Hedging approach

b. Conservative approach

a. Hedging approach:

The term hedging approach is often used in the sense of risk reducing

investment strategy involving transactions of simultaneous but opposite nature so that

the effect of one is likely to counter balance the effects of the other. With reference to

an appropriate financing mix, the term hedging can be said to refer to a process of

matching maturity of financial needs. This approach to financing decision to

determine an appropriate financing mix is, therefore also called as maturity approach.

According to this approach the maturity of the source of funds should match

the nature of the assets to be financed for the purpose of analysis, the assets can be

broadly classified into two classes.

1. Those that are required in a certain amount for a given level of operation and

hence do not vary over time.

2. Those that fluctuates over time.

When the firm follows marching approach, long term financing will be used to

finance permanent working capital. Temporary working capital should be financed

out of short-term funds. The rationale underlying marching approach is treat the

maturity of sources of funds should match the nature of assets to be financed.

Estimated total funds for company X for the year Y



Months

Total Funds

required (Rs in

Thousand)

Permanent

Requirements (Rs in

Thousand)

Seasonal

Requirements(Rs in

Thaousand)

1 2 3 4

January 9500 7900 1600

February 9000 7900 11000

March 8500 7900 600

April 8000 7900 100

May 7900 7900 0

June 8150 7900 250

July 9000 7900 1100

August 9350 7900 1450

Septembe

r9500 7900 1600

October 10000 7900 2100

November 9000 7900 1100

December 8500 7900 600

According to the hedging approach the permanent portion of funds should be

financed with long-term funds and the seasonal portion with short-term funds. With

the approach, the short term financing requirements (current assets) would be just

equal to the short term financing (current liabilities). There would therefore be on net

working capital.

b. Conservative approach:

This approach suggests that the estimated requirements of funds should be met

from long term sources, the use of short term funds should be restricted to only

emergency situations or when there is an unexpected outflow of funds. In the case of

Hypothetical company “X” in the total requirements, including the entire rupees

10,000 needed in October, will be financed by long term services. The short-term



funds will be used to meet contingencies. The amount given represent the extent to

which short term financial needs are being financed by long term funds, that is the net

working capital. The net working capital reaches the highest level (Rs. 2100) in

October (Rs. 10,000 – 7,900). It may be noted that any long term financing in excess

of Rs. 7900 in permanent financing needs of the company represents net working

capital.

Other sources of working capital:

1. Loans from financial institutions

2. Floating of debentures

3. Accepting public deposits

4. Rising of funds by internal financing

5. Issue of shares

1. Loans from financial institutions:

The option is ruled out because banks do not finance always for working

capital requirement. This facility may not be available to all companies.

2. Floating of debentures:

Probability of sources is less because still Indian capital market could not get

popularity. The company not associated with reputed groups fails to attract investors.

However issue of convertible bonds is gaining momentum.

3. Accepting public deposits:

The success is directly related to the image of the company problem of low

profitability in many companies is very common.

4. Issue of shares:



It can be considered but the companies have to command respect of investors

how profit margin and lack of knowledge of the company makes this sources not an

attractive one.

5. Raising of funds by internal financing:

It is a problem for many companies because the prices of end products are

controlled and do not permit the companies to pay reasonable dividend and retain

profit for additional working capital requirement.

However feasible solution lies in increasing the profitability through cost

control, reduction, managing cash operating cycle and rationalizing inventory or stock

etc.,

Modes of security:

Hypothecation:

Under this mode of security the bank provides credit to borrowers against the

security of movable property usually inventory of goods. The goods hypothecated,

however continue to have in the possession of the owner of these goods. The right of

lending bank (hypothecated) depends upon the terms of the contract between the

borrower and the lender although the bank does not have physical possession of the

goods it has the legal right to sell the goods to realize the outstanding loan.

Pledge:

As a mode of security is different from hypothecation in that in the former

unlike in the latter, the goods, which are offered as a security, are transferred to the

physical possession of the lender an essential prerequisite of pledge. Therefore it

means that the goods are in the custody of the bank. The borrower who offers the

security is called pawner while the bank is called the Pawnee. The lodging of the

goods by the pawner is a kind of bailment.



The bank must take reasonable care of goods pledged with it. The term

reasonable care means, “care which a prudent person would take to protect his

property”.

Lien:

The term lien refers to the right of a party to retain goods belonging to another

party until a debt due to him is paid. Lien can be of two types, particular lien and

general lien.

Particular lien is a right to retain goods until a claim pertaining to these goods

is fully paid. On the other hand general lien can be applied till all dues of the claim

are paid. Bank enjoys general lien.

Mortgage:

It is the transferred of interest in specific immovable property for securing the

payment of money advanced. The person who parts with the interest in the property

is called mortgager and the person in whose favor the transfer is the made. The

mortgaged property of which the mortgage interest in the property is terminated as

soon as the debt is paid.

Charge:

A charge is not that transfer of interest in the property through it is a security

of payment. But a mortgage is a transfer of interest in the property.

1. A charge need not be in writing but a mortgage deed must be attested.

2. A charge may be created by the act of parties or by the operation of law, but a

mortgage can be created only by the act of parties.

3. Generally a charge cannot be enforced against a transferee or consideration

without notice. In a mortgage the transferee of the mortgaged property can

acquire the remaining interest in the property if any is left.



MANAGEMENT OF CASH, INVENTORY AND RECEIVABLES

Cash management:

What is cash?

Cash is the most liquid asset that a business owns. It includes money and such

instruments as cheques, money orders and bank drafts. Cash in the business

enterprise may be compared to the blood in the human body. In broad sense it

includes ‘rear cash’ items such as time deposits with banks, marketable securities etc.,

and such securities / deposits can be immediately sold or converted into cash if

necessary. The term cash management includes both cash and rear cash assets.

Motives of holding cash:

1. Transaction motive:

A firm enters into a variety of business transactions in both in flows and

outflows of cash. At time the cash outflows may exceed the cash inflows. In order to

meet the business obligations in such situations, it is necessary to maintain adequate

cash balance. The firms with the motive of meeting routine business payments keep

this cash balance.

2. Precautionary motive:

A firm’s cash balance to meet unexpected contingencies such as floods,

strikes, presentment of bills for payment earlier than the expected date, unexpected

showing down of collection of accounts receivables, sharp increase in price of raw

materials etc., The more is the possibility of such contingencies, the more is the

amount of cash kept by this firm.



3. Speculative motive:

A firm also keeps cash balance to take advantage of unexpected opportunities

typically outside the normal cause of the business. Such move is therefore of purely a

speculative nature. For example a firm may like to take an payment of immediate

cash or delay purchase of materials in the anticipation of declining prices. Similarly,

it may like to keep some cash balance to make profit by buying securities in times

when prices fall on account of tight money conditioned.

Compensation motive:

Banks provide certain services to their clients free of charge. They therefore,

usually require clients to keep minimum cash balance with them, which helps to earn

interest and thus compensate them for free services provided.

Business firms normally do not enter into speculative activities and therefore

out of four motives of holding cash balance the two most important motives are the

cash transactions and compensation motive.

How to have effective cash management?

Big corporations with sizable funds generally display a highly independent

management of cash assets. In these firms a responsible fiscal officer is charged with

responsibility of managing working cash balance in relation to the needs for the

payment of obligations. To search for the optimum cash probably overstates the

company’s capabilities.

A proper cash management necessitates the development and application of

some practical administrative procedures to accelerate the inflow of cash and to

improve the utilization of excess funds. This practical administrative procedure

includes:

1. Planning of cash requirements

2. Effective control of cash flow



3. Production utilization of exceeds funds



Objectives of cash management:

A highly liquid, vital asset is cash. It is needed to meet every type of

expenditure. Hence it should be sufficiently made available. If a firm falls to provide

funds to meet the obligations, it will be clear indication of technical insolvency of

firm. If the cash position of the firm is strong, it can command business operations.

Cash discounts can be obtained on purchases. Obligations can be met immediately.

Cost of capital will be minimized. However, it cannot also hold cash in an idle way.

It should be made productive. Keeping these two views, viz., liquidity and

profitability, the following objectives of cash management can be identified.

i. To make cash payments

ii. To maintain minimum cash reserve

To make cash payments:

The very objective of holding cash is to meet the various types of expenditure

to be incurred in business operations. Several types of expenditures have to be met at

different points of time and the firm should be prepared to make such cash payments.

The firm should remain liquid to meet the obligations. Otherwise the business

suffers.

It is observed that “cash is an oil to lubricate the every turning wheels of

business, without it the process of grinds to stop”. Thus one of the basic objectives of

cash management is to maintain the images of the organization by making a prompt

payment to creditors and to avail cash discounts facilities.

To maintain minimum cash reserve:

Another important objective of cash management is to maintain reserve. This

means in the process of meeting obligations on time, the firm should not maintain

unnecessarily heavy cash reserves. It cannot keep cash idle. Excess cash balance

should be productive. Maintaining minimum cash reserve is made possible by

synchronizing cash inflows and outflows through cash budgeting. Cash collection



should be expedited and cash outflows should be controlled to conserve cash

resources. Thus as far as possible the firm should maintain minimum cash reserve to

attain the objective of profitability.

Importance of cash management:

Cash management assumes more important than other current assets because

cash is the most significant and the least productive asset that the firm holds.

It is significant because it is used to pay firm’s obligations. However, cash is

unproductive and as such, the aim of cash management is to maintain adequate

cash position to keep the firm sufficiently liquid to use excess cash in some

profitable way.

Management of cash is also important because it is difficult to predict cash

flows accurately and that there is not perfect coincidence between inflows and

outflows of cash. Thus, during some periods, cash outflows exceed cash

inflows, because payments for taxes, dividends, excise duty, seasonal

inventory build up etc., are met through it. At other times cash inflows will be

more than cash payments, because there may be large cash sales and debtors

may be realized in large sums promptly.

Cash management is also important cash constitutes the smallest portion of the

total current assets, even then, considered time management is devoted for it.

Strategies of cash management:

1. Cash planning:

Cash inflows and outflows should be planned to project cash surplus or deficit

for each period of planning. Cash budget should be prepared for this purpose.

2. Managing cash flows:

The inflow and outflow of cash should be property managed. The inflow of

cash should be accelerated, while the outflow of cash should be decelerated as far as

possible.



3. Optimum cash level:

The firm should decide on the appropriate level of cash balances. The cost of

excess cash and the danger of cash deficiency should be matched to determine the

optimum level of cash balances.

4. Investing idle cash:

The idle cash or precautionary cash balances should be properly invested to

earn profits. The firm should decide on the division of such balances into bank

deposits and marketable securities.

Functions of cash management:

1. To forecast cash inflow and outflow.

2. Plant the cash requirement.

3. Determine the safe level of cash.

4. Monitor the safety level of cash.

5. Locate funds needed.

6. Regulate cash inflow.

7. Determine the criteria for investment of excess cash.

8. Regulate cash outflow.

9. Avail banking facilities and maintain good relationship with bankers.

Problems of cash management

1. Impact of inflation on cash flow:

Inflation is growth in value terms and therefore it provides of rapid inflation a

firm should expect to find itself in a very unfavorable cash flow position, like that of

the firm which is growing very fast. In the words of W.C.F. Hautrey” in advances

terms it comes dangerously close to compounding a felony”.



Timing of cash flow:

Period to another the figure indicates the variations during the different firms

with identical cash balance at the beginning and at the end of the year, but with vastly

different patterns of cash flow. Most amounts are to be dimensional, which means an

annuity multiplied by a price. Cash flow amounts passes the perverse third dimension

of time and indeed, it is the time dimension which is at the root of the various

problems created by accounting concepts, therefore it the long term profit are aimed at

but in short term the cash flow is much more important.

2. Environment:

There are environmental constraints that create cash flow problems for a firm.

Such problem may be created by the very nature of its operations, such a location or

season ability of the market place. Every firm should, therefore, examine its own

position in respect of its environment that will affect its short-term flow.

3. Managerial decisions:

A cash flow does not flow of its own accord. It is direct consequence of

management decisions. The management procedures employed for maximizing the

use of cash through the control of payable and related payments are:

Timings payments to vendors so that bills are paid only as they fall due.

Establishing procedure that will prevent or minimize the loss of discounts.

Centralizing payable and disbursement procedures.

Reducing “compensating balance” a “deposit with banks”.

Improving control over inter-company transfers

Utilizing manpower more effectively.

Strategic tax planning.



This need not be if management uses strategic tax planning to minimize its tax

expenditure. Currently, a management employs the following the techniques to

reduce its tax payment.

1. It uses acerbated depreciation method or adopts guidelines and

depreciation rate.

2. It uses investment credit to fall advantage by strategic acquisition and

disposition of property, plant and equipment.

3. It reduces research and developments, costs and similar expenses in the

years in which they are incurred instead of capitalizing them and

amortizes such costs over a number of years.

4. It adopts changes in accounting procedures particularly those initiated

by the internal reserve service or exploits changes in reporting periods.

Cash forecasting:

Cash forecasts are required to prepare cash budgets. Cash forecasting may be

done on short term or long-term basis. Generally, forecast covering period of one

year or less are considered short term, those beyond one year considered long term.

Types of cash forecast

Short term forecast:

It covers a period of one year or less. The important uses of short term cash

forecast are:

It helps in determining cash requirements.

It helps in anticipating short term financing.

It helps in managing money market investments.


Short – term forecast

Long – term forecast

40


Long-term cash forecasting:

Long-term cash forecasts are prepared to give an idea of the company’s

financial requirements. Once a company has developed a long term cash forecast, it

can be used to evaluate the impact of new product developments or plant acquisition

on the firms financial position; three, five or more years in future.

The Major uses of long-term cash forecasts are:

1. It indicates a company’s future financial needs, especially for its

working capital requirements.

2. It helps in evaluating proposed capital projects. It pinpoints the cash

required to finance these projects as the cash to be generated by the

company to support them.

3. It helps in improving corporate planning. Long-term cash forecasts

compel each division to plan for future and to formulate projects

carefully. Long-term cash forecasts may be two, three or five years.

How to manage debts?

a. Establish a credit policy:

The company should consider whether it is appropriate to offer credit at all

and if so how much, to whom and under what circumstances.

b. Assess customers’ credit worthiness:

From their banker or other sources before allowing trade credit.

c. Establish effective administration of debtors:

That not goods are dispatched until it has been vouched that the present order

will take the customer above his predetermined credit limit.

That invoices for supplied on credit go off the customers as soon as possible

after the goods are dispatched and this encourages the customers to initiate

payments sooner rather than later.

That existing debtors are systematically reviewed and that slow payers are sent

reminders.



d. Establish a policy on bad debts:

The company should decide what is policy on writing off bad debts should be.

This policy should be planned except in unusual circumstances. It is important that

writing off a bad debt only occurs when all steps mentioned in the policy have been

followed. Such writing off should be done at a senior level management.

e. Consider offering discount for prompt payment:

It is possible to enter into agreement with a factoring company. In such cases,

payment is received from factoring company immediately after sale.



INVENTORY MANAGEMENT

Inventory:

It refers to stock, raw materials, components, and spares or work-in-progress

maintains in an organization to have continuous production and sales. Inventory

management is the third component of working capital management. It involves the

processes of providing continuous flow of raw materials to production department.

More than 60% of the working capital will normally be invested in the inventory.

Hence, the management of inventory has gained considerable recognition in the

subject of financial management. An efficient system of inventory management

directly contributes to the growth of profitability of the business concern. Due to

inflation and the concept of time value of money, inventory management has gained

important recognition in the day-to-day management of business units.

The scientific process of implementing inventory management provides

inventory at right time, from right source and at right prices. It also involves the step

that is to be taken with regard to storage and supervision of these materials. The main

objective of inventory management is to reduce the order placing and receiving and

inventory carrying cost. This not only ensures continuous flow of raw materials but

also the cost of production. The excess and inadequate supply of raw materials

directly disturbs the normal functioning of the business units. Excess inventory leads

to idle investment, high carrying cost and wattage. Inadequate inventory directly

affects the production process. Therefore, scientific principles are to be adopted to

manage the inventory. To avoid all these problems, in Japan, JIT concept has been

introduced (Just In Time). It refers to the supply of raw materials to the production

department directly by the suppliers. The agreement will normally be made with

supplier of materials on such terms, so that the supply of raw materials must be made

without any interruption to the normal production activities.

The success of this arrangement mainly depends on the sound infrastructure

facilities. In India, only few industries have introduced JIT concept to procure raw

materials directly. Example: Kirloskar and Maruthi Udyog Private Limited. These

have introduced this technique in procuring certain components directly from the

suppliers.



OBJECTIVES OF INVENTORY MANAGEMENT

The important objectives of inventory management are:

1. To provide continuous supply of raw materials to carry

uninterrupted production.

2. To reduce the wastage and to avoid loss of pilferage, breakage and

deterioration.

3. To exploit the opportunities available to reduce the cost of

purchase.

4. To introduce scientific inventory management techniques.

5. To provide right materials at right time, at right sources and at right

prices.

6. To meet the demand for goods by the ultimate consumers on time.

7. To avoid excess and inadequate storing of materials.

8. To protect quality of raw materials.

9. To reduce the order placing and receiving costs to the minimum.

10. To ensure effective utilization of the floor space.

Costs associated with holding inventory:

The continuous flow of inventory is most essential to carry out smooth

productive activities. The success and timely supply of finished goods, mainly

depends on uninterrupted supply of raw materials to the production department. To

ensure this flow of raw materials, the company has to maintain adequate quantity of

inventory. Storing of these components involves many types of costs and

uncertainties. As the value of the materials, increases than the value of a rupee, it

should be maintained judiciously. Some of the costs associated in managing the

inventories are discussed below.

1. Financial costs:

It is also known as capital cost. The finance required to purchase the

inventory and the cost beard for mobilizing, it is known as financial cost. Therefore

adequate supply of finance at cheapest cost must be made available to maintain the

inventory.



2. Costs of storage:

Inventory is to be stored properly by protecting the quality. The space

required for storing the inventory must be adequately provided. This cost consists of

the rent payable for storing the materials and maintenance of inventory cost

(Insurance).

3. Price fluctuations:

Inventories are exposed to wide fluctuations in the price. Many a times, the

prices of materials may be reduced. If the price paid for procuring the materials is

higher than the price that is prevailing, it is a loss to the business firm.

4. Risk of obsolesce:

Due to the increased research and innovative and creative minds of

technologies, new materials and products will enter into the market. Under such

circumstances, the product manufactured today becomes obsolete.

5. Deterioration in quality:

In a practical situation, the production department for various reasons may not

issue most of the materials stored. In the process, such material losses its quality or

deteriorates itself from original value.

6. Theft, damages and accident:

The materials are stored in the warehouse. If it is not properly taken care, it is

exposed to different types of uncertainty viz., theft, damage and fire accident etc., all

these are losses or increase the cost production.

7. Order placing cost:

Order placing cost is the permanent cost, which is incurred by the business

firm to place the order for materials, the salary of clerk, manager and establishment

charges will also be considered in managing the inventory.

8. Inventory carrying cost:

It maintains the expense of stores, bins to the staff who are in charge of the

warehouse or storage. Hence these costs are reduced to increase the profitability of

the firm.



T O O L S

9. Cost of shortage of stock:

Many a times, business firms may not be able to arrange the adequate supply

of regular for various reasons. As a result, production work may be stopped.

Therefore, sufficient care should not be taken to have this cost running the business.

Tools of inventory management:

1. Fixation of levels:

It is a tool through which the inventories are maintained by fixing different

levels namely: maximum level, re-order level, Minimum level and Danger level.

Fixations of levels are made by considering different factors viz., nature of raw

materials, cost, availability lead-time, storage space and cost etc.,

Maximum level:

It is a level set for materials beyond which it should not be stored.

Considering the various factors namely availability of raw materials, lead-time,

storage space etc., Materials stored beyond maximum level creates several financial

and managerial problems to the firm sets maximum level. The following formula is

used to fix maximum level.

Maximum stock level = Re-order level = Re-ordering quality – (minimum

consumption x minimum re-ordering period)

Re-order level:


Fixation of levels

ABC analysis

EQQ

Perpetual inventory system

VED analysis

FSN analysis

Periodical inventory evaluation

46


Re-order level is that level fixed for the materials to indicate the urgency of

procuring them for the market. This level is fixed by considering the rate of

consumption of materials, lead-time and the availability of raw material. Once the

materials reaches this level, stores controller places his request to purchase the

materials. So those, he can maintain storage of such items to maximum level.

Re-order level = maximum consumption x maximum re-order period.

Minimum level:

It is also known as safety stock, below which the storing of materials leads to

severe consequences. In other words, it is a level at which stores controller takes

immediate action in procuring the materials. Any negligence on the part of the in

charge of stores may lead to stoppage of production. Considering lead-time, rate of

consumption and the nature of material sets this level.

Minimum stock level = re-ordering level – (normal consumption x normal re-order

period)

Danger level:

It is the level beyond which storage of materials should not fall. It also

indicates the necessity to arrange for quick purchase of materials. Otherwise, a firm

has to stop the production of major plants. The stores in charge may procure the

materials even at the cost of extra expenses and strain.

Danger level = average consumption x maximum re-order period for emergency

purchase.

2. ABC analysis:

Under this method, the material is managed by giving importance to its value.

Classifications are being made by grading the materials as A,B and C. Grade A

materials are costly high in value but less in number and are supervised and controlled

closely. Grade C materials are cheap in value but more in quantity and least attention

are given in monitoring these times. Grade B materials are moderate in value and

moderate number of such items are maintained with moderate control.

3. Economic order quantity:



Economic order quantity is that quantity of materials to be ordered where it

will have least or minimum order placing and carrying cost. It is also called as the

size of the materials to be purchased most economically. The ordering cost or order

placing costs consists of salary of the staff who are in charge of ordering goods,

transportation costs, inspection costs, cost of stationery, typing, postage, telephone

charges etc., Carrying costs refers to the cost of capital, cost of storage, insurance cost

and cost of spoilage etc., both these costs should be maintained at minimum to order

for a specific quantity of materials this can be calculated by using a formula where A

= annual consumption in rupees; S = cost of placing an order; I = inventory carrying

cost of one unit.

2AS

Economic order quality =

I

4. Perpetual inventory system:

It is also referred as continuous stock checking. Under this system, registers

are maintained for materials, entries are made as and when the materials are received

and issued. The physical verification of materials is conducted throughout the year.

Hence it is identified as a costly technique of inventory control. Though it is a costly

technique, the benefits enjoyed by the management are many statements of materials,

follow up action, monitoring etc., can be smoothly carried out. As a result of this

benefit, many trading as well as manufacturing concerns are adopting this technique

for inventory management.

5. VED analysis:

It is most suitable method for automobile industries specially to maintain spare

parts. All parts are classified into vital, essential and desirable components. Vital

parts for the manufacturing of a product will be closely monitored. Inadequate supply

of these parts may substantially damage the productive activities. E type of materials

is no doubt that they are essential, but their levels of stocks are moderately low.

Desirable (D) components may or may not be maintained. Non-availability of D type

of spares do not damage the normal functioning of the industry.

6. FSN analysis:



Under this method, materials are grouped according to the movements. Fast

moving items, slow moving and non-moving items. Fast moving items are stored in

large quantity and a close watch on the movement of such items is kept. The

production department does not frequently need slow moving items; accordingly

moderate quantity with moderate supervision will be maintained. The production

departments rarely require non-moving items. Hence a smaller number of materials

are kept in stores and less importance is given in inventory management.

7. Periodical inventory valuation:

Under this system inventory valuation with checking will be carried out at

different intervals, generally twice or thrice in a year. During the period of stock

checking, normal functioning of the organization will be closed for one or two days

and complete stock verification and valuation will be done accordingly. Most of the

trading concerns adopting this technique for their inventory management.

Factors influencing inventory requirement:

1. Lead-time:

It refers to the time gap between the recognition of a need and its fulfillment.

During lead-time, production has to depend on the existing stock of raw materials, as

there is no delivery of the same. Both lead-time and consumption rate can be

increased abruptly and inventories are generally maintained to tie over this

contingency. Therefore, as the lead-time increases, the inventory maintained on hand

also increases.

2. Cost of holding inventory:

Whenever inventory are held, it involves costs

Material cost:

The cost of purchase of raw materials plus transport and handling charges.

Order cost:



The cost of placing an order with the supplier and generally, in the nature of

stationery and administrative costs.

Carrying cost:

Consists of the cost of funds locked up in inventory, storage cost etc.,

Stock out cost:

The cost of shortage of inventory, causing a loss in current profits and decrease in

future sales.

3. Reorder point:

The represents the level of inventory at which an order should be placed to

replenish stocks and is determined by the rate of consumption of inventory and lead-

time. If the reorder point is at a higher level, inventory will be high and if is set a

lower level, stock of raw materials will tend to be low.

4. Reduction in variety:

Generally, a production firm will have in stock a large variety of items used in

different stages of production process. As the operations of the firm expand, the

stocks of these items too increase, making control difficult. Therefore, firms try to

reduce the variety of stock items, which they hold, thus reducing the inventory on

hand.

5. Service level:

The service level of a firm is the ratio of the number of orders it can fulfill to

the number of orders received i.e., how many of the orders a firm has received can be

fulfilled by it. To have a higher service level, a firm most obviously has a high level

of raw materials and finished goods.

6. Scrap and obsolete inventory:



Sometimes, a firm’s inventory can become obsolete due to technological

development or change in consumer tastes and preferences. In such a situation, a firm

must quickly dispose off its obsolete inventory to avoid incurring further losses. This

decreases the level of inventory on hand.


Production and trading concerns have to carry large inventory. Trading

concerns have to carry large inventory to ensure smooth trading activity. While

retailers have to stock a variety of products, since they sell to ultimate consumers,

wholesalers need to carry stock of only a single / few items, since they sell to

intermediaries. Retailers may thus need more funds. Similarly, service firms do not

carry an inventory since they provide services.

8. Inventory turnover:

Firms belonging to the same industry may have different inventory levels due

to difference in turnover. Inventory turnover reveals how many times the inventory

turns over during a period i.e., the ratio of sales to inventory. Greater the turnover,

lesser the investment in inventory. A firm having a high turnover can manage a

relatively large volume of trade with the same amount of inventory. Inventory

carrying costs also tend to be less, as also risks associated with price declines.

9. Method of inventory valuation:

The level of inventory also depends on the method of valuing inventory.

Under FIFO, material acquired is consumed first and the closing stock represent

material acquired last. Under LIFO, goods acquired recently are disposed off first and

the closing stock represents material purchased in the beginning of the period. if

LIFO were followed in times of rising prices, investment in inventory would be less

than if FIFO had been used. The opposite is true to declining prices.

10. Ability of management to predict disruption:



If the management of a firm can predict disruptions in production with

reasonable accuracy, it can maintain a lower inventory than when it cannot predict

disruptions, as higher levels will have to be maintained to meet contingencies.

11. Credit terms availed:

If the supplier provides material on demand but agrees to accept payment only

at the time of sale of finished goods, a firm need not maintain high inventory levels.

Factors influencing inventory of raw material:

1. Quantity of estimated production:

The quantity of raw material to be stocked depends on the quantity and pattern

of goods to be produced. The production and sales manager must thus be consulted

before fixing the raw materials to be held. If the firm anticipates a decrease in

demand, production naturally decreases and therefore fewer raw materials would need

to be stocked. The opposite is true, if demand is expected to rise. Moreover, if a firm

produces a variety of finished goods, its investment in inventory will be substantial

because different kinds of raw materials will have to be stored.


The nature of business of a firm influences the level of raw material it has to

stock. Production firms, for e.g., tend to have a higher stock of raw materials while

trading firms will not have any stock of raw materials – they store only finished

goods.

3. Need to increase inventory:

Sometimes, it is more profitable for a firm to have higher levels of raw

materials. Increased inventory is advantageous in the following situations.

When quantity discounts are being offered, which prove economical to the

firm, i.e., when the benefits of the discount far exceed the cost of carrying

increased inventory.

When the supply of raw materials is not reliable or is seasonal.

In cases where the firm produces a seasonal product and so needs to increase

stocks of raw materials during the peak season.



When the lead-time is high, the firm will have to carry out more safety stocks

to meet the delay in delivery of material.

4. Business cycles:

During the boom period, stocks of raw materials have to be high to meet the

expected rise in demand. Moreover, prices of raw materials are usually cheaper in the

initial stages of a boom period and companies therefore take advantage of this and

buy in bulk increasing their stock levels in the process.

5. Management policy:

The policy of the management towards inventory and its control determines

the level of raw material. For e.g., if the firm follows the JIT method of stocking

inventory, there will be lower levels of raw materials, lesser investment in inventory,

lesser cost and lower risk. However the JIT approach has its disadvantages – the unit

price of raw material in small purchases is higher than in big lots. Ordering costs also

increase, because of frequent orders and there exists a risk in the case of rising prices

of raw materials. To overcome these drawbacks, a firm may store a higher level of

raw material, which increases the investment in inventory.

Factors influencing inventory of finished goods:

Since a firm has no control over the rate at which its products are sold, it has

to hold an adequate stock of finished goods to meet changes in demand. But holding

a large stock of finished goods increases the carrying cost and also the risk of loss in

case of a price decline or changes in consumer tastes and preferences. The following

factors influence the level of finished goods stocked by a firm.

1. Inventory turnover:

The level of finished goods inventory, depends on how well production and

sales are co-ordinate. A liberal credit polity can dispose off finished goods faster,

thus reducing the level of finished goods, but it also increase the funds tied up in

inventory, because cash is not immediately realized when finished goods are sold.

The possibility of bad debts also increases.

2. Need to store finished goods:

The need to store finished goods varies from business to business. Firms

producing seasonal goods, for e.g., have to store higher level of finished goods to



meet continuous demand throughout the year. Some firms supply raw materials to

other firms on the conditions that the latter source their finished goods to them. The

firm sending the finished goods to its suppliers need not hold a very high level of

finished goods, as also firms which manufacture against advance orders.

3. Business cycle:

A firm ends up carrying out a higher inventory of finished goods during

recession, because of decreased demand and a lower inventory during boom due to

peak demand.

4. Durability of product:

The durability of product determines its stock level. Perishable products such

as processed foods cannot be stored in large numbers. Producers of FMCGs cannot

afford too large or too small an inventory due to rapid changes in consumer tastes and

preferences rendering the goods obsolete; durable goods however can be stocked in

large numbers.

5. Management attitude:

Dynamic, proactive managers try to anticipate future changes in demand by

using advanced techniques to increase the accuracy of such estimates. Therefore,

adjustments in production and inventory can be made and the risk / loss due to faulty

estimates can be reduced. Conservative managers on the other hand do not bother

about estimating changes in demand – they prefer to carry large stocks and err on the

side of caution.



Factors influencing inventory of work-in-progress:

Until work – in – progress are converted to finished goods and sold, funds are

tied up in them. The following factors determine the inventory of work-in-progress.

1. Length of production cycle:

Longer the time taken for inventory to travel through various production

processes, greater are the funds invested in work – in- progress and vice – versa. A

complicated production process would mean a longer production cycle and large

funds locked up in work – in – progress. The production process can however be

speeded up and the production cycle shortened, by implementing advanced techniques

of production.

2. Operating efficiency:

Greater the operating efficiency, shorter the production cycle and lower the

funds invested in work – in – progress.

3. Sub – contract:

Some firms sub-contract various jobs of the production process to outside

contractors and merely assemble the various parts received from these contractors.

Such firms will have a very low investment in work – in – progress.



RECEIVABLE MANAGEMENT

Introduction:

What are accounts receivable?

John.J Hampton defines accounts receivable as “Asset accounts representing

amounts owed to a firm, as a result of the sale of goods / services in the ordinary

course of business”. Therefore, they represent the claims of a firm against its

customers and are shown in the assets side of a balance sheet under the heading

accounts receivable / trade receivable / customer book / book debts. Firms to allow

customers a reasonable period of time to pay for goods purchased and thus represents

an extension of credit to them provide the facility.

The problem of managing receivables arises only when goods are sold on

credit, which has become the sine qua non of today’s competitive economy. If

competitors are offering credit, a firm will be forced to do the same to retain, if not

increase in its market share. As a marketing tool, credit is generally used to promote

sales and profits. However, it is also lengthens the cash cycle since goods sold are not

converted to cash but a book. If funds are not tied up in receivables, the company can

invest the same in profitable avenue and earn a good return.

Therefore, the opportunity cost of lost profits is one of the major costs of

carrying receivables. The others are cost in involved in investigating the credit

worthiness, collection costs and risk of bad debts. A firm selling goods for cash can

reduce these costs, but only at the cost of sales / customers. A firm, selling on cash,

cannot survive when it’s reducing the volume of receivables without harming sales.

He should manage receivables in such a way that it optimizes profits. The objective

of the credit policy should be to promote sale and profits till the point where the ROI

in funding additional receivables is less than the cost of funds used to do the same.

Meaning of receivables management:

Accounts receivables form the second largest constituent of CA after

inventory and thus the need for their effective management arises. Since selling



goods on credit locks up funds in receivables, the firm will have to borrow money to

finance its operating needs. The finance manager has to determine the ideal level of

receivables, so that there is smooth flow of working capital. A higher debtors

turnover ratio will also help us in minimizing borrowings to meet the working capital

requirement. Receivables management, therefore consists of maintaining debtors at

an optimum level, determining the degree of credit sales to be made, making the

turnover of debtors faster, minimizing the cost of borrowing funds for working

capital, etc.,

Purpose of receivables management:

Receivables came into existence as result of credit sales. The objective of

receivables is thus directly related to the objectives of credit sales.

1. Increasing sales:

A firm tends to sell more goods on credit than the cash, because many

customers are either not prepared or not in a position to pay cash when they purchase

goods. The firm can therefore sell goods to such customers, only if it offers credits.

2. Increasing profits:

Profits increase when goods are sold on credit. This happens, because of two

reasons

Increased sales,

Higher profit margin charged on credit than on cash sales.

3. Meeting competition:

If a firm’s competitors have been extending credit facilities, the firm is forced

to do the same. Otherwise, its chance to lost customers, who would rather buy goods

where credit facilities are offered.

Objectives:



Accounts receivables represent an extension of credit to customer allowed

them a reasonable period of time in which to pay for the goods, which they have

received. The creditors are generally made to open an account in the sense that they

are no formal acknowledgement of the debt obligation through a financial instrument.

As marketing tools they are intended to promote sales and thereby profits. However,

extension of credit involves risk and cost. The objective of receivables management

is it permits sales and profits until that point is reached where the return on investment

is further additional credit (cost of capital). The specific cost of benefits that is

relevant to the determination of the objectives of receivables management are

examining below.

Costs: There are major categories of cost are

1. Collection costs

2. Capital costs

3. Delinquency costs and

4. Default costs

1. Collection cost:

The costs are administrative cot incurred in collecting the receivables from the

customers to whom credit sales have been made. Additional expenses on the creating

and maintenance of credit department with staff accounting records, stationery,

postage, and other related items. Expenses involved in acquiring credit information

either through outside specialist agencies or by the staff of the firm itself.

2. Capital cost:

The increased level of accounts receivables is an investment in assets. They

have to be financed thereby involving a cost. There is a time lag between the sale of

goods to and payments by the customers. Meanwhile the firm has pay employees and

suppliers of raw materials thereby implying that the firm should arrange for additional

funds to meet its obligation while waiting for payments for its customers. The cost on

the use of additional capital to support credit sales, which alternatively could be

profitably, employed else where is therefore a part of the cost of extending credit or

receivables.

3. Delinquency cost:



Yet another cost is associated with extending credit to customers. This rise

out of the failure of the customers to meet obligation when payment on credit sales

due after the expiry of the period of credit. Such cots are called delinquency cost.

The important components are

Blocking up of funds for an extended period

Cost associated with steps that have to be intended to collect the over dues,

such reminders and other collection efforts, legal charges whenever necessary and so

on.

4. Default cost:

Finally in addition to the above costs the firm may not be able to recover the

over dues because of the inability of the customers. Such debts are treated are bad

debts and have to be written off as they cannot be realized. Such credit is known as

default cost associated with credit sales and accounts receivables.

Purpose of receivables:

1. Achieving growth in sales:

If it sells goods on credit, it will generally be in a position to sell more goods

than if it insisting on immediate cash payment. This is because many customers are

either not prepared or not in a position to pay cash when they purchase the goods.

The firm can sell goods to such customer’s in case it resorts to credit sales.

2. Increasing profits:

Increase in sales results in higher profits for the firm not only because of

increase in the volume of sales but also because of the firm charging a higher margin

of profit on credit sales as compared to cash sales.

3. Meeting completion:

A firm may have to resort of granting of credit facilities to its customers

because of similar facilities to its customers because of similar facilities being granted

by the competing firm to avoid the loss from customers who would buy else where if

they did not receive the expected credit.

Characteristics of maintaining receivables:

1. Expansion of sales:



Thought it is a good policy to effect cash sales to minimum possible extent, it

may not always be possible to do so customers may not be willing to buy goods on

cash down basis. They have therefore to be encouraged with the offer of credit terms.

In the absence of such an offer, a firm may not be able to sell goods. Receivables

enable it to push its sales effectively in the market.

2. Increased profits:

As a result of increase in sales profits rise. This is ordinarily so because the

marginal contribution effected by an increase in sales is greater than additional cost

associated with such increase as also with administration of credit policy. The

maintenance of receivables involves a credit sanction, which means that the funds of

the firm are thrown open for the use of customers.

3. Financing receivables:

The uses of credit invariably involve the tie in of capital. It follows therefore

that this capital has to be financed by some source of funds. It is usually customary to

finance receivables out of:

profit retained in business

Contribution from stock holders

Debt financing.

Whatever the source of financing, it carries its own cost with the help of which

receivables must be financed. Receivables may be financed from ting capital or long-

term debt or by using additional capital or long-term debt as the case may be.

4. Administrative expenses:



The maintenance of receivables calls for the use of an administrative

machinery in different ways. A firm may be constrained to appoint several persons or

engage collection agencies to remind and even call on the delinquent customers to

make payment. A number of collection letters and reminders usually follow which

eventually increase the cost of collection.

5. Bad debts:

The decision to maintain receivables implies that some amount of bad debts

would be incurred because of default on the port of the delinquent customers. A firm

can only hope to nullify its bad debts. As best it can only hope and strive hard for

reducing them to the minimum. It is therefore advisable for a firm to assess the

impact of the changes in collection cost is bad debt losses administrative expenses and

such other factors from time to time.

Level of sales:

The most important factor in determining the volume of receivables is the

level of a firm’s credit sales. With an increase in the size of sales, it may decide to

bring about a proportionate increase in the magnitude of receivables.

Credit policy:

A firm with a liberal credit policy may keep a higher level of receivables that

with a conservative or rigid credit policy. Moreover, customers may not pay their

receivables promote. It should be remembered that weak customers might be

promoted in payment if they are persuaded to pay, failing which they are likely to be

converted into defaulters. In establishing its credit policies a firm to find a

satisfactory middle ground between incurring collection costs that accompany a

highly aggressive policy and suffering excessive default and bad debts that

accompany lenient policy.

Terms of trade:



The size of receivables is closely linked with a firm’s trade terms which

include the period of credit, the rate of discount, etc., The pressure of competition

always tend to constrain a firm to offer credit terms that are at least as generous as

those offered by competitors. The terms of credit thus become almost customary.

Profits:

A firm investigates different possibilities and forecast the effect of each

possibility on its future profits. As the level of receivables increases cost of financing

them goes, up, however with an increase in receivables there is also an increase in

sales, the relation between cost and benefit in the maintenance of receivables has to be

properly traced. If in the ultimate analysis it were discovered that the benefit is

greater than the cost of the decision would certainly be in favors in maintaining

receivables.

Market:

It may be necessary for a firm to explore a new market for its products or

services. One of the attractive ways in which a firm enters a new market is by

inducing customers to buy from it because of the facilities of receivables extended to

them. Such an inducement moreover accelerates the growth rate to the firm and

enables it to undertake plans to expansion.

Grant of credit:

Size of receivable depends upon the policies and practices of the firm in

determining which customers are to be granted credit.

Payable habits of customers:

These too are capable of influencing a firm’s policy in regard to receivables.

Collection policies:

The vigor with which a firm collects its dues from customers affects its

policies in regard to receivables; for, if the amount when due are not collected, a firm

suffers some financial difficulties, if not losses.

Credit policy:



Risks of loss and the burdens involved in the tying up of funds are considered

while determining a credit policy.

Operating efficiency:

The degree of operating efficiency in billing record keeping and other

functions also exercise influence on a firms credit policy.

The volume of cash sales:

The tendency of credit expansion is usually related to the volume of credit

sales.

Credit collection:

Individual firms set up their own well organization credit collection

departments.

Advantages of receivables:

It is an interesting fact that business enterprises have little or no understanding

of this method of borrowing or how simply their accounts receivables may be

employed as a source of borrowing cash.

The assignment of accounts receivables furnishes additional operating cash

and there is no need for diluting the equity and control of owners. Owners

moreover, small and medium size corporations find it difficult to rise

additional as through security issues.

Small medium size and even large corporations find it expensive to raise funds

through long-term debt. The accounts receivables financing arrangements

provides a business firm with an established source of fund which may be

used for long as well as short term purposes and which does not obligate it to

pay money when it is not needed. Business firms find it very difficult to

secure cash through unsecured loans from commercial banks and other debts,

account receivables financing therefore serves as limited loan to a rapid and

successful finance undertaking company.

Accounts receivable financing is of a revolving nature and provides a

continuous source of operating.

It is flexible because borrowing under it may be contributed throughout its life

or used only temporarily to meet a constant need.



If a firm makes use of accounts receivables financing it does not have to wait

to get back the money, it has invested in the goods it sells. It simply assigns

the credit sales of its financing source.

A wise use of debt capacity as in the employment of accounts receivables for a

firm will have more cash with which it can take advantage of any profitable

opportunities, which may develop.

It enables businessmen to protect and improve a firm credit rating for the latter

is in position to pay on due dates.

Costs of maintaining accounts receivables:

Capital costs: Maintaining receivables result in locking up of funds. This is

because there is a time lag between the sale of goods and payment by

customers. The firm therefore has to arrange for funds to meet. Its

obligations-payments to employees, suppliers etc., and while waiting for its

customers to pay up. These funds can be owned or borrowed. Both however,

involve a cost. While the cost of borrowed funds is represented by the rate of

interest the firm has to pay, the cost of owned funds is nothing but the

opportunity cost of funds.

Administrative costs: Additional administrative costs have to be incurred in

the form of salaries to staff maintained for keeping the accounts of customers,

cost of investigation of potential credit customers to determine their credit

worthiness, etc.,

Collection costs: Additional costs are incurred to collect payment from credit

customers and extra efforts may be needed to recover money from defaulting

customers.

Cost of bad debts: Sometimes, defaulting customers cannot pay up, the firm

has to write off their dues as bad debt.

Factors affecting size of receivables:

Volume of credit sales:



The basic factor, which increases or decreases the size of receivables, is the

volume of credit sales. If a firm sells goods only for cash, it will no have receivables.

Higher the proportions of credit sales to total sales, greater the size of receivables.

The level of credit sales depends on the management policy. If a firm need sales to

push a product, it will have to adopt a liberal credit policy, which increases the size of

receivables.

1. Credit policies:

Credit policy refers to those decisions variables, which influence the amount

of trade credit i.e., investment in receivables. In other words, it is a policy adopted to

increase credit sales, which consists of

Time period allowed collecting debts

Types of discounts offered

Assessment of potential customers’ credit worthiness

Collection policy

Any special terms offered depending on the particular circumstances of the

firm and the customer.

A firm’s credit policy determines the amount of risk it is willing to take in its

sales activities. A lenient / liberal credit policy will imply a higher level of

receivables because even customers who can afford to pay cash immediately delay

payments. Financial weak customers will default increasing the size of receivables.

The policy varies with changes in the economy. During recession companies will

have to adopt a more liberal credit policy to encourage sales, which increases the size

of receivables. Customers may also take a longer time to pay. During boom people

will want to buy more with the surplus cash and credit will be low, reducing size of

receivables. Collection period also gets reduced.

The credit policy can be rigid or liberal. If a firm follows a rigid credit policy,

the volume of its receivables will be low, as also the risk and debtors management

will be better. If liberal credit policy is followed, the size of receivables increases and

with it, the risk of bad debts, as even customers who can afford to pay avail of credit.

The inflow of cash thus reduces.

2. Competition:



If a firm is in a competitive industry, it will be forced to follow a liberal credit

policy to retain its market share. This is reflected in the increased size of receivables.

3. Location:

The location of a firm influences its credit policy. If the firm is situated in an

isolated or far-off place, it may be coerced to offer liberal credit to attract customers.

4. Kind of products:

The type and nature of products manufactured by a firm influence the size of

receivables. Firms manufacturing exclusive products can afford a conservative

policy. While those manufacturing competitive products will have to offer liberal

credit. When new products are introduced, liberal credit policies have to be followed

till the market accepts the new product.

5. Expansion plans:

When a firm wants to enter new markets, it may have to offer incentives to

customers in the form of liberal credit. Therefore, during the early stages of

expansion, more credit becomes essential and the size of receivables increases

correspondingly.

6. Relation of profits:

Credit is used to increase sales and thereby the profits but beyond a certain

point, the cost of increased sales will be greater than the revenue from the same.

Therefore, it is advantages to a firm to increase sales only upto the point where

benefits exceed the cost.

7. Credit collection efforts:

Effective and efficient collection efforts can reduce the size of receivables

without harming sales. If adequate attention is not paid to collection or if collection is

not effective the firm will find it saddled with the high debts.

8. Customer habits:



Some customer’s delay paying their dues though they are financially sound.

The unnecessarily increase the size of receivable and the cost of funding them.

Therefore, customer payment habits should be studied before granting credit.

Approach to receivables management:

It is the credit department in an organization, which performs the job of

granting credit to customers, supervising the collection of receivables. The basic

objective of receivables management is to maximize the ROI of funds invested in

receivables. Managing receivables means making decisions relating to the incitement

of funds in receivables, as a part of internal short run operating process. The goal of

liquidity entails using cash as economically as possible to expand receivables without

adversely affecting sales and the chances of increasing short-term profits.

Therefore, finance managers must keep in mind the dual objectives of

maintaining sufficient cash for current operations and of expanding credit sale to earn

more profits. Policies, which stress on short credit periods, strict. Credit standards

and a highly aggressive collection policy may help reduce bad debts and the amount

of funds locked up in receivables, but they also discourage sales and therefore depress

the profits. Consequently, the rate of return on the total investment of the firm may be

lower than that achievable with a higher level of sales, receivables and profits.

Liberal credit policies, on the other hand, may increase the receivables and bad debts

without increasing sales and profits correspondingly. So, the objective of receivables

management is to achieve a balance between these two policies, which result in the

combination so those sales and profit rates that maximize the overall rate on total

investment. To achieve this, there must be co-ordination between the sales and

finance manager.

The two basic goals of financial management, liquidity and profitability,

concentrate on the following in receivables management.

10. The prospect of collecting receivables when they become due.

11. The prospect of shortening future receivables activities. Liquidity increases as

the certainty of collecting receivables on maturity increase and vice-versa.



RATIO ANALYSIS AND CLASSIFICATION OF RATIOS

Ratio Analysis:

Ratio analysis is a powerful tool of financial analysis. In such an analysis the

ratios are used as yardstick for evaluating the financial condition and performance of

the firm. Analysis and interpretation of various accounting ratios give a skilled and

experienced analyst a better understanding of the financial condition and performance

of the firm than what he could have obtained only through a perusal of financial

statements.

Meaning of ratios:

The relationship between two accounting figures, expressed mathematically is

known as a ratio (financial ratio). The term ratio refers to the numerical or

quantitative relationship between two figures. A ratio is the relationship between two

figures, and obtained by dividing the former by the later. Radios are designed to

show how one number is related to another. Ratios are relative form of financial

statements to measure the firms’ liquidity, profitability and solvency.

Significance of ratio analysis:

Following are the significance of ratio analysis

A. Managerial uses of ratio analysis:

1. Helps in decision-making:

Financial statements are prepared primarily for decision-making. But the

information provided in financial statements is not and in itself and no meaningful

conclusion can be drawn from these statements alone. Ratio analysis helps in making

decisions from the information provided in these financial statements.

2. Helps in financial forecasting and planning:

Ratio analysis is of much help in financial forecasting and planning. Planning

is looking ahead and the ratios calculated for a number of years work as a guide for

the future. Meaningful conclusions can be drawn for future from these ratios. Thus,

ratio analysis helps in forecasting and planning.



3. Helps in communicating:

The financial strength and weakness of a firm are communicated in a more

easy and understandable manner by the use of ratios. The information contained in

the financial statements is conveyed in a meaningful manner to the one for whom it is

meant. Thus, ratios help in communication and enhance the value of the financial

statements.

4. Helps in co-ordination:

Radios even help in co-ordination, which is of utmost importance in effective

business management. Better communication of efficiency and weakness of an

enterprise results in better coordination in enterprise.

5. Helps in control:

Ratio analysis even helps in making effective control of the business.

Standard ratio can be based upon preformed financial statements and variances and

deviations, if any, can be found by comparing the actual with the standards so as to

take a corrective action at the right time. The weakness or otherwise, if any, come to

the knowledge of the management which helps in effective control of the business.

6. Other uses:

These are so many other uses of the ratio analysis. It is an essential part of the

budgetary control and standard costing. Ratios are of immense importance in the

analysis and interpretation of financial statements as they bring the strength or

weakness of a firm.

B. Utility to share holders / investors:

An investor in the company will like to assess the financial position of the

concern where he is going to invest. His first interest will be the security of the

investment and then a return in the form of dividend or interest. For the first purpose

he will try to assess the value of fixed assets and the loan raised against them. The

investor will feel satisfied only if the concern has sufficient amount of assets. Long-

term solvency ratios, on the other hand, will be useful to determine profitability

position. Ratio analysis will be useful to the investor in making up his mind whether

present financial position of the concern warrants further investment or not.



C. Utility to creditors:

The creditors or suppliers extend short-term credit to concern. They are

interested to know whether financial position of the concern warrants their payments

at a specified time or not. The concern pays short-term creditors out of its current

assets. If the current assets are quite sufficient to meet current liabilities then the

creditors will not hesitate in extending credit facilities. Current and acid test ratios

will be an idea about the current financial position of the concern.

D. Utility to employees:

The employees are also interested in the financial position of the concern

especially profitability. Their wage increases and amount of fringe benefits are

related to the volume of profits earned by the concern. The employees make use of

information available in financial statements. Various profitability ratios relating to

gross profit, operating profit, net profit, etc enable employees to put forward their

viewpoint for the increase of wages of other benefits.

E. Utility to government:

Government is interested to know the overall strength of the industry. Various

financial statements published by industrial units are used to calculate ratios for

determining short-term, long term and overall financial position of the concerns.

Profitability indexes can also be prepared with the help of ratios. Government may

base its future policies on the basis of industrial information available from various

units. The ratios may be used as indicators of overall financial strength of public as

well as private sector. In the absence of the reliable economic information,

governmental plans and policies may not prove successful.

F. Tax audit requirements:

The finance act, 1984, interested section 44 AB in the Income Tax Act. Under

this section every assesse engaged in any business having turnover or gross receipts

exceeding Rs. 40 lacks is required to get the accounts audited by a chartered

accountant and submits the tax audit report before the due date for filing the return of

income under section 139(1). In case of a professional, a similar report is required if



the gross receipts exceed Rs. 10 lacks. Clause 32 of the Income Tax Act requires that

the following accounting ratios should be given:

Gross profit / turnover

Net profit / turnover

Stock-in-trade / turnover

Material consumed / finished goods produced.

Advantages of ratio analysis:

Simplifies financial statements

Facilitates inter-firm comparison

Makes inter-firm comparison possible

Helps in planning

Limitations of ratio analysis:

The ratio analysis is one of the most powerful tools of financial management.

Though ratios are simple to calculate and easy to understand, they suffer from some

serious limitations.

1. Limited use of a single ratio:

A single ratio, usually, does not convey much of a sense. To make a better

interpretation a number of ratios have to be calculated which is likely to continue the

analyst than help him in making any meaningful conclusions.

2. No fixed standards:

No fixed standards can be laid down for ideal ratios. There are not well-

accepted standards or rules of thumb for all ratios, which can be accepted as norms. It

renders interpretation of the ratios difficult.

3. Inherent limitation of accounting:

Like financial statements, ratios also suffer from the inherent weakness of

accounting records such as their historical nature. Ratios of the past are not

necessarily true indicators of the future.

4. Change of accounting procedure:

Change in accounting procedure by a firm often makes ratio analysis

misleading, example, a change in the valuation of methods of inventories, from FIFO

to LIFO increases the cost of sales and reduces considerably the value of closing



stocks which makes stock turnover ratio to be lucrative and an unfavorable gross

profit ratio.

5. Window dressing:

Financial statements can easily be window dressed to present a better picture

of its financial and profitability position to outsiders. Hence, one has to be very

careful in making a decision from ratios calculated from such financial statements.

But it may be very difficult for an outsider to know about the window dressing made

by a firm.

6. Personal bias:

Ratios are only means of financial analysis and not an end in itself. Ratios

have to be interpreted and different people may interpret the same ratio in different

ways.

7. Incomparable:

Not only industries differ in their nature but also the forms of the similar

business viable differ in their size and accounting procedures, etc., It makes

comparison of ratios difficult and misleading. Moreover, comparisons are made

difficult due to differences in definitions of various financial terms used in the ratio

analysis.

8. Absolute figure distractive:

Ratios devoid of absolute figures may prove distortive, as ratio analysis is

primarily a quantitative analysis and not a qualitative analysis.

9. Price level changes:

While making ratio analysis, no consideration is made to changes in price

levels and this makes the interpretation of ratio invalid. If the price level changes are

considered for ratio analysis, then it may lead to misleading results.

10. Ratios are a composite of many figures:

Ratios are a composite of many different figures. Some over a time period,

others are at an instant of time while still others are only averages.



FUNCTIONAL CLASSIFICATION OF THE RATIOS

1. Liquidity ratios or short-term solvency ratios:

Liquidity refers to the ability of a firm to meet its obligations in the short run,

certain the financial condition of a firm. Liquidity ratios are calculated by

establishing relationships between current assets and current liabilities. To measure

the liquidity of a firm, the following ratios can be calculated.

a. Current ratio:

Current ratio may be defined as the relationship between current assets and

current liabilities. This ratio, also know as working capital ratio. This ratio is most

widely used to make the analysis of a short-term financial position or liquidity of a

firm. It is calculated by dividing the total of current assets by current liabilities. Thus,

Current Assets

Current ratio =

Current liabilities

Components of current ratio:

Current assets:

1. Cash in hand

2. Cash at bank

3. Debtors

4. Bill receivable

5. Prepaid expenses

6. Money at calls and short notice

7. Stock

8. Sundry supplies

9. Other amounts receivable with in a year



Current liabilities:

1. Creditors

2. Bill payable

3. Bank overdraft

4. Expenses outstanding

5. Interest due or payable

6. Reserve for unbilled expenses

7. Installment payable on long-term loans

8. Any other amount which is payable in short period (one year)

Significance of current ratio:

1. Current ratio indicates the firm’s ability to pay its current liabilities i.e., day-

to-day financial obligations.

2. It shows short-term financial strength and solvency of a firm.

3. It is a test of a credit strength and solvency of a firm.

4. It indicates the strength of the working capital.

5. It indicates the capacity to carry on work effective operations.

6. It discloses the over-trading or under-capitalization.

7. It shows the tendency of over investment in inventory.

8. Higher the ratio i.e., more than 2:1 indicates adequate working capital.

9. Lower ratio i.e., less than 2:1 indicates inadequate working capital.

10. It discloses the quantity of working capital position.

Ideal Ratio:

A ratio equal or near to the thumb of 2:1 i.e., current assets double the current

liabilities is considered to be satisfactory.



CALCULATION OF THE RATIO FOR THE COMPANY FOR 2008-10

Particulars 2008 2009 2010

Current Assets 52,99,17,000 61,67,88,000 69,15,53,300

Current

Liabilities

36,55,53,000 35,92,18,000 42,91,07,400

Ratios 1.44 1.71 1.61

INTERPRETATION:

The company is showing an ideal ratio of almost 1.5:1for all the three

years .This shows that the company is liquid and that it has the ability to pay its

current obligation in time as and when they are due.


1.3

1.35

1.4

1.45

1.5

1.55

1.6

1.65

1.7

1.75

Current Ratio

2008 2009 2010

1.44

1.71

1.61

75


The current ratio for the company is the best for the year 2009 at 1.71:1 and

the lowest at 1.44 in the year 2008 this shows that the company has a favourable

growth rate as far as current ratio is concerned.

b. Quick ratio:

Quick ratio is also known as liquid ratio or acid test ratio or near money ratio.

It is the ratio between quick or liquid assets and quick liabilities. The term quick asset

refers to current assets, which can be converted into cash immediately or at a short

notice without diminution of value. Liquid assets comprise all current assets minus

stock and prepaid expenses. Liquid assets liabilities comprise all current liabilities

minus bank overdraft. The quick ratio can be calculated by dividing the total of the

quick assets by total current liabilities. Thus,

Quick or liquid assets

Quick ratio =

Liquid or current liabilities

Sometimes bank overdraft is not included in current liabilities while

calculating quick or acid test ratio, on the argument that bank overdraft is generally a

permanent way of financing and is not subject to be called on demand. In such cases,

the quick ratio is found by dividing the total quick assets by quick liabilities (i.e.,

current liabilities – bank overdraft).

Significance of quick ratio:

1. It is the true test of business solvency.

2. Higher ratio i.e., more than 2:1 indicates financial difficulty.

3. Lower ratio i.e., less than 1:1 indicates financial difficulty.

4. This is an important ratio of financial institutions.

5. It is a stringent test of liquidity.

6. It gives better picture of firm’s ability to meet its short-term debts out of short-

term assets.

7. If the current ratio is more than 2:1 but liquid ratio is less than 1:1 it indicates

excessive inventory.



8. It is more of qualitative nature of test.

Ideal Ratio:

An acid test ratio of 1:1 is considered satisfactory as a firm can easily meet

current claims. It is the true test of the firm’s solvency. It gives a better picture of

firm’s ability to pay its short-term debts out of short-term assets. It is more of a

qualitative nature of test.



Liquid Assets 31,20,02,000 41,64,54,000 38,29,15,600

Current Liabilities 36,55,53,000 35,92,18,000 42,91,07,000

Ratios 0.85 1.15 0.89

ANALYSIS & INTERPRETATION:

Usually, a high acid test ratio is an indication that the firm is liquid &has the

ability to meet its current or liquid liabilities in time & on the other hand a low quick

ratio represents that the firm’s liquidity position is not good.

From the above table, it is depicted that the ratios in 2007-08 is 0.85, 1.15 in

2007-08, & 0.89 in 2009-10.The rise in quick ratio from 2008-2009 shows that the

firms went short of its assets to meet its short term obligations &in 2010 the ratio


00.20.40.60.8

11.2

2008 2009

0.89LIQUID RATIO

0.85

1.15

2010

77


comes down to 0.89 as the firm covered its short term obligations, but it is not up to

the ideal ratio of 1:1.

C. Absolute liquidity ratio or cash position ratio:

It is a variation of quick ratio. When liquidity is highly restricted in terms of

cash and cash equivalents, this ratio should be calculated. Liquidity ratio measures

the relationship between cash and near cash items on the one hand, and immediately

maturing obligations on the other. The inventory and the debtors are excluded from

current assets, to calculate this ratio.

Cash + Marketable securities

Cash position ratio =

Current Liabilities

Generally, 0.75:1 ratio is recommended to ensure liquidity. This test is more

rigorous measure of a firm’s liquidity position. If the ratio is 1:1, then the firm has

enough cash on hand to meet all current liabilities. This type of ratio is not widely

used in practice





Absolute Liquid

Assets

72,64,000 1,18,41,300 1,55,69,000

Current Liabilities 36,55,53,000 35,92,18,000 42,91,07,400

Ratios 0.019 0.032 0.036


From the above table it is depicted that quick ratios are 0.019 in 2007-08,0.032

in 2008-09 0.036 in 2009-10. The all depict that the company is incapable of meeting

its short-term obligations. This shows there has been a continuous fall in absolute

liquid assets, which indicates that the firm is accelerating to cover its short term debts,

never the less the ratio is not up to the standard one.


0

0.005

0.01

0.015

0.02

0.025

0.03

0.035

0.04

0.019

0.0320.036

ABSOLUTE LIQUIDITY RATIO

2008 2009 2010

79


D. Inventories to working capital ratio:

It represents the relationship between inventory or stocks and working capital

of the firm. Inventory or stock refers to closing stock of raw materials, work-in-

progress (i.e., semi-finished good) and finished goods. Working capital is the excess

of current assets over current liabilities. It is usually expressed as a percentage. It is

expressed as:

Inventory

Inventory to working capital ratio = x 100

Working capital

The ratio indicates the portion of working capital tied up in inventories or

stocks and thereby throws some light on the liquidity of a concern. It also indicates

whether there is overstocking or under stocking. As per the standard or ideal

inventory to working capital ratio, the inventories should not absorb more than 75%

of working capital.

Ideal Ratio:

As per the standard, in the inventory to working capital ratio, the inventories

should not absorb more than 75 percentage of working capital





Inventory 21,39,14,000 20,03,34,000 30,86,38,000

Working Capital 16,03,64,000 25,75,70,000 26,24,46,000

Ratios 1.33% 0.77% 1.17%

Analysis and Interpretation:

In the above table, the ratio in 2007-08 was 1.33 %, 77% in 2008-09, 117 % in

2009-10, which shows that there was over stocking of inventories which came down

in 2008-09 and again increased in 2009-2010, which is not a good sign for the

company. Thus, the company should curtail its inventory over stocking in order to get

an optimum liquidity.


0

0.2

0.4

0.6

0.8

1

1.2

1.4 1.33%

0.77%

1.17%

Inventory to Working Capital Ratio

2008 2009 2010

81


3. Activity ratios or turnover ratio:

It is also refers to as assets management ratios measures the efficiency or

effectiveness with which a firm manages its resources or assets. The ratios are called

turnover ratios because they indicate the speed with which assets are converted or

turned over into sales. These ratios are calculated by establishing relationship

between sales and assets. The various turnover ratios are as follows:

a. Inventory turnover ratio:

This is also known as stock velocity. This ratio is calculated to consider the

adequacy of the quantum of capital and its justification for investing in inventory. A

firm must have reasonable stock in comparison to sales. It is the ratio of cost of sales

and average inventory. This ratio helps the financial manager to evaluate inventory

policy. This ratio reveals the number of times finished stock is turned over during a

given accounting period. This ratio is used for measuring the profitability. The

various ways in which stock turnover ratios may be calculated are as follows:

Cost of goods sold

Stock turnover ratio =

Average stock

Cost of goods sold may be calculated as under:

Cost of goods sold = Opening stock + purchases + Direct

Expenses – closing stock

This ratio indicates whether investment is inventory is within proper limit or

not. The quantum of stock should be sufficient to meet the demands of the business

but it should not be too large to indicate unnecessary lock-up of capital in stock and

danger of stock-items obsolete and getting it wasted by passing of time. The

inventory turnover ratio measures how quickly inventory is sold. It is a test of



efficient inventory management. To judge whether the ratio of the firm is satisfactory

or not, it should be compared over time on the basis of trend analysis



Cost Of Goods Sold 99,41.59,500 1,02,53,90,000 1,24,87,31,400

Average Stock 3,37,24,400 4,01,43,000 6,35,37,300

Ratios 29.47 25.54 19.65

Cost Of Goods Sold Includes=Opening stock+Purchases+Manufacturing expenses-

Closing stock

Average Stock =Opening stock + Closing stock/2


Usually, a high inventory turn over indicates efficient management of

inventory because more frequently the stocks are sold, the lesser amount of money is

required to finance the inventory. A low inventory turn over ratio indicates an

inefficient management of inventory.


0

5

10

15

20

25

30

35

29.4725.54

19.65

Stock Turnover Ratio

2008 2009 2010

83


From the above table we can observe that there has been a decrease in the

inventory turn over ratio from 29.47 in 2008 to 19.65 in 2010, which is an indication

of low inventory turnover ratio due to which the company has to finance more amount

of money in inventory.

b. Debt collection period ratio:

It indicates the numbers of time on the average the receivable are turnover in

the each year. The higher the value of ratio, the more is the efficient management of

debtors. It measures the accounts receivable (trade debtors and bill receivables) in

terms of number of days of credit sales during a particular period. It is calculated as

follows:

Average debtors

Debt collection period= x 365

Net credit sales

The purpose of this ratio is to measure the liquidity of the receivables or to find out

the period over which receivable remain uncollected.

Ideal Ratio:

The shorter the collection period the better is the quality of debtors as a short

collection period implies quick payment by debtors. Similarly a higher collection

period implies an inefficient collection performance, which in turn adversely affects

the liquidity or short term paying capacity of a firm out of its current liabilities.





Days 365 365 365

Debtors Turnover

Ratio

4.17 3.84 4.13

Days 88 Days 95 Days 89 Days

Analysis and Interpretation:

Debtors’ turnover ratio indicates the number of times the debtors are turn over

during a year. Higher debtors velocity shows good management while low debtors

velocity shows inefficient management of debtors/sales and less liquid are the debtors.

But a precaution is needed while interpreting a very high debtors turnover ratio

because a very high ratio may imply a firms inability due to lack of resources to sell

on credit.


84 86 88 90 92 94 96

88

95

89

Collection Period

Days

2010

2009

2008

85


From the above table we observe that the collection period has been 88 days in

2007-2008, 95 days in 2008-2009, 89 days in 2009-2010. Which shows that the firm

has been set standards of period of 90 days is poor collection from its debtors.

c. Debt payment period ratio:

This is also known as accounts payable or creditor’s velocity. A business firm

usually purchases on credit goods, raw materials and services from other firms. The

amount of total payables of a business concern depends upon the purchases policy of

the concern, the quantity of purchases and suppliers’ credit policy. Longer the period

of outstanding payable is, lesser is the problem of working capital of the firm. But

when the firm does not pay off its creditors within time, it may have adverse effect on

the business.

Creditor’s turnover indicates the number of times the payable rotate in a year.

It signifies the credit period enjoyed by the firm paying creditors. Accounts payable

include sundry creditors and bills payable.

Payables turnover shows the relationship between net purchases for the whole

year and total payable (average or outstanding at the end of the year).

Accounts creditors

Debt payment ratio = x 365

Net credit purchase

Net purchase = all credit purchases – purchase returns

Ideal Ratio:

A higher ratio shows that the creditors are not paid in time. A lower ratio

shows that the business is not taking the full advantage of credit period allowed by the

creditors.





CREDITORS 98,83,12,800 89,60,36,000 1,19,83,64,500

AVG ACCOUNTS

PAYABLE

32,38,37,600 31,73,04,87,300 34,22,08,200

DAYS 119 130 105

Analysis & Interpretation:

A higher payment period implies that greater credit period is enjoyed by the

firm and consequently larger the benefit reaped by the credit suppliers. A higher ratio

may also imply lesser discount facilities availed or higher prices paid for the goods

purchased on credit.

From the above table, one can ascertain that the company is moderately using

its used its credit facilities provided to it by its creditors.


0 20 40 60 80 100 120 140

119

119

130

105

CREDITORS TURNOVER RATIO

2010

2009

2008

Days

87


d. Cash turnover ratio:

It’s calculated as

Net annual sales

Cash turnover ratio =

Cash

Cash for the purpose means cash in hand, cash at bank, and readily realized

marketable securities. Turnover refers to the total annual sales (cash sales credit

sales) effected during the year however, sales means net annual sales i.e., total sales –

sales returns.

This ratio indicates the extent to which cash resources are efficiently utilized

by the enterprise. It also helps in determining the liquidity of the concern.




NET ANNUAL

SALES

1,13,23,19,000 1,23,39,34,000 1,42,54,31,000

CASH 72,64,000 1,18,41,300 1,55,69,000

Ratios 155.87 104.20 91.55



This ratio measures the velocity of sales turnover with a minimum cash

balance. From the above information it is clear that the company has achieved

favorable sales figure in the year 2006-07 as well as in the preceding years.


0

20

40

60

80

100

120

140

160

180

155.87

104.291.55

CASH TURNOVER RATIO

2008 2009 2010

89


e. Working capital turnover ratio:

This ratio is a measure of the efficiency of the employment of the working

capital. It indicates over trading and under trading and is harmful for the smooth

conduct of business. This ratio finds out the relation between cost of sales and

working capital. It helps in determining the liquidity of a firm in as much as it gives

the rate at which inventories are converted to sales and then to cash.

Net sales

Working capital turnover ratio =

Net working capital

(Net working capital = current assets – current liabilities)

Higher sales in comparison to working capital mean overtrading and lower

sales in comparison to working capital means under trading. A higher working capital

turnover ratio shows that there is low investment in working capital and there is more

profit.





Sales 1,13,23,20,000 1,23,39,34,000 1,42,54,31,000

Net Working Capital 16,03,63,000 25,75,70,000 26,24,46,000

Ratios 7.06 4.79 5.43


Higher sales in comparison to working capital mean over trading &lower sales

in comparison to working capital means under trading. A higher working capital

turnover ratio shows that there is low investment in working capital &there is more

profit.

From the above table it can be ascertained that the amount invested by the

company in working capital for the year 2007-08 was 7.06, 4.790 in 2008-09, 5.43in

2009-10 which is favorable to the company as there is less amount of cash outlay in

terms of working capital which helps the firm to maintain a favorable liquidity

position.


0

1

2

3

4

5

6

7

8

7.06

4.79 5.43

Working Capital turnover Ratio

2008 2009 2010

91


f. Fixed assets turnover ratio:

It is also known as sales to fixed asset ratio. This ratio measures the efficiency

and profit earning capacity of the firm. Higher the ratio, greater is the intensive

utilization of fixed assets. Lower ratio means under-utilization of fixed assets.

Net sales

Fixed asset turnover ratio =

Net fixed assets

(net fixed assets = value of assets – depreciation)



Sales 1,13,23,19,000 1,23,39,34,000 1,42,54,31,000

Net Fixed Assets 24,91,26,000 23,59,31,000 27,38,90,000

Ratios 4.54 5.23 5.20

4.2

4.4

4.6

4.8

5

5.2

5.4

4.54 5.23 5.20

Fixed Asset Turnover Ratio

2008 2009 2010


The assets turnover ratio has increased over a period of time from 4.54 in

2007-08, 5.23 in 2008-09, and 5.20 in 2009-10, which proves the company is making

effective utilization of its fixed assets to the fullest extent.



h. Total assets turnover ratio:

This is the ratio between sales and total assets and it shows whether or not the

total assets have been properly utilized and measures the effective use of capital. The

higher the ratio, the greater will be the return but too high a ratio means over trading.

Net sales

Total assets turnover ratio =

Total assets

The standard ratio is 2:1



Net Sales 1,13,23,20,000 1,23,39,34,000 1,42,54,31,000

Total Assets 77,50,83,000 88,53,22,000 1,09,09,57,000

Ratios 1.46 1.39 1.30

Analysis& Interpretation:

It depicts whether or not the total assets have been properly utilized &

measures the effective use of capital. The higher the ratio, the greater will be the

return but too high a ratio means overtrading.

From the above table we can observe that the ratios have been steadily

increasing from 2008-09 though there was a slight decrease in the ratio in 2008-09 the

company is making full utilization of it’s of its total assets

4. Profitability ratio:


1.2 1.25 1.3 1.35 1.4 1.45 1.5

1.46

1.39

1.30

Total Assets Turnover Ratio

2010

2009

2008

93


It measures the overall performance of business – profit margin ratios and rate

of return ratios. Profit margin ratios show the relationship between profit and sale.

Rate of return ratios reflect the relationship between profit and investments. The

various profitability ratios are as follows.

a. Gross profit ratio:

The gross profit ratio is also known as gross margin ratio, trading margin ratio

etc., it is expressed as a “Per Cent Ratio”. The difference between net sales and cost

of goods sold is known as gross profit. Gross profit is highly significant. The earning

capacity of the business can be ascertained by taking the margin between cost of

goods sold and sales. It is very useful as a test of profitability and management

efficiency. It is generally contented that the margin of gross profit should be

sufficient enough to recover all operating expenses and other expenses and also leave

adequate amount as net profit in relation to sales and owners’ equity. Thus, in a

trading business, gross profit is net sales minus trading cost of sales.

Gross profit

Gross profit ratio = x 100

Net sales

OR

Sales – cost of goods sold

Gross profit ratio = x 100

Net sales

Gross profit ratio shows the gap between revenue and trading costs.

Maintenance of steady gross profit ratio is important. An analysis of gross profit

margin should be carried out in the light of information relating to purchasing,

increasing or reducing the sales price of goods sold by mark up and mark downs,

credit and collections and merchandising policies.

A higher ratio may be the result of one or all of the following:



1. Increase in the selling price of goods sold without any corresponding increase

in the cost of goods sold.

2. Decrease in the cost of goods sold without corresponding decrease in selling

price.

3. Both selling price and cost of goods sold may have changed, the combined

effect being increase in gross margin.

4. Out of sales-mixes, product having higher gross profit margin, should have

been sold in larger quantity.

5. Under-valuation of opening stock or over-valuation of closing stock.

6. On the other hand, if the gross profit ratio is very low, it may be an indicator

of lower and poor profitability.

A lower ratio may be the result of the following factors:

1. Decrease in the selling price of goods sold, without corresponding decrease in

cost of goods sold.

2. Increase in cost of goods sold without any increase in selling price.

3. Unfavorable purchasing policies.

4. Over-valuation of opening stock or under-valuation of closing stock.

5. Inability of management to improve sales volume.

Higher ratio is better. A ratio of 25% to 30% may be considered good.





Gross Profit 13,81,59,000 20,85,66,000 17,67,00,000

Net Sales 1,13,23,19,000 1,23,39,34,000 1,42,54,31,000

Ratios 12.2% 16.9% 12.39%

Analysis& Interpretation:

The gross profit of the company is showing consistency for all the three years.

The company has an ideal gross profit ratio. The ratios are 12.2%, 16.9% and 12.39%

for the respective three years. This may be due to changes in economic factors like

increase in selling price without any corresponding proportionate increase in costs

incurred or decrease in cost without any decrease in selling price.

b. Net profit ratio:


0

5

10

15

20

12.2%

16.9%

12.39%

GROSS PROFIT RATIO

2008 2009 2010

96


It establishes the relationship between net profit (after tax) and sales and

indicates the efficiency of the management in manufacturing, selling, administrative

and other activities of the firm. This ratio is used to measure the overall profitability

and it is calculated as:

Net profit

Net profit ratio = x 100

Net sales

This ratio indicates the firm’s capacity to face adverse economic conditions

such as price competition, low demand, etc., Higher the ratio, the better is the

profitability.





Net Profit After

Tax

1,89,12,000 4,77,44,000 5,01,27,000

Net Sales 1,13,23,19,200 1,23,39,34,000 1,42,54,31,400

Ratios 1.67% 3.86% 3.51%

Note: Ratios in percentage


The company ratio of the company for all the three financial years is on a

healthier side as it is showing favorable trend of growth to the outsiders about the

percentage net profit after tax on its net sales this ratio reveals the true picture of

company’s financial position.


0 0.5 1 1.5 2 2.5 3 3.5 4 4.5

1.67%

3.86%

3.51%

Net Profit Ratio

2010

2009

2008

98


c. Operating ratio:

This ratio establishes the relationship between total operating expenses and

sales. Total operating expenses include cost of goods, administrative expenses,

financial expenses and selling expenses. Cost of goods sold is also known as direct

operating expenses. Operating ratio is generally expressed in percentages.

Cost of goods sold + Operating expenses

Operating ratio = x 100

Net sales

Cost of goods sold = operating stock + purchase – closing stock

Operating expenses = administrative expenses + financial expenses

+ Selling expenses





Cost Of Goods Sold+ Operating

Exp

1,04,02,91,400 1,08,33,26,70

0

1,31,04,22,400

Net Sales 1,13,23,19,300 1,23,39,34,10

0

1,42,54,31,400

Ratios 91.87% 87.79% 91.93%



The company is having a healthy operating ratio as the ratio for all the three

years is almost near to 10% except for the year 2009 where it is 12% and thus the

graph depicts the financial soundness of the company.


85 86 87 88 89 90 91 92

91.87%

87.79%

91.93%

Operating Ratio

2010

2009

2008

100


e. Return on capital employed ratio:

This is also known as return on investment or rate of return. The prime objective of

making investments in any business is to obtain satisfactory return on capital invested.

It indicates the percentage of return on the capital employed in the business and it can

be used to show the efficiency of the business as a whole.

Operating profit

Return on capital employed = x 100

Capital employed

The term capital employed refers to long-term funds supplied by the creditors and

owners of the firm. It can be computed in two ways. First, it is equal to non-current

liabilities (long-term liabilities) plus owners’ equity. Alternatively, it is equivalent to

net working capital plus fixed assets. Thus, the capital employed basis provides a test

of profitability related to the sources of long-term funds. A comparison of this ratio

with similar firms, with the industry average and over time would provide sufficient

insight into how efficiently the long-term funds of owners and creditors are being

used. The higher the ratio, the more efficient use of the capital employed.





Operating Profit 9,20,27,800 15,06,07,400 11,50,09,000

Capital employed 40,95,30,100 52,61,04,200 66,18,49,800

Ratios 22.47% 28.62% 17.37%



The operating ratio is showing a favorable trend and is considered to be a good

ratio as the company is a manufacturing undertaking. This shows that the company

has enough funds from its margin to cover interest, income tax, dividends and

reserves. This reveals the operating efficiency of the company.


0

5

10

15

20

25

30

22.47%

28.62%

17.37%

Return On Capital Employed

2008 2009 2010

102


f. Return on owner’s fund ratio:

This ratio establishes the profitability from the shareholders point of view.

Net profit

Return on owner’s fund = x 100

Shareholders fund

The term net profit as used here means net income after payment of interest

and tax including net non-operating income (i.e. non-operating income minus non-

operating expenses). It is the final income that is available for distribution as

dividends to shareholders. Shareholders’ funds include both preference and equity

share capital and all reserves and surplus belonging to shareholders.

For the purpose of the study, only that ratio concerning working capital and

fund flows has been considered and analysis and interpretation has been done in the

next chapters.





Net Profit After Tax 1,89,12,300 4,77,44,000 5,01,27,000

Shareholders funds 11,94,80,400 16,81,24,200 21,71,25,100

Ratios 15.82% 28.39% 23.08%

Analysis and Interpretation

The ratio of return on capital employed of the company for all the three

financial years are fluctuating and unstable as the percentage of increase or decrease

in operating profit differs from the percentage of inc\crease or decrease in the capital

employed for all the three years. The ratio for the year 2009 is highest and this is the

period when the company has earned more on its capital employed.


0 5 10 15 20 25 30

15.82%

28.39%

23.08%

ReturnOn Shareholders funds

2010

2009

2008

104


FUND FLOW STATEMENT

Techniques of analysis & interpretation of financial statements:

The following methods are generally used for the purpose of analysis and

interpretation of financial statements:

1. Comparative Statement

2. Common Size Statements

3. Trend Analysis

4. Ratio Analysis

5. Cash flow statements

6. Fund flow statements

Fund Flow Statement

The fund flow statement is a statement, which shows the movement of funds

and is a report of the financial operations of the business undertaking.

The fund flow statement shows how the attitude of an business organization is

financed or how the available financial resources have been used during the particular

period of time. It indicates in a summarized form the various means through which

the funds were collected during a particular period and the ways in which these funds

were employed.

Fund flow statement is a widely used tool in the hands of financial executives

for analyzing the financial performance of a concern.

The fund flow statement is made up of three words, i.e., funds, flow and statement.

'FUND' according to the fund flow statement means:

Cash

Money

Marketable securities

Working capital



However the concept of fund as working capital is the most popular one and

considered appropriate. The study of sources and uses of funds is beneficial to

management and organization at large since it reveals the soundness and solvency of

the organization.

The term FLOW means movement and includes both 'inflow' and 'outflow'.

The term 'flow of funds' means transfer of economic values from one asset of equity

to another.

The fund flow statement is a method by which we study changes in the

financial position of a business enterprise and financial statements ending date. It is a

Statement showing sources and uses of funds for a given period of time.

A fund flow statement is an essential tool for the financial analysis and is of

primary importance to the financial management. The basic purpose of a fund flow

statement is to reveal the changes in the working capital on the two balance sheet

dates. It reveals how the expansion and development activity of an enterprise is

financed also tells the financial needs of the enterprise.

Working Capital = Current Assets - Current Liabilities

Working Capital = Total Current Assets - Total Current Liabilities

Current Assets:

It refers o cash and other assets or resources commonly identified as those,

which are reasonably expected to be realized in cash or sold or consumed during the

normal operating period of the company.

Current Liabilities:

It refers to all obligations which are likely to mature within one year in the

normal course of business operations and which are cleared off by creating current

liabilities or out of the current assets.



Components of Current Assets and Current Liabilities

Current assets Current Liabilities

Cash Balance Accounts payable / Bills payable

Bank Balance Sundry creditors

Inventory/Stock of

goods

Bank overdraft

Temporary Investments Outstanding expenses

Pre-paid expenses Unclaimed dividend

outstanding incomes Provision for taxation

Accounts receivable Proposed dividend

Bill receivable Short-term loan

Sundry Debtors Any provision against current assets

Non-Current Assets / Liabilities:

It refers to all those assets and liabilities other than current assets and current

Liabilities.

Components of Non current assets and Non-current Liabilities

Non-Current Liabilities Non-Current assets

Share Capital Fixed Assets

Long term loans Fictitious Assets like goodwill Patents Rights, Trade

Marks

Debentures Long term Investments

Share premium A/c. Profit and Loss A/c. (Debit balance)

Forfeited shares A/c. Discount on issue of shares and

Debentures

Profit and Loss A/c (Credit

balance)

Deferred expenditures like preliminary Expenses,

advertising expenses

Appropriation of profits

Provisions like provision

for tax,

Provision for deprecations

Capital reserve



It helps in analysis of financial operations The financial statements reveal the

net effect of various transactions on the operational and financial position of a

concern. The Balance Sheet gives a static time. But it does not disclose the

cause for changes in the assets and liabilities between two different points.

The fund flow statement explains the causes for such changes and also effects

of such changes on the liquidity position of the company.

It helps in the formation of a realistic dividend policy. Sometimes a firm has

sufficient profits available for distribution as dividend but yet it may not be

advisable to distribute dividend for lack of liquid or cash reserves. In such

cases, fund flow statement helps to formulate a realistic dividend policy.

It helps in proper allocation of funds. The resources of a concern are always

limited and it wants to make the best use of these resources. A projected fund

flow statement constructed for the future helps in making managerial

decisions.

It helps in taking corrective action if there is any imbalance between the

sources and uses of the funds.

Preparation of Fund Flow Statement:

The financial information required for preparing the fund flow statement is

obtained from the balance sheet of two periods and other required information

from the books of accounts of the organization. In the process of fund flow

statement these statements are prepared,

It helps in analysis of financial operations The financial statements reveal the

net effect of various transactions on the operational and financial position of a

concern. The Balance Sheet gives a static time. But it does not disclose the

cause for changes in the assets and liabilities between two different points.

The fund flow statement explains the causes for such changes and also effects

of such changes on the liquidity position of the company.

It helps in the formation of a realistic dividend policy. Sometimes a firm has

sufficient profits available for distribution as dividend but yet it may not be



advisable to distribute dividend for lack of liquid or cash reserves. In such

cases, fund flow statement helps to formulate a realistic dividend policy.

It helps in proper allocation of funds. The resources of a concern are always

limited and it wants to make the best use of these resources. A projected fund

flow statement constructed for the future helps in making managerial

decisions.

It helps in taking corrective action if there is any imbalance between the

sources and uses of the funds.

Preparation of Fund Flow Statement:

The financial information required for preparing the fund flow statement is

obtained from the balance sheet of two periods and other required information from

the books of accounts of the organization. In the process of fund flow statement these

statements are prepared,

1. Statement of changes in working capital,

2. Statement which indicate funds from operation (for determining funds

generated every year through the business activity)

3. Sources and application of funds.

Statement of Changes in Working Capital:

Statement of changes in the working capital is prepared in order to ascertain

the increase or decrease in working capital between two accounting periods. This

statement is prepared with the help of current assets and current liabilities. The net

difference between current assets and current liabilities indicate either increase or

decrease in the working capital. The decrease will appear as a source and the increase

as an application.

Funds from Operation:



The funds from operation form the main source of funds of any organization.

The funds from operation will not be equal to profits as shown by profits and loss

account. The net profit as per the profit and loss account is the balance arrived at after

deducting from revenues, a number of expenses which do not represent current

outflow of funds such as depreciation, loss on sale of assets etc. to arrive at precisely

the funds from operation an adjusted profit and loss account or a statement of funds

from operation is prepared.

Statement of Sources and Application of Funds:

After the preparation of statement of changes in the working capital the

statement of sources and application of funds is prepared. The statement of sources

and application of funds saves as a bridge between successive balance sheets. It ties-

up the balance sheet and profit and loss account together by using information taken

from both statements. This statement contains two main groups of items. One is the

mean by which resources are acquired and the other their deployment.



FUNDS FLOW STATEMENT

Schedule Of Changes In Working Capital For 2009-2010

Particulars 2009 2010 Increase in

working capital

Decrease in

working capital

Current Assets:

1.)Inventories 200333852 30863782

9

108303977 -

2.)S. Debtors 370463880 31975567

9

- 50708201

3.) Cash & Bank

Balance

11841332 15569064 3727732 -

4.) Other Current

assets

7078047 10094569 3016522 -

5.) Loans &

Advances

27071078 37496224 10425146 -

Current Liabilities:

1.)Current

Liabilities

345859536 39808601

2

- 52226476

2.) Provisions 13358500 31021436 17662936

Increase In

Working Capital

4875764

125473377 125473377



Profit And Loss Adjustment Account

Dr. Cr.

Particulars Amount

(Rs.)

Particulars Amount

(Rs.)

To Transfers to General Reserve 20000000 By Balance B/d. 4954744

To Goodwill written off 5208391 By funds from

operations (b/f)

113446829

To Brands written off 4500000

To Depreciation on factory

building

7254095

To Proposed Dividend 13785250

To Depreciation on office building 906811

To Depreciation on plant and

machinery

34056899

To Depreciation on electric

equipment & instruments

7638256

To Depreciation on Furniture &

Fittings

1876783

To Depreciation on Vehicles 669200

To Depreciation on office

equipments

288277

To Depreciation on computers 2687441

To Balance C/d. 19530170

Total 118401573 118401573



FUNDS FLOW STATEMENT

Sources of funds Amount

(Rs.)

Application of funds Amount

(Rs.)

Plant & Machinery

Sold

140926 Dividend paid 13785250

Furniture &

Fittings Sold

74375 Land purchased 7562943

Issue of Share

capital

113633345 Factory building purchased 3034182

Secured Loans

taken

89423842 Office building purchased 18136228

Funds from

operation

113446829 Plant & Machinery purchased 44436101

Electric equipments &

installations purchased

10943817

Furniture & fittings purchased 13577878

Vehicles purchased 1343892

Office equipments purchased 551930

Capital work in progress 184636183

Computer purchased 3656000

Unsecured loans paid 2679149

Investments 7500000

Increase in Working Capital 4875764

Total 316719317 316719317



Analysis & Interpretation

The statement of changes in the working capital shows net increase for the year

2009-10 by Rs.4875764. The profit percentage has shown a constant growth from the

past two years and has also grown at a healthy rate for the accounting year 2009-10

The funds from operation for the year 2009-10 are Rs.113446829. The funds

from operation is showing a good sign for the company as out of total funds a major

part was raised from funds from operation or cash profit. The company has also paid

out its short term loans which show that the solvency position of the company is

favorable.

The company has also diverted its funds appropriately in proper channels like

purchase of various fixed assets, which in turn increases the overall productivity of

the organization.

The company has paid sufficient amount of dividends to its share holders and

has also transferred reasonable amount of cash to its reserves & surplus account. To

meet its capital expenditures the company has also raised own funds.



FINDINGS AND SUGGESTIONS

FINDINGS:

Medreich Sterilabs limited is an upcoming pharmaceutical industry. In

these recent years this company has earned a lot of respect not only in the national

arena while competing with the Indian industry but also has survived the competition

with the international companies. This company has shown signs of survival and

growth this can be inferred from the company’s financial position analysis of the

recent years, according to the ratio analysis as a tool for financial statements

This project is related to the study of the financial position of the company

in the three years ranging from 2008-2010.the findings are on the basis of

a) liquidity ratios

b) Turnover ratios

c) Profitability ratios

a) Liquidity ratios for the for the financial years 2007-2009

Particulars 2008 2009 2010 Remarks

Current ratio 1.44:1 1.71:1 1.61:1 Satisfactory

Quick ratio 0.85:1 1.15:1 0.89:1 Satisfactory

Absolute liquid ratio 0.019:1 0.032:1 0.036:1 Poor

Inventory to working

capital ratio

1.33:1 0.77:1 1.17:1 Satisfactory

In this concern, the liquidity ratios are showing satisfactory standard, except in

the case of absolute liquid ratio where in it is far below the standard limit. The ratio of

absolute liquidity also shows that the company is not maintaining ideal proportion of

cash and marketable securities. The over all solvency and liquidity position of the

company is satisfactory. It shows that the company is utilizing the funds to its

optimum extent and the company is utilizing its financial resources properly.



3) Activity or turnover ratios:

Particulars 2008 2009 2010 Remarks

Stock turnover ratio 29.47 25.54 19.65 Good

Debtors turnover

ratio

4.17 3.84 4.13 Satisfactory

Debt collection

period

88 Days 95 Days 89 Days Poor

Creditor’s turnover

ratio

3.05 2.82 3.50 Average

Credit payment

period

119 days 129days 104days Average

Working capital

turnover ratio


Fixed asset turnover

ratio

4.54 5.23 5.20 Good

Capital turnover

Ratio

2.76 2.34 2.15 Good

Total assets turnover

ratio


On analyzing the working capital ratio it is found that the working capital is

converted 5.43 times for the year 2009-10 which is better than the previous year. The

stock turnover ratio for the company is showing a constant growth of 20 to 23 times

which is a good ratio .the debtors turn over ratio and the collection period for the

company is not good as it would like to be. The collection period and the payment

period are both too high which shows that the company is too liberal for its debtors

and that the company is not maintaining the solvency position .the company is

utilizing its fixed assets and net worth i.e. the capital employed optimally in

converting it into sales. The company is utilizing its total assets to the optimum level.



4) Profitability ratio

Particulars 2008

(%)

2009

(%)

2010

(%)

Remarks

Gross profit ratio 12.2 16.9 12.39 Satisfactory

Net profit ratio 1.67 3.86 3.51 Good

Operating profit ratio 8.12 12.20 8.06 Satisfactory

Operating ratio 91.8

7

87.79 91.93 Good

Return on share holder’s funds 15.8

2

28.39 23.08 Good

Return on total assets 2.44 5.29 4.59 Satisfactory

Return on capital employed 22.4

7

28.62 17.37 Satisfactory

The gross profit of the company is satisfactory in terms of growth this may be

due to the current market condition which may have prompted the company to face

the severe competition. Whereas the net profit. Ratio is good for the entire three years.

The-operating ratio and the operating profit ratio is showing satisfactory position for

the company. The return of the share holder’s funds is showing that the company is

able to satisfy its share holders by paying constant amount of dividend per share.



SUGGESTIONS

It should implement proper credit policy with regard to collection of debtors

The company should improve its absolute liquid assets by maintaining large

amount of cash and marketable securities.

To adopt better credit policy towards its debtors to recover the debts easily and

efficiently.

The company should maintain better cash reserves at its disposal to meet its

current obligations at necessary times.



Bibliography

Books

Management accounting ---- R.K.Sharma & Gupta

Cost &Management accounting ---- S.P.Jain & K.L.Narang

Financial Management ---- S.N.Maheshwari

Website

www.medreich.com

www.google.com

www.msn.com


http://www.msn.com/

http://www.google.com/

http://www.medreich.com/

Finance Project

Documents

Transcript of Finance Project