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FINANCIAL MANAGEMENT

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Financial Management

FINANCIAL MANAGEMENT

Unit 1. Introduction.

A business is an activity which is carried on with the intention of earning profits. If the operations of a typical manufacturing organization are considered, it involves the purchasing of raw material, processing the same with the help of various factors of production like labour and machinery, manufacturing the final product and marketing and selling the finished product in the market to earn the profits.

Thus production, marketing and business financing are the key operational areas in case of any business organization, out of which finance is the most crucial one. This is so as the functions of production and marketing are related with the function of finance. If the decisions relating to money and funds fail, it may result into the failure of the business organization as a whole. Hence, it is utmost important to take the proper financial decisions and that too at a proper point of time.

Finance is the life-blood of modern business economy. We cannot imagine a business without finance in the modern world. It is the basis of all economic activities, no matter; the business is big or small. The problem of finance and that of financial management is to be dealt within every organisation. The problem of finance is equally important to government, semi-governments and private bodies, and to profit and non-profit organisations.

Definition.

Financial management is that managerial activity which is concerned with planning and controlling of firms financial resources.

According to Paul. G. Hasings, 'Finance' is the management of the monetary affairs of a company. It includes determining what has to be paid for raising the money on the best terms available and devoting the available resources to best uses."

Kenneth Midgley and Ronald Burns state. "Financing is the process of organizing the flow of funds so that a business can carry out its objectives in the most efficient manner and meet its obligations as they fall due."

Financial Management is an area of financial decision making harmonizing individual motives and enterprise goals.-Weston and Brigam.

Financial Management is the application of the planning and control functions to the finance function.- Howard and Upton.

Financial Management is the operational activity of a business that is responsible for obtaining and effectively, utilizing the funds necessary for efficient operations.- Joseph and Massie.

From the above definitions of the term finance given above, it can be concluded that the term business finance mainly involves rising of funds and their effective utilization keeping in view the over all objectives of the firm. The management makes use of the various financial techniques, devices etc for administering the financial affairs of the firm in the most effective and efficient way.

FINANCE AND RELATED DISCIPLINES.

Financial management -an integral part of over all management is not a totally independent area. It draws heavily on related disciplines and fields of study, such as Economics, Accounting, Marketing, Production, and Quantitative Methods.

FINANCIAL MANAGEMENT AND ECONOMICS.

The relevance of economics to Financial Management can be described in the lights of the two broad areas of economics, -macro economics, and micro economics. Macro economics is concerned with the over all institutional environment in which the Company operates. It looks at the Economy as a whole. It is concerned with the institutional structure of the banking system, money and capital markets, financial intermediaries, monetary credit, and fiscal policies. Since the business operates in the macro economic environment, it is important for financial managers to understand the broad economic environment.

Micro economics deals with the economic decisions of individuals and organizations. It concerns itself with the determination of optimal operating strategies. A financial manger uses these to run the firm efficiently and effectively.

FINANCIAL MANAGEMENT AND ACCOUNTING.

Accounting function is a necessary input in to the finance function. ie. accounting is a sub function of finance. Accounting generates information about a firm. The end products of accounting constitute financial statements such as Balance Sheet, P&L Account and the statement of changes in financial position. The information contained in this reports and statements assist financial managers in assessing the past performance and taking future decisions of the firm and in meeting the legal obligations such as payment of Taxes and so on. Thus accounting and finance are functionally closely related.

FINANCE AND OTHER RELATED DISCIPLINES.

Apart from economics and accounting, finance also draws considerably for its key day today decisions- on supportive disciplines such as Marketing, Production, and Quantitative methods. For instance financial managers should consider the impact of new product development and promotion plans made in the marketing area since their plans will require Capital or Fund out flows and have an impact on the projected cash flows. Similarly changes in the production process may necessitate capital expenditure which the financial managers must evaluate and finance. And finally the tools of analysis developed in the quantitative techniques are helpful in analyzing complex financial management problems.

Thus the marketing, production and quantitative techniques are only indirectly related to day to day decision making by financial managers and are supportive in nature , while Economics and Accounting are primary disciplines on which the financial managers draws substantially.

SCOPE OF FINANCIAL MANAGEMENT.

The approach to the scope and functions of financial management is divided in to two broad categories. Traditional Approach and Modem Approach.

TRADITIONAL APPROACH.

The traditional approach to the scope of financial management refers to the subject matter, in academic literature in the initial stages of its development, as a separate branch of academic study. The term 'Corporation Finance' was used to describe what is known as Financial management. As the name suggests, the concern of 'Corporation Finance' was with the financing of Corporate enterprises. In other words the scope of finance function was treated by the traditional approach in the narrow sense of procurement of fund by corporate enterprises to meet their financing needs. So the field of study included,

1. Institutional arrangements in the form of financial institutions which comprise the organization of Capital Market.

2. Financial instruments through which Funds are raised from the capital market. &

3. The Legal and Accounting relationship between a firm and its sources of funds.

The traditional approach was criticized in the following grounds.

1. The approach equated finance function with raising and administering of funds only. The limitation was that internal decision-making was completely ignored.

2. The focus was on financing problems of Corporate enterprises (i.e. Companies). Non corporate organizations lay outside its scope.

3. The approach laid over emphasis on the problems of long term financing. Hence day to day financial problems and working capital management of a business did not receive any attention.

MODERN APPROACH.

The modern approach views the term 'Financial management' in a broad sense and provides a conceptual and analytical frame work for financial decision making. According to it Finance function covers both acquisitions of funds as well as their allocations. Thus the Financial Management, in the modern sense of the term, can be broken down in to 3 major decisions as functions of Finance.

1. The investment Decision

2. The Financing Decision

3. The Dividend Policy Decision.

FINANCE FUNCTIONS.

1. INVESTMENT DECISION.

The investment decision relates to the selection of Assets in which funds will be invested by a firm. The Assets which can be acquired fall in to two broad categories.

A. Long Term or Fixed Assets, which yield a return over a period of time in future.

B. Short term or Current Assets which in the normal course of business are convertible in to cash usually within a year.

The aspects of financial decision making with reference to long term assets is popularly known as Capital Budgeting and financial decision making with reference to current assets is popularly termed as Working Capital Management.

CAPITAL BUDGETING.

Capital Budgeting is probably the most crucial financial decisions for a firm. It relates to the selection of an asset or investment proposal or course of action whose benefits are likely to be available in future over the life time of the project.

The first aspect of capital budgeting decision relates to the choice of the new asset out of the alternatives available or the reallocation of capital, when an existing asset fails to justify the funds committed. Whether an asset will be accepted or rejected will depend upon the relative benefits and returns associated with it. The measurement of worth of the investment proposal is, there for, a major element in Capital budgeting decisions.

The second element of Capital Budgeting decision is the analysis of risk and uncertainty. Since the benefits from the investment proposals extend in to the future, there accrual is uncertain. They have to be estimated under various assumptions of the physical volume of sales and the level of prices. An element of risk in the sense of 'uncertainty of future benefits' is thus involved in the capital budgeting. The returns from capital budgeting decisions should, there fore, be evaluated in relation to the risk associated with it.

WORKING CAPITAL MANAGEMENT.

Working capital management is concerned with the management of current asset. One aspect of working capital management is the trade off between profitability and risk. There is a conflict between profitability and liquidity. If a firm does not have adequate working capital, it may become illiquid and consequently may not have the ability to meet its current obligations. If current assets are too large, profitability is adversely affected. The key strategies and considerations in ensuring a trade oil' between profitability and liquidity is one of the major dimensions of working capital management. In addition, the individual current asset should be efficiently managed so that neither in adequate nor unnecessary funds are locked up.

2. FINANCING DECISIONS.

The second major decision involved in financial management is the financing decision. The concern of the financing decision is with the Financing Mix or Capital Structure or Leverage. The term capital structure refers to the proportion of debt (i.e., fixed interest source of financing) and equity capital (or variable dividend security). The financing decision of a firm relates to the choice of the proportion of these sources to finance the investment requirements. A capital structure with a reasonable proportion of debt and equity capital is called optimum capital structure.

3. DIVIDEND POLICY DECISION.

The third major decision of financial management is the decision relating to dividend policy. Two alternatives are available in dealing with the profits of the firm. They can be distributed to the share holders in the form of dividends or they can be retained in the business itself. The final decision will depend upon the preference of the share holders and the investment opportunities available within the firm. The optimum dividend policy is one which maximizes the market value of the Co's shares. Most profitable Co's pay cash dividend regularly. Periodically additional shares, called Bonus shares, are also issued to the existing share holders in addition to the cash dividend.

OBJECTIVES OF FINANCIAL MANAGEMENT.

Financial management is concerned with the efficient use of capital funds. It evaluates how funds are procured and used. Financial management covers decision making in three inter related areas namely Investment, Financing and Dividend policy. The financial manager has to take these decisions with reference to the objectives of the firm. The objectives provide a frame work for optimal financial decision making. There are two widely discussed approaches in this regard.

1. Profit Maximization Approach

2. Wealth Maximization Approach.

PROFIT MAXIMISATION APPROACH.

According to this approach, actions that increase profits should be undertaken and that decrease profits should be avoided. Profits maximization approach implies that the functions of financial management/ Decisions taken by financial mangers (i.e. the investment, financing, and dividend policy decisions) should be oriented towards maximization of profits or Rupee income of the firm. Or the Company should select those assets, projects, and decisions which are profitable and reject those which are not.

In the Economic theory, the behaviour of a Company is analyzed in terms of profit maximization. While maximizing profits, a firm either produces maximum output for a minimum input, or uses minimum input for a given out put. So the underlying logic of profit maximization is efficiency. Profit is a test of economic efficiency and it provides a yard stick by which economic performance can be judged.

The profit maximization criterion has however been criticized on several grounds. The main technical flaws are ambiguity, timing of benefits and quality of benefits.

1. AMBIGUITY.

One practical difficulty with profit maximization criterion for financial decision making is that, the term profit is a vague and ambiguous concept. It is amenable to different interpretations by different people. It is not clear in what sense the term profit has been used. It may be total profit before tax or after tax or profitability rate. Rate of profitability may again be in relation to Share capital; owner's funds, total capital employed or sales. Furthermore, the word profit does not speak anything about the short-term and long-term profits. Profits in the short-run may not be the same as those in the long run. A firm can maximise its short-term profit by avoiding current expenditures on maintenance of a machine. But owing to this neglect, the machine being put to use may no longer be capable of operation after sometime with the result that the firm will have to make huge investment outlay to replace the machine. Thus, profit maximisation suffers in the long run for the sake of maximizing short-term profit. Obviously a loose expression like profit can't form the basis of operational criterion for financial management.

2.TIMING OF BENEFIT

A more important technical objection to profit maximization is that it ignores the differences in the time pattern of the benefits received. The profit maximization criterion does not consider the distinction between returns received in different time periods and treats all benefits irrespective of the timings, as equally valuable. This is not true in actual practice as benefits in early years should be valued more highly than equivalent benefits in later years. The assumption of equal value is in consistent with the real world situation.

3.QUALITY OF BENEFITS.

Profit maximization ignores the quality aspect of benefits associated with a financial course of action. The term quality refers to the degree of certainty with which benefits can be expected. As a rule, the more certain the expected return, the higher is the quality of the benefits. An uncertain and fluctuating return implies risk to the investors.

To conclude the profit maximization criterion is unsuitable and in appropriate as an operational objective of investment, financing and dividend decision of a firm. It is not only vague and ambiguous, but it also ignores risk and time value of money.

WEALTH MAXIMIZATION APPROACH.

This is also known as value maximization or Net Present Worth maximization. It removes the technical limitations of profit maximization criterion.(i.e. ambiguity, timing of benefit and quality of benefit.)

Wealth maximization means maximizing the Net Present Value (or wealth) of a course of action. The Net present value of a course of action is the difference between the present value of its benefits and the present value of its costs. A financial action which has a positive Net Present Value creates wealth and there fore it is desirable. A financial action resulting in negative NPV should be rejected. Between a number of desirable mutually exclusive projects, the one with the highest NPV should be adopted.

The objective of wealth maximisation takes care of the questions of the timing and risk of expected benefits. These problems are handled by selecting an appropriate rate for discounting the expected flow of future benefits. It should be remembered that the benefits are measured in terms of cash flows. In investment and financing decisions it is flow of cash which is important, not the accounting profits. The Wealth created by a Company through its actions is reflected in the market value of companies' shares. The value of the companies share is represented by the market price, which in turn, is a reflection of the firm's financial decisions. The market price of the share serves as the performance indicator.

UNIT 2.

SOURCE OF FINANCE

Business is concerned with the production and distribution of goods and services for the satisfaction of needs of society. For carrying out various activities, business requires money. Finance, therefore, is called the life blood of any business. The financial needs of a business can be categorised as follows:

(a) Fixed capital requirements: In order to start business, funds are required to purchase fixed assets like land and building, plant and machinery, and furniture and fixtures. This is known as fixed capital requirements of the enterprise. The funds required in fixed assets remain invested in the business for a long period of time.

(b)Working Capital requirements: No matter how small or large a business is, it needs funds for its day-to-day operations. This is known as working capital of an enterprise, which is used for holding current assets such as stock of material, bills receivables and for meeting current expenses like salaries, wages, taxes and rent. For financing such requirements short-term funds are needed.

CLASSIFICATION OF SOURCE OF FUNDS.

A. Period Basis.

On the basis of period, the different sources of funds can be categorized into three parts. These are long-term sources, medium-term sources and short-term sources. The long-term sources fulfill the financial requirements of an enterprise for a period exceeding 5 years and include sources such as shares and debentures, long-term borrowings and loans from financial institutions. Such financing is generally required for the acquisition of fixed assets such as equipment, plant, etc. Where the funds are required for a period of more than one year but less than five years, medium-term sources of finance are used. These sources include borrowings from commercial banks, public deposits, lease financing and loans from financial institutions.

Short-term funds are those which are required for a period not exceeding one year. Trade credit, loans from commercial banks and commercial papers are some of the examples of the sources that provide funds for short duration. Short-term financing is most common for financing of current assets such as accounts receivable and inventories.

B. Ownership Basis.

On the basis of ownership, the sources can be classified into owners funds and borrowed funds. Owners funds means funds that are provided by the owners of an enterprise, which may be a sole trader or partners or shareholders of a company. Apart from capital, it also includes profits reinvested in the business. The owners capital remains invested in the business for a longer duration and is not required to be refunded during the life period of the business. Such capital forms the basis on which owners acquire their right of control of management. Issue of equity shares and retained earnings are the two important sources from where owners funds can be obtained.

Borrowed funds on the other hand, refer to the funds raised through loans or borrowings. The sources for raising borrowed funds include loans from commercial banks, loans from financial institutions, issue of debentures, public deposits and trade credit. Such sources provide funds for a specified period, on certain terms and conditions and have to be repaid after the expiry of that period. A fixed rate of interest is paid by the borrowers on such funds. At times it puts a lot of burden on the business as payment of interest is to be made even when the earnings are low or when loss is incurred. Generally, borrowed funds are provided on the security of some fixed assets.

LONG TERM FUNDS

1. Retained Earnings.

A company generally does not distribute all its earnings amongst the shareholders as dividends. A portion of the net earnings may be retained in the business for use in the future. This is known as retained earnings. It is a source of internal financing or self financing or ploughing back of profits. The profit available for ploughing back in an organisation depends on many factors like net profits, dividend policy and age of the organisation.

Merits.

The merits of retained earning as a source of finance are as follows:

(i) Retained earnings is a permanent source of funds available to an organisation;

(ii) It does not involve any explicit cost in the form of interest, dividend or floatation cost;

(iii) As the funds are generated internally, there is a greater degree of operational freedom and flexibility;

(iv) It may lead to increase in the market price of the equity shares of a company.

2. Trade Credit.

Trade credit is the credit extended by one trader to another for the purchase of goods and services. Trade credit facilitates the purchase of supplies without immediate payment. Such credit appears in the records of the buyer of goods as sundry creditors or accounts payable. Trade credit is commonly used by business organisations as a source of short-term financing. It is granted to those customers who have reasonable amount of financial standing and goodwill. The volume and period of credit extended depends on factors such as reputation of the purchasing firm, financial position of the seller, volume of purchases, past record of payment and degree of competition in the market. Terms of trade credit may vary from one industry to another and from one person to another. A firm may also offer different credit terms to different customers.

3. Factoring.

Factoring is a financial service under which the factor renders various services which includes: (a) Discounting of bills (with or without recourse) and collection of the clients debts. Under this, the receivables on account of sale of goods or services are sold to the factor at a certain discount. The factor becomes responsible for all credit control and debt collection from the buyer and provides protection against any bad debt losses to the firm. There are two methods of factoring recourse and non-recourse. Under recourse factoring, the client is not protected against the risk of bad debts. On the other hand, the factor assumes the entire credit risk under non-recourse factoring i.e., full amount of invoice is paid to the client in the event of the debt becoming bad. The organizations, that provide such services include SBI Factors and Commercial Services Ltd., Canbank Factors Ltd., Foremost Factors Ltd.etc.

4. Lease Financing.

A lease is a contractual agreement whereby one party i.e., the owner of an asset grants the other party the right to use the asset in return for a periodic payment. In other words it is a renting of an asset for some specified period. The owner of the assets is called the lessor while the party that uses the assets is known as the lessee (see Box A). The lessee pays a fixed periodic amount called lease rental to the lessor for the use of the asset. The terms and conditions regulating the lease arrangements are given in the lease contract. At the end of the lease period, the asset goes back to the lessor. Lease finance provides an important means of modernization and diversification to the firm. Such type of financing is more prevalent in the acquisition of such assets as computers and electronic equipment which become obsolete quicker because of the fast changing technological developments. While making the leasing decision, the cost of leasing an asset must be compared with the cost of owning the same.

5. Public Deposits.

The deposits that are raised by organisations directly from the public are known as public deposits. Rates of interest offered on public deposits are usually higher than that offered on bank deposits. Any person who is interested in depositing money in an organisation can do so by filling up a prescribed form. The organisation in return issues a deposit receipt as acknowledgment of the debt. Public deposits can take care of both medium and short-term financial requirements of a business. The deposits are beneficial to both the depositor as well as to the organisation. While the depositors get higher interest rate than that offered by banks, the cost of deposits to the company is less than the cost of borrowings from banks. Companies generally invite public deposits for a period up to three years. The acceptance of public deposits is regulated by the Reserve Bank of India.

6. Commercial Paper (CP).

Commercial Paper emerged as a source of short term finance in our country in the early nineties. Commercial paper is an unsecured promissory note issued by a firm to raise funds for a short period, varying from 90 days to 364 days. It is issued by one firm to other business firms, insurance companies, pension funds and banks. The amount raised by CP is generally very large. As the debt is totally unsecured, the firms having good credit rating can issue the CP. Its regulation comes under the purview of the Reserve Bank of India.

7. Issue of Shares.

The capital obtained by issue of shares is known as share capital. The capital of a company is divided into small units called shares. Each share has its nominal value. For example, a company can issue 1,00,000 shares of Rs. 10 each for a total value of Rs. 10,00,000. The person holding the share is known as shareholder. There are two types of shares normally issued by a company. These are equity shares and preference shares. The money raised by issue of equity shares is called equity share capital, while the money raised by issue of preference shares is called preference share capital.

(a) Equity Shares.

Equity shares is the most important source of raising long term capital by a company. Equity shares represent the ownership of a company and thus the capital raised by issue of such shares is known as ownership capital or owners funds. Equity share capital is a prerequisite to the creation of a company. Equity shareholders do not get a fixed dividend but are paid on the basis of earnings by the company. They are referred to as residual owners since they receive what is left after all other claims on the companys income and assets have been settled. They enjoy the reward as well as bear the risk of ownership. Their liability, however, is limited to the extent of capital contributed by them in the company. Further, through their right to vote, these shareholders have a right to participate in the management of the company.

Merits.

The important merits of raising funds through issuing equity shares are given as below:

(i) Equity shares are suitable for investors who are willing to assume risk for higher returns;

(ii) Payment of dividend to the equity shareholders is not compulsory. Therefore, there is no burden on

the company in this respect;

(iii) Equity capital serves as permanent capital as it is to be repaid only at the time of liquidation of a company. As it stands last in the list of claims, it provides a cushion for creditors, in the event of winding up of a company;

(iv) Equity capital provides credit worthiness to the company and confidence to prospective loan providers;

(v) Funds can be raised through equity issue without creating any charge on the assets of the company. The assets of a company are, therefore, free to be mortgaged for the purpose of borrowings, if the need be;

(vi) Democratic control over management of the company is assured due to voting rights of equity shareholders.

Limitations.

The major limitations of raising funds through issue of equity shares are as follows:

(i) Investors who want steady income may not prefer equity shares as equity shares get fluctuating returns;

(ii) The cost of equity shares is generally more as compared to the cost of raising funds through other sources;

(iii) Issue of additional equity shares dilutes the voting power, and earnings of existing equity shareholders;

(iv) More formalities and procedural delays are involved while raising funds through issue of equity share.

(b) Preference Shares.

The capital raised by issue of preference shares is called preference share capital. The preference shareholders enjoy a preferential position over equity shareholders in two ways: (i) receiving a fixed rate of dividend, out of the net profits of the company, before any dividend is declared for equity shareholders; and (ii) receiving their capital after the claims of the companys creditors have been settled, at the time of liquidation. In other words, as compared to the equity shareholders, the preference shareholders have a preferential claim over dividend and repayment of capital. Preference shares resemble debentures as they bear fixed rate of return. Also as the dividend is payable only at the discretion of the directors and only out of profit after tax, to that extent, these resemble equity shares. Thus, preference shares have some characteristics of both equity shares and debentures. Preference shareholders generally do not enjoy any voting rights. A company can issue different types of preference shares.

Types of Preference Shares ;

1. Cumulative and Non-Cumulative: The preference shares which enjoy the right to accumulate unpaid dividends in the future years, in case the same is not paid during a year are known as cumulative preference shares. On the other hand, on non-cumulative shares, dividend is not accumulated if it is not paid in a particular year.

2. Participating and Non-Participating: Preference shares which have a right to participate in the further surplus of a company shares which after dividend at a certain rate has been paid on equity shares are called participating preference shares. The non-participating preference are such which do not enjoy such rights of participation in the profits of the company.

3. Convertible and Non-Convertible: Preference shares that can be converted into equity shares within a specified period of time are known as convertible preference shares. On the other hand, non-convertible shares are such that cannot be converted into equity shares.

Merits.

The merits of preference shares are given as follows:

(i) Preference shares provide reasonably steady income in the form of fixed rate of return and safety of investment;

(ii) Preference shares are useful for those investors who want fixed low risk;

(iii) It does not affect the control of equity shareholders over the management as preference shareholders dont have voting rights;

(iv) Payment of fixed rate of dividend to preference shares may enable a company to declare higher rates of dividend for the equity shareholders in good times;

(v) Preference shareholders have a preferential right of repayment over equity shareholders in the event of liquidation of a company;

(vi) Preference capital does not create any sort of charge against the assets of a company.

8. Debentures.

Debentures are an important instrument for raising long term debt capital. A company can raise funds through issue of debentures, which bear a fixed rate of interest. The debenture issued by a company is an acknowledgment that the company has borrowed a certain amount of money, which it promises to repay at a future date. Debenture holders are, therefore, termed as creditors of the company. Debenture holders are paid a fixed stated amount of interest at specified intervals. Public issue of debentures requires that the issue be rated by a credit rating agency like CRISIL (Credit Rating and Information Services of India Ltd.) on aspects like track record of the company, its profitability, debt servicing capacity, credit worthiness and the perceived risk of lending.

A company can issue different types of debentures . Issue of Zero Interest Debentures (ZID) which do not carry any explicit rate of interest has also become popular in recent years. The difference between the face value of the debenture and its purchase price is the return to the investor.

Types of Debentures.

1. Secured and Unsecured: Secured debentures are such which create a charge on the assets of the company, thereby mortgaging the assets of the company. Unsecured debentures on the other hand do not carry any charge or security on the assets of the company.

2. Registered and Bearer: Registered debentures are those which are duly recorded in the register of debenture holders maintained by the company. These can be transferred only through a regular instrument of transfer. In contrast, the debentures which are transferable by mere delivery are called bearer debentures.

3. Convertible and Non-Convertible: Convertible debentures are those debentures that can be converted into equity shares after the expiry of a specified period. On the other hand, non-convertible debentures are those which cannot be converted into equity shares.

4. First and Second: Debentures that are repaid before other debentures are repaid are known as first debentures. The second debentures are those which are paid after the first debentures have been paid back.

Merits.

The merits of raising funds through debentures are given as follows:

(i) It is preferred by investors who want fixed income at lesser risk;

(ii) Debentures are fixed charge funds and do not participate in profits of the company;

(iii) The issue of debentures is suitable in the situation when the sales and earnings are relatively stable;

(iv) As debentures do not carry voting rights, financing through debentures does not dilute control of equity shareholders on management;

(v) Financing through debentures is less costly as compared to cost of preference or equity capital as the interest payment on debentures is tax deductible.

9. Commercial Banks.

Commercial banks occupy a vital position as they provide funds for different purposes as well as for different time periods. Banks extend loans to firms of all sizes and in many ways, like, cash credits, overdrafts, term loans, purchase/discounting of bills, and issue of letter of credit. The rate of interest charged by banks depends on various factors such as the characteristics of the firm and the level of interest rates in the economy. The loan is repaid either in lump sum or in installments. Bank credit is not a permanent source of funds. Though banks have started extending loans for longer periods, generally such loans are used for medium to short periods. The borrower is required to provide some security or create a charge on the assets of the firm before a loan is sanctioned by a commercial bank.

Merits

The merits of raising funds from a commercial bank are as follows:

(i) Banks provide timely assistance to business by providing funds as and when needed by it.

(ii) Secrecy of business can be maintained as the information supplied to the bank by the borrowers is kept confidential;

(iii) Formalities such as issue of prospectus and underwriting are not required for raising loans from a bank. This, therefore, is an easier source of funds;

(iv) Loan from a bank is a flexible source of finance as the loan amount can be increased according to business needs and can be repaid in advance when funds are not needed.

10. Special Financial Institutions.

After independence a large number of financial institutions have been established in India with the primary objective of providing long-term financial assistance to industrial enterprises. Some of these institutions have been set up on the initiative of the Central Government, while others have been set up in different states on the initiative of the concerned State Governments. Thus there are all-India institutions like Industrial Finance Corporation of India (IFCI), Industrial Credit and Investment Corporation of India (ICICT), Industrial Development Bank of India (IDBI), and Industrial Reconstruction Corporation of India (IRCI). They mainly provide long-term finance for large companies. On the other hand, at the state level there are State Financial Corporations (SFCs) and Industrial Development Corporations (SIDCs). These state level institutions mainly provide long-term finance to relatively smaller companies.

These institutions (both national level and state level) are known as 'Development Banks' because their main objective is to provide financial assistance to industrial enterprises for investment projects, expansion or modernisation of plants in accordance with the priorities laid down in the Five Year Plans.

Besides the development banks, there are several other institutions known as investment companies or investment trusts which subscribe to the shares and debentures offered to the public by companies. For example, the Life Insurance Corporation of India (LIC), General Insurance Corporation of India (GIC), the Unit Trust of India (UTI), etc., come under this category.

Merits.

The merits of raising funds through financial institutions are as follows:

(i) Financial institutions provide long term finance, which are not provided by commercial banks;

(ii) Besides providing funds, many of these institutions provide financial, managerial and technical advice and consultancy to business firms;

(iii) Obtaining loan from financial institutions increases the goodwill of the borrowing company in the capital market. Consequently, such a company can raise funds easily from other sources as well;

(iv) As repayment of loan can be made in easy installments, it does not prove to be much of a burden on the business;

(v) The funds are made available even during periods of depression, when other sources of finance are not available.

11. International Financing.

In addition to the sources discussed above, there are various avenues for organisations to raise funds internationally. With the opening up of an economy and the operations of the business organisations becoming global, Indian companies have an access to funds in global capital market. Various international sources from where funds may be generated include:

(i) Commercial Banks ( Foreign): Commercial banks all over the world extend foreign currency loans for business purposes. They are an important source of financing non-trade international operations. The types of loans and services provided by banks vary from country to country. For example, Standard Chartered emerged as a major source of foreign currency loans to the Indian industry.

(ii) International Agencies and Development Banks: A number of international agencies and development banks have emerged over the years to finance international trade and business. These bodies provide long and medium term loans and grants to promote the development of economically backward areas in the world. These bodies were set up by the Governments of developed countries of the world at national, regional and international levels for funding various projects. The more notable among them include International Finance Corporation (IFC), EXIM Bank and Asian Development Bank.

(iii) International Capital Markets: Modern organisations including multinational companies depend upon sizeable borrowings in rupees as well as in foreign currency. Prominent financial instruments used for this purpose are:

(a) Global Depository Receipts (GDRs): The local currency shares of a company are delivered to the depository bank. The depository bank issues depository receipts against these shares. Such depository receipts denominated in US dollars are known as Global Depository Receipts (GDR). GDR is a negotiable instrument and can be traded freely like any other security. In the Indian context, a GDR is an instrument issued abroad by an Indian company to raise funds in some foreign currency and is listed and traded on a foreign stock exchange. A holder of GDR can at any time convert it into the number of shares it represents. The holders of GDRs do not carry any voting rights but only dividends and capital appreciation. Many Indian companies such as Infosys, Reliance, Wipro and ICICI have raised money through issue of GDRs.

(b) Foreign Currency Convertible Bonds (FCCBs): Foreign currency convertible bonds are equity linked debt securities that are to be converted into equity or depository receipts after a specific period. Thus, a holder of FCCB has the option of either converting them into equity shares at a predetermined price or exchange rate, or retaining the bonds. The FCCBs are issued in a foreign currency and carry a fixed interest rate which is lower than the rate of any other similar nonconvertible debt instrument. FCCBs are listed and traded in foreign stock exchanges. FCCBs are very similar to the convertible debentures issued in India.

SHORT TERM FUNDS.

After establishment of a business, funds are required to meet its day to day expenses. For example raw materials must be purchased at regular intervals, workers must be paid wages regularly, water and power charges have to be paid regularly. Thus there is a continuous necessity of liquid cash to be available for meeting these expenses. For financing such requirements short-term funds are needed. There are a number of sources of short-term finance which are listed below:

1. Trade credit

2. Bank credit

Loans and advances

Cash credit

Overdraft

Discounting of bills

3. Customers advances

4.. Loans from co-operatives.

5. Indigenous bankers.

1. Trade Credit.

Trade credit refers to credit granted to manufactures and traders by the suppliers of raw material, finished goods, components, etc. Usually business enterprises buy supplies on a 30 to 90 days credit. This means that the goods are delivered but payments are not made until the expiry of period of credit. This type of credit does not make the funds available in cash but it facilitates purchases without making immediate payment. This is quite a popular source of finance.

2. Bank Credit.

Commercial banks grant short-term finance to business firms which is known as bank credit. When bank credit is granted, the borrower gets a right to draw the amount of credit at one time or in installments as and when needed. Bank credit may be granted by way of loans, cash credit, overdraft and discounted bills.

(i) Loans

When a certain amount is advanced by a bank repayable after a specified period, it is known as bank loan. Such advance is credited to a separate loan account and the borrower has to pay interest on the whole amount of loan irrespective of the amount of loan actually drawn. Usually loans are granted against security of assets.

(ii) Cash Credit

It is an arrangement whereby banks allow the borrower to withdraw money upto a specified limit. This limit is known as cash credit limit. Initially this limit is granted for one year. This limit can be extended after review for another year. However, if the borrower still desires to continue the limit, it must be renewed after three years. Rate of interest varies depending upon the amount of limit. Banks ask for collateral security for the grant of cash credit. In this arrangement, the borrower can draw, repay and again draw the amount within the sanctioned limit. Interest is charged only on the amount actually withdrawn and not on the amount of entire limit.

(iii) Overdraft

When a bank allows its depositors or account holders to withdraw money in excess of the balance in his account upto a specified limit, it is known as overdraft facility. This limit is granted purely on the basis of credit-worthiness of the borrower. Banks generally give the limit upto Rs.20,000. In this system, the borrower has to show a positive balance in his account on the last friday of every month. Interest is charged only on the overdrawn money. Rate of interest in case of overdraft is less than the rate charged under cash credit.

(iv) Discounting of Bill

Banks also advance money by discounting bills of exchange and promissory notes.. When these documents are presented before the bank for discounting, banks credit the amount to cutomers account after deducting discount. The amount of discount is equal to the amount of interest for the period of bill.

3. Customers Advances.

Sometimes businessmen insist on their customers to make some advance payment. It is generally asked when the value of order is quite large or things ordered are very costly. Customers advance represents a part of the payment towards price on the product which will be delivered at a later date. Customers generally agree to make advances when such goods are not easily available in the market or there is an urgent need of goods. A firm can meet its short-term requirements with the help of customers advances.

4. Loans from Co-operative Banks

Co-operative banks are a good source to procure short-term finance. Such banks have been established at local, district and state levels. District Cooperative Banks are the federation of primary credit societies. The State Cooperative Bank finances and controls the District Cooperative Banks in the state. They are also governed by Reserve Bank of India regulations. Some of these banks like the Vaish Co-operative Bank was initially established as a co-operative society and later converted into a bank. These banks grant loans for personal as well as business purposes. Membership is the primary condition for securing loan. The functions of these banks are largely comparable to the functions of commercial banks.

5. Indigenous Bankers.

They are private individuals engaged in the business of financing small and local business units. They provide short term and medium term loans. However they charge very high rates of interest and are, therefore, considered only as a last resort of finance.

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Unit 3.

WORKING CAPITAL MANAGEMENT

Introduction

Capital required for a business can be classified under two main heads:

i. Fixed Capital

ii. Working Capital

Fixed capital / Long term funds is required to meet long term obligations namely purchase of fixed assets such as plant & machinery, land, building, furniture etc. Any business requires funds to meet short-term purposes such as purchase of raw materials, payment of wages and other day-to-day expenses. These funds are called Working capital. In short, Working Capital is the funds required to meet day-to-day operations of a business firm. And hence study of Working capital is considered to be very significant. An inefficient management of working capital leads to not only loss of profits but also to the closure of the business firm.

There are two concepts of Working capital namely,

1. Gross Working Capital (GWC)

2. Net Working Capital.

Generally working capital refers to the gross working capital and represents funds invested in total current assets of the firm. That means according to this concept working capital means Total Current Assets.

Net Working Capital is often referred to as circulating capital and represents the excess of current assets over current liabilities. Current liabilities are short-term obligations which are to be paid in the ordinary course of the business within a short period of one accounting year. Net working capital is positive when current assets exceed current liabilities. It is negative when current liabilities exceed current assets.

Working capital management is concerned with the problems that arise in attempting to manage the current assets, current liabilities and the inter relationship that exist between them. The goal of working capital management is to manage firms current assets and current liabilities in such a way that a satisfactory level of working capital is maintained. This is so because, if the firm cant maintain a satisfactory level of working capital, it is likely to become insolvent.

TYPES OF WORKING CAPITAL

Sometimes, working capital is divided into two varieties as:

i) Permanent working capital

ii) Variable working capital

Permanent Working Capital: (Fixed working capital):- Though working capital has a limited life and usually not exceeding a year, in actual practice some part of the investment in that is always permanent. Since firms have relatively longer life and production does not stop at the end of a particular accounting period some investment is always locked up in the form of raw materials, work-in-progress, finished stocks, book debts and cash. The investment in these components of working capital is simply carried forward to the next year. This minimum level of investment in current assets that is required to continue the business without interruption is referred to as permanent working capital.

Fluctuating (Variable Working Capital): This is also known as the circulating or transitory working capital. This is the amount of investment required to take care of the fluctuations in the business activity. While permanent working capital is meant to take care of the minimum investment in various current assets, variable working capital is expected to care for the peaks in the business activity.

NEED FOR WORKING CAPITAL - OPERATING CYCLE.

The basic aim of Financial management is to maximize the wealth of the share holders and in order to achieve this; it is necessary to generate sufficient sales and profit. However sales do not convert in to cash instantly. The time between purchase of inventory items (raw material or merchandise) for the production and their conversion into cash is known as operating cycle or working capital cycle..

A study of the operating cycle would reveal that the funds invested in operations are re-cycled back into cash. The cycle, of course, takes some time to complete. The longer the period of this conversion the longer is the operating cycle. A standard operating cycle may be for any time period but does not generally exceed a financial year.

If it were possible to complete the sequence instantly, there would be no need for current assets( working capital). But since it is not possible, the firm is forced to have current assets. Since cash inflows and outflows do not match, the firm has to keep cash for meeting short term obligations.

FACTORS DETERMINING THE WORKING CAPITAL REQUIREMENTS.

The total working capital requirement of a firm is determined by a wide variety of factors. These factors affect different organisations differently and they also vary from time to time. In general the following factors are involved in a proper assessment of the amount of working capital needed.

1. General nature of business.

The working capital requirements of an enterprise are basically related to the conduct of those business. Enterprises fall in to some broad categories depending on the nature of their business. For instance, public utilities have certain features which have a bearing on their walking capital needs. The two relevant features are Cash nature of business; and Sale of services than commodities. In view of these features they do not maintain big inventories and have there fore, probably little or least requirement of working capital. At the other extreme are trading and financial enterprises. The nature of their business is such that they have to maintain a sufficient amount of cash, inventories and book debts. They have necessarily to invest proportionately large amount in working capital.

2. Production Cycle.

Another factor which affects is production cycle. The term production cycle refers to the time involved in the manufacture of goods. It covers the time span between the purchase of raw materials and the completion of the manufacturing process leading to the production of finished goods. Funds will have to be necessarily tied up during the process of manufacture, necessitating enhanced working capital. The longer the time span (production cycle), the larger will be the funds tied up and there fore, the larger the working capital needed and vice versa. Further even within the same group of industries, the operating cycle may be different due to technological considerations. For economy in working capital, that process should be selected which has a shorter manufacturing process. Appropriate policies concerning terms of credit for raw materials and other supplies and advance payment from customers can help in reducing working capital requirement.

3. Business cycle.

The working capital requirements are also determined by the nature of the business cycle. During the boom period the need for working capital is likely to grow to cover the lag between increased sales and receipt of cash as well as to finance purchases of additional material to face the expansion of the level of activity. The decline stage in the business cycle will have exactly an opposite effect on the level of working capital requirement. The decline in the economy is associated with a fall in the volume of sales, which will lead to a fall in the level of inventories and book debts. The need for working capital in recessionary condition is bound to decline.

4. Production policy.

The quantum of working capital is also determined by production policy. In the case of certain lines of business, the demand for the product is seasonal ie they will be purchased during certain months of the year. Such companies may either confine their production only to periods when goods are purchased or they follow a steady production policy through out the year. In the former case there will be serious production problems. During slack season the firm will have to maintain its working force and physical facilities with out adequate production and sales. A steady production through out the year will cause large accumulation of finished goods. This will require additional working capital.

5. Credit Policy.

The level of walking capital is also determined by the credit policy which relates to sales and purchase. The credit sales will result in higher amount of debtors and more working capital. On the other hand if liberal credit terms are available from the suppliers of goods the need for working capital will be less. The walking capital requirements of a business are, thus, affected by the terms of purchase and sales.

6. Growth and Expansion.

As a Co grows it is logical to expect that a larger amount of working capital will be required. It is difficult to determine the relationship between the growth in the volume of business of a Co and the increase in the working capital. Other things being equal, growing Go's need more working capital than those that are static.

7. Availability of Raw Material.

The availability of Raw material without interruption would some times affect working capital. There may be some material which cant be procured easily either because their sources are few or irregular. To sustain smooth production the firm might be compelled to purchase and stock them in large quantities. This will result in excessive inventory of such materials.

8 Profit level.

Higher profit margin of a Co would generate more internal funds.. Net profit is a source of working capital to the extent that it has been earned in cash. The availability of such funds for working capital would depend upon level of tax, dividend and reserves, and depreciations.

a. Level of Tax:- The amount of tax to be paid is determined by the prevailing tax regulations and very often taxes have to be paid in advance. An adequate provision for tax is an important aspect of working capital planning. If tax liability increases, it will lead to an increase in the level of working capital and vice versa.

b. Dividend Policy:- The payment of dividend consumes cash resource and affects working capital. If the firm does not pay dividend and but retains the profit, working capital will increase.

c. Depreciation Policy. :- as depreciation charges do not involve any cash out flow, the amount so retained can be used as working capital.

9 Price Level Changes.

Changes in the price level also affect the requirement of working capital. Rising prices would necessitate the use of more funds for maintaining an existing level of activity. For the same level of materials and assets higher cash out flows are required. The effect of rising prices will be that a higher level of working capital is needed.

MANAGEMENT OF CASH.

Cash is an important current asset for the operations of business. Cash is the basic input that keeps business running continuously and smoothly. Too much cash and too little cash will have a negative impact on the overall profitability of the firm as too much cash would mean cash remaining idle and too less cash would hamper the smooth running of the operations of the firm. Therefore, there is need for the proper management of cash to ensure high levels of profitability. It is a usual practice to include near cash items such as marketable securities and bank term deposits in cash. The basic characteristics of near cash items is that, they can be quickly and easily converted into cash without any transaction cost or negligible transaction cost.

Motives for Holding Cash. The firms need to hold cash may be attributed to the three motives given below:

The transaction motive.

The precautionary motive.

The speculative motive.

The Compensation motive.

1.Transaction Motive: The transaction motive requires a firm to hold cash to conduct its business in the ordinary course and pay for operating activities like purchases, wages and salaries, other operating expenses, taxes, dividends, payments for utilities etc. The basic reason for holding cash is non-synchronization between cash inflows and cash outflows. Firms usually do not hold large amounts of cash, instead the cash is invested in market securities whose maturity corresponds with some anticipated payments. Transaction motive mainly refers to holding cash to meet anticipated payments whose timing is not perfectly matched with cash inflows.

2.Precautionary Motive: The precautionary motive is the need to hold cash to meet uncertainties and emergencies. The quantum of cash held for precautionary objective is influenced by the degree of predictability of cash flows. In case cash flows can be accurately estimated the cash held for precautionary motive would be fairly low. Another factor which influences the quantum of cash to be maintained for this motive is, the firms ability to borrow at short notice. Precautionary balances are usually kept in the form of cash and marketable securities. The cash kept for precautionary motive does not earn any return, therefore, the firms should invest this cash in highly liquid and low risk marketable securities in order to earn some returns.

3. Speculative Motive.A firm also keeps cash balance to take advantage of un expected opportunities, typically outside the normal course of business. Such motive is, there fore, of purely speculative nature. For e.g., a firm may like to take advantage of an opportunity of purchase raw materials at the reduced price on payment of immediate cash. Similarly it may like to keep some cash balance to make profit by buying securities in times when their prices fall.

4. Compensation Motive.

Another motive to hold cash balance is to compensate banks for providing certain services and loans. Banks provide a variety of services to business firms such as clearance of cheque, supply of credit information, transfer of funds and so on. While for some of these services banks charge a commission or fees, for others they seek indirect compensation. Usually clients are required to maintain a minimum balance of cash at the bank. Since this balance cant be utilised by the firms for transaction purpose, the bank themselves can use the amount to earn a return. Such balances are called as compensating balances.

OBJECTIVES OF CASH MANAGEMENT.

The basic objectives of cash management are two fold. Meeting payment schedule and minimising funds locked up as cash balance.

A. Meeting Payment Schedule.

In the normal course of business, (inns have to make payment of cash on a regular and continuous basis to suppliers of goods, employees, and so on. At the same time there is a constant inflow of cash through collections from debtors. A basic objective of cash management is to meet the payment schedule, that is to have sufficient cash to meet the cash disbursement needs of a firm It prevents insolvency or bankruptcy arising out of the in ability of a firm to meet its obligations. It also helps in keeping good relation with banks and creditors. Cash discount can be availed of, if the payment is made within the due date.

B. Minimising Funds Locked up as Cash Balance.

In minimising the cash balance, two conflicting aspects have to be reconciled. A higher cash balance ensures proper payment with all its advantages. But this will result in a large balance of cash remaining idle. Low level of cash balance may result in failure of the firm to meet the payment schedule. The finance manager should, there fore, try to have an optimum amount of cash balance, keeping in view the above factors.

CASH MANAGEMENT TECHNIQUES / PROCESS.

The strategic aspect of an efficient cash management are: -

1. Preparation of cash budget

2. Efficient Inventory Management

3. Speedy Cash collection

4. Delaying Payments.

SPEEDY CASH COLLECTION.

In managing cash efficiently, the cash inflow process can be accelerated through systematic planning and refined techniques. There are two broad approaches to do this. In the first place the customers should be encouraged to pay as quickly as possible. Secondly the payment from the customers should be converted in to cash with out any delay.

A. Prompt payment by customers.

One way to ensure prompt payment by customers is prompt billing. What the customer has to pay and the dale and period of payment should be notified accurately and in advance. The use of mechanical devises for billing along with a self addressed return envelope will speed up the payment.

Another technique is offering cash discount. The availability of discount implies savings to customers. To avail these facility, customers would be eager to make payment early.

B. Early conversion of payment in to cash.

A firm can conserve cash and reduce its requirements for cash balance, if it can speed up its cash collections. Cash collection can be accelerated by reducing the time gap between the time the customer pays the bill and the time the cheque is collected and funds become available for the firms use.

Three steps are involved in this time interval.

1 Transit or Mailing time :- This is the lime taken by the post office too transfer the cheque from the customers to the firm. This delay is referred to as Postal Float.

2. Time taken in processing the cheque within the firm before they are deposited in the Bank.

3. Collection time within the bank called Bank Float.

The early conversion of payment in to cash, as a technique to speed up collection , is done to reduce the time lag between depositing of the cheque by the customer and the realisation of money by the firm. The collection of account receivable can be accelerated, by reducing transit, processing and collection time. An important cash management technique adopted for this is Decentralised Collection. The principal methods of establishing a decentralised collection network are;

A. Concentration Banking .

This is a system of operating through a number of collection centres, instead of a single collection centre at the head office. Under this arrangement, the customers are required to send their payments (cheques) to the collection centres covering their region. It reduces the mailing time, & time involved in sending the bill to the customers.

B. Lock Box System.

Under this system, a firm arranges a Post office Lock Box at important collection centres. The customers are required to remit payments to the Post office lock box. The firms local bank is given the authority to pick up the remittances directly from the Box. The bank pick ups the mail several times a day and deposits the cheques in the firms A/C. after crediting the A/C, the bank sends a deposit slip along with the list of payments and other enclosures if any.

Although the use of concentration banking and lock box system accelerates the collection of cash, they involve a cost, (cost in terms of maintenance of collection centres, compensation to the bank for services etc.). If the income exceeds the cost, the system is profitable.

DELAYING PAYMENTS.

Apart from speedy collection of cash , the operating cash requirements can be reduced by slow disbursement of A/C Payable. Slow disbursement represent a source of fund requiring no interest payment. There are several techniques to delay payment of A/C payable, namely

1. Avoidance of early payment

2. Centralised disbursement

3. Floats

4. Accruals

1.Avoidance of early payments.

One way to delay payments is to avoid early payments. According to the terms of credit, a firm is required to make payment within a stipulated period. If the firm pays it accounts payable before the due date, it has no special advantage. Thus a firm would be well advised not to make payments early, i.e. not before the due date.

2.Centralised Disbursements.

All the payments should be made by the head office from a centralised disbursement account. Such an arrangement would delay payments, because it involves increase in the transit time. The remittance from the head office to the customers in distant places would involve more mailing time.

3. Floats

It refers to the amount of money tied up in cheques that have been written, but not yet en cashed It is due to transit and payment delays. There is a time lag between the issue of a cheque and its presentation. So although the cheque has been issued, cash would be required later, when the cheque is presented for encashment. There fore a firm can send remittance, although it does not have cash in its Bank A/C at the time of issue of cheque. There are two ways of doing it.

1. Paying from a distant Bank: The firm may issue a cheque on banks away from the creditor's bank. This would involve relatively longer transit time for the creditor's bank to gel payment and thus enable the firm to use its funds longer.

2. Cheque Encashment Analysis : Another way is to analyse on the basis of past experience, the time lag in the issue of cheques and their encashment. For E.g.: Cheques issued to pay wages and salary may not be cashed immediately, it may be spread over a few days, say 25% on first day, 50% on the second day and balance 3r day. It would mean that the firm should keep in the bank, not the entire amount of a pay roll, but only a fraction represented by actual withdrawal each day. This would enable to save operating cash.

3. Accruals: - These are liabilities, that represent a service/goods received by a firm, but not yet paid for. For e.g.: Salary to employees who render service in advance and receive payment later. They extend a credit to the firm for a period at the end of which they are paid (a week or a month). The longer the period, the greater is the amount of free financing and the smaller is the amount of cash balance required.

MANAGEMENT OF RECEIVABLES.

An efficient control of stocks and liquid resources in conjunction with credit facility is an essential part of management control. Credit and collection policies significantly influence working capital requirements. With proper credit terms, the flow of cash from receivables is synchronised to liquidate current expenses with out requiring additional funds from short term sources.

Accounts receivables constitute a significant portion of the total current assets of the business. They are a direct result of 'trade credit' which has become an essential marketing tool in modern business. When a firm sells goods for cash, payments are received immediately and there fore, no receivables are created How ever when a firm sells goods or services on credit, the payments are postponed to future dates and receivables are created.

Meaning of Receivables.

The term receivables is defined as "debt owed to the firm by customers arising from sale of goods or service in the ordinary course of business." Account receivables represents an extension of credit to customers, allowing them a reasonable period of time to pay for the goods purchased. Receivables are a direct result of credit sales. Credit sale is resorted to, by a firm to push up its sales which ultimately results in pushing up the profits earned by the firm. At the same time, selling goods on credit result in blocking of funds in Accounts Receivables.

Additional funds are, there fore, necessary for the operational needs of the business, which involve extra cost in terms of interest. Moreover increase in receivables also increases the chance of bad debts. Thus creation of account receivable is beneficial as well as dangerous. Management of account receivables may, there fore, be defined as the process of making decisions relating to the investment of funds in this asset which will result in maximising the over all return of the investment of the firm.

Thus the objective of receivables management is to promote sales and profits until that point is reached , where the return on investment in further funding of receivables is less than the cost of funds raised to finance that additional credit.

Objectives of credit sales.

The major objectives of credit sales are,

1. Achieving growth in sales:

If a firm sells goods on credit, it will generally be in a position to sell more goods than if it insisted on immediate cash payment. This is because many customers are either not prepared or not in a position to pay cash when they purchase goods . the firm can sell goods to such customers , in case it gives credit.

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 Competition.

A firm may have give credit facilities to its customers because of similar facilities being granted by the competing firms to avoid the loss of sales from customers who would buy else where if they did not receive the expected credit.

The over all objective of committing funds to A/C receivable is to generate a large flow of operating revenue and hence profit than what would be achieved in the absence of no such commitment.

Cost of maintaining receivables.

The costs with respect to maintenance of receivables can be identified as follows.

1. Capital Costs

Maintenance of A/C receivables results in blocking of the firms financial resources in them. This is because there is a time lag between the sale of goods to customers and the payments by them. The firm has, there fore, to arrange for additional funds to meet its own obligations, such as payment to employees, suppliers of raw materials, etc while awaiting for payments from its customers. Additional funds may either be raised from outside or out of profits retained in the business. In both cases the firm incurs a cost. In the former case, the firm has to pay the interest to the outsider, while in the second case there is an opportunity cost to the firm. - i.e. the money the firm could have earned otherwise by investing the funds else where.

2 Administrative Cost.

The firm has to incur additional administrative cost for maintaining Account Receivables in the form of salaries to the staff kept for maintaining accounting records relating to customers, cost of conducting investigation regarding customers credit worthiness etc.

3. Collecting Cost.

The firm has to incur costs for collecting payments from its credit customers. Some times additional steps may have to be taken to recover money from defaulting customers.

4. Defaulting Cost.

Some times after making all serious efforts to collect money from defaulting customers, the firm may not be able to recover the over dues because of the in ability of the customers. Such debts are treated as bad debts and have to be written off since they cant be realised.

FACTORS AFFECTING THE SIZE OF RECEIVABLES.

The size of Account Receivables is determined by a number of factors. Some are:

1. Level of sales.

This is the most important factor in determining the size of receivables. Generally in the same industry, a firm having a largo volume of sales will be having u larger level of receivables as computed to a firm with a small volume of sales.

2. Credit Policies.

The term credit policy refers to those decision variables that influence the amount of trade credit, i.e. investment in receivables. These include total amount of credit to be accepted, the length of the credit period to be extended, and the cash discount to be given. A firms credit policy determines the amount of risk the firm is willing to under take in sales activities. If a firm has a liberal credit policy, it will experience a higher level of receivables as compared to a firm with rigid policy.

3. Terms of Trade.

The size of receivables is also affected by the terms of trade (or credit terms) offered by the firm, the two important components are credit period and cash discount.

A. Credit Period -

The term credit period refers to the time duration for which credit is extended to the customers. It is generally expressed in terms of "net date". For eg, if a firms credit terms are 'net 15' it means the customers are expected to pay within 15 days from the date of credit sale.

B. Cash Discount.

Most of the firms offer cash discounts to their customers for encouraging them to pay their dues before the expiry of the credit period. Allowing cash discounts results in a loss to the firm because of recovery of less amount than what is due from the customer, but it reduces the volume of receivables and puts extra funds at the disposal of the firm for alternative investment. The amount of loss thus suffered is, there fore, compensated by the income otherwise earned by the firm.'

4 Stability of sales.

In the business of seasonal character, total sales and the credit sales will go up in the season and there fore volume of receivables will also be large. If the firm supplies goods on installment basis its balance in receivables will be high.

SYSTEM OF CONTROL OF RECEIVABLES.

It is in the interest of the enterprise to keep the investment in receivables in a controllable limit. The financial management should consider the following four factors which control the receivables management cost at a minimum point.

1. Deciding acceptable level of Risk.

The first consideration in this regard is to decide to whom goods are to be sold bearing in mind the risk involved. Because every credit transaction involves risk element, the financial management should consider the credit capacity of every customer before allowing any credit to him. Capacity of a customer can be judged by understanding his Character, Capacity^ Capital, Collateral Security offered and Conditions of sales.

2. Terms of Credit Sales.

The next thing the company has to decide is the Credit Terms and the Level of Discount. The extension of credit represents an investment having some cost of capital. It will increase the sale of the organisation resulting in larger profits. In deciding upon the credit terms the firm should think over certain basic issues involved in it - such as cost of capital, cash discount, volume of sales, period of credit sales, and so on. By considering all these factors, i.e. the Cost and the Benefits the financial manager should fix the most desirable credit terms.

3. Credit Collection Policy.

After granting the credit sale, the Co. should try to get the amount collected from its customers as early as possible. It needs a sound and strict collection policy to keep bad debts and losses at the minimum. The must also provide a certain amount as reserve for bad debt. The company should follow a collection procedure in a clear cut sequence. i.e. polite letter, strong worded reminders, personal visits and then legal action.

4. Analysing the Investments in Receivables.

The last step is to analyse the amount of receivables from time to time with the help of certain ratios such as calculation of average collection period, debtors turn over ratio, ratio of receivables to current assets etc. A proper analysis of receivables will help the management in keeping the amount of receivables within reasonable limits.

Unit 4

FINANCIAL STATEMENT ANALYSIS.

The financial statements are prepared for the purpose of presenting a periodical review or report of the progress made by the concern. It shows the 'status of the investment' in the business, and 'results achieved' during the accounting period.

Financial statements refer to at least two statements which are prepared at the end of a given period. These statements are Income Statement (P'&L Account ) and Position Statement, (i.e. Balance Sheet). The purpose of' Income statement' is to ascertain the net result of trading activities. Position statement is prepared to find out the financial position of the business as on a particular date.

According to John. N .Myer, " the financial statements provide a summary of the accounts of a business enterprise, the balance sheet reflecting the assets and liabilities and the income statement showing the results of operations during a certain period.

In addition to P&L A/C and Balance sheet, Statement of Retained Earnings, Fund Flow Statement and cash flow Statements are also considered as important financial statements.

The financial statements are of much interest to a number of groups of persons. These groups are very much interested in the analysis of financial statements. The process of critical evaluation of the financial information contained in the financial statements in order to understand and make decisions regarding the operations of the firm is called Financial Statement Analysis. It is basically a study of relationship among various financial facts and figures as given in a set of financial statements, and the interpretation thereof to gain an insight into the profitability and operational efficiency of the firm to assess its financial health and future prospects.

Analysis means to put the meaning of a statement in to simple terms for the benefit of a person. Analysis comprises resolving the statements by breaking them in to simpler statements by a process of re arranging, regrouping, and collection of information Broadly the term is applied to almost any kind of detailed enquiry in to financial data. A financial manager has to evaluate the past performance, present financial position, liquidity situation, enquire in to profitability of the firm and to plan for future operations. For all this, they have to study the relationship among various financial variables in a business as disclosed in various financial statements.

USERS OF FINANCIAL STATEMENT ANALYSIS.

Analysis of financial statement is an attempt to measure the enterprises liquidity, profitability, solvency and other indicators to assess its efficiency and performance. Analysis of financial statements is linked with the objective and interest of the individual / agency involved. Some of the agencies interested include Management, investors, creditors, bankers, workers, Government, and public at large.

1 MANAGEMENT.

Management is interested in the financial performance and financial condition of the enterprise. It would like to know about its viability as an on going concern, management of cash, debtors, inventory and fixed asset and adequacy of capital structure. Management would also be interested in the overall financial position and profitability of the enterprise as a whole and its various departments and divisions.

2. INVESTORS

An investor is interested in the profitability and safety of his investment and would like to know whether the business is profitable, has growth potential and is progressing on sound lines. The present investors want to decide whether they should hold the securities of the company or sell them. Potential investors, on the other hand, want to know whether they should invest in the shares of the company or not. Investors (Shareholders or owners) and potential investors, thus, make use of the financial statements to judge the present and future earning capacity of the business, to judge the operational efficiency of the business and to know the safety of investment and growth prospects.

3. BANKERS AND LENDERS

Bankers and lenders are interested in serving of their loans by the enterprise, i.e. regular payment of interest and repayment of principal amount on schedule dates. They also like to know the safety of their investment and reliability of returns.

4. SUPPLIERS/ CREDITORS.

Creditors dealing with the enterprise are interested in receiving their payments as and when fall due and would like to know its ability to honor its short-term commitments.

5. EMPLOYEES

Employees interested in better emoluments, bonus and continuance of the business, would like to know its financial performance and profitability.

6. GOVERNMENT

Government and regulatory authorities would like to ensure that the financial statements prepared are as per the specified laws and rules, and are to safe guard the interest of various concerned agencies. E.g.: Taxation authorities would be interested in ensuring proper assessment of tax liability of the enterprise as per the laws.

Stock exchange uses the financial statements to analyze and thereafter, inform its members about the performance, financial health, etc. of the company.

7. Customers

Customers are interested to ascertain continuance of an enterprise. For example, an enterprise may be supplier of a particular type of consumer goods and in case it appears that the enterprise may not continue for a long time, the customer has to find an alternate source.

8.. Public

Enterprises affect members of the public in a variety of ways. For example, enterprises may make a substantial contribution to the local economy in many ways including the number of people, they employ and their patronage of local suppliers. Financial statements may assist the public by providing information about trends and recent developments in the prosperity of the enterprise and the range of its activities.

Different agencies thus look at the enterprise from their respective viewpoint and are interested in knowing about its profitability and financial condition. In short a detailed cause and effect study of profitability and financial condition is the over all objective of financial statement analysis.

TYPES OF FINANCIAL ANALYSIS

Following are the various types of financial analysis.

A. On the basis of material used.

1 External analysis

Analysis of financial statements may be carried out on the basis of published information. i.e information made available in the Annual Report of the enterprise. Such analysis are usually carried out by those who do not have access to the detailed accounting records of the Co. ie Banks, Creditors etc.

2 Internal Analysis.

Analysis may also be based on detailed information available within the Co, which is not available to the outsiders. Such analysis is called internal analysis. This type of analysis is of a detailed one and is carried out on behalf of the management for the purpose of providing necessary information for decision-making. Such analysis emphasizes on the performance appraisal and assessing the profitability of different activities.

B. According to objectives of analysis.

1. Short Term Analysis

Short term analysis is mainly concerned with the working capital analysis. In the short run, a Co must have ample funds readily available to meet its current needs and sufficient borrowing capacity to meet the contingencies. In short term analysis the current assets and current liabilities are analyzed and liquidity is determined.

2. Long Term Analysis.

In the long term a Co: must earn a minimum amount sufficient to maintain a reasonable rate of return on the investment to provide for the necessary growth and development of the Co; and to meet the cost of capital. Financial planning is also desirable for the continued success of a Co. Thus in the long term analysis the stability and the earning potentiality of the Co is analyzed, i.e fixed assets, long term debt structure and the ownership interest is analyzed.

C. According to the Modus Operandi of analysis.

1. Horizontal Analysis.

Analysis of financial statements involves making comparisons and establishing relationships among related items. Such comparison or establishing of relationship may be based on financial statements of a Co for a number of years and the financial statements of different Co's for the same year. Such analysis is called Horizontal Analysis. It may take the following two forms.

A. Comparative Financial Statement Analysis

B. Trend Analysis.

2. Vertical Analysis.

Analysis of financial data based on relationship among items in a single period of financial statement is called vertical analysis. From a single Balance Sheet or P&L A/C, relationships of various items may be established. E.g., various assets can be expressed as percentage of total assets. Statements containing such analysis are also called as common size statements. The common size P&L A/C is more useful in analyzing the operating results and costs during the year. It shows each element of cost as a percentage of sales. Similarly common size Balance Sheet shows fixed assets as a percentage to total assets.

TOOLS OF FINANCIAL ANALYSIS

(METHODS).

The analysis of financial statements consist of a study of relationship and trends to determine whether or not the financial position of the concern and its operating efficiency have been satisfactory. In the process of this analysis various tools or methods are used by financial analyst. These tools are,

1. Comparative statements

2. Common size statements

3. Trend Analysis

4. Average Analysis

5. Statement of changes in working capital

6. Fund Flow Analysis

7 Cash Flow analysis &

8. Ratio Analysis.

COMPARATIVE FINANCIAL STATEMENTS.

The preparation of comparative financial statement is an important device of horizontal analysis. Financial data becomes more meaningful when compared with similar data for a previous period or a number of periods. Statements prepared in a form that reflect financial data for two or more periods are known as comparative statements. Annual data can be compar