CET453 CONSTRUCTION PLANNING AND MANAGEMENT – MODULE V

MODULE V
SYLLABUS
Budgetary Control Systems: Types of budgets, new approaches for budgeting, responsibility
of accounting, profit centre approach.
Financial Management: Meaning and scope, financial statement analysis, financial ratio
analysis, funds flow analysis.
Working Capital Management: Meaning, policy for working capital, estimating working
capital needs. Capital investment decision, long term financing working of financial institutions
in India and abroad, self-financing, financing mechanisms
COURSE OUTCOMES
CO5: Students will be able to explain the financial and legal aspects involved in a construction
project.
BUDGETARY CONTROL
It is the system of management control and accounting in which all the operations are
forecasted and planned in advance to the extent possible and the actual results compared with
the forecasted and planned ones.
ESSENTIALS OF BUDGETARY CONTROL
1) Establishment of budgets for each function and section of the organization.
2) Executive responsibility in order to perform the specific tasks so that objectives of the
enterprise may be attained.
3) Continuous comparison of the actual performance.
4) Taking suitable remedial action to achieve the desired objective if there is a variation of the
actual performance from the budgeted performance.
5) Revision of budgets in the light of changed circumstances.
OBJECTIVES OF BUDGETARY CONTROL
1) Planning: A budget is a plan of the policy to be pursued during the defined period of time
attain a given objective. The budgetary control will force all levels of management to plan in
time all the activities to be done during the future periods. A budget as a plan of action achieves
the following five purposes.
• Action is guided by well thought out plan because a budget is prepared after a careful study
and research.
• The budget serves as a mechanism through management’s objectives and policies are
effected.
• It is a bridge through which communication is established between the top management
and the operatives who are to implement the policies of the top management.
• The most profitable course of action is selected from the various available alternatives.
• A budget is a complete formulation of the policy of the undertaking to be pursued for the
purpose of attaining a given objectives.
2) Co-ordination: The budgetary control co-ordinates the various activities of the firm and
secures co-operation of all concerned so that the common objective of the firm may be
successfully achieved.
• It co-ordinates the broader economic trends and the economic position of an undertaking.

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• A budget gives direction to the business and imparts meaning and significance to its
achievement by making comparison of actual performance and budgeted performance.
3) Control: Control consists of the action necessary to ensure that the performance of the
organization conforms to the plans and objectives. Control of performance is possible with pre
determined standards which are laid down in a budget.
• Thus, budgetary control makes control possible by continuous comparison of actual
performance with that of the budget so as to report the variations from the budget, to the
management for corrective action.
BUDGETARY CONTROL INVOLVES:
• Establishment of budgets
• Continuous comparison of actual with budgets for achievement of targets.
• Revision of budgets after considering the changes in the circumstances.
• Placing the responsibility for failure to achieve the budget targets.
COMPONENTS OF BUDGETARY CONTROL SYSTEM
• Physical budgets: Those budgets which contain information in terms of physical units
about sales, production etc.
For example, quantity of sales, quantity of production, inventories, and manpower budgets are
physical budgets.
• Cost budgets: Budgets which provides cost information in respect of manufacturing,
selling, administration etc.
For example, manufacturing costs, selling costs, administration cost, and research and
development cost budgets are cost budgets.
• Profit budgets: A budget which enables in the ascertainment of profit,
For example, sales budget, profit and loss budget, etc.
• Financial budgets: A budget which facilitates in ascertaining the financial position of a
concern
For example, cash budgets, capital expenditure budget, budgeted balance sheet etc.
ADVANTAGES
Points Description
[Link] The use of budgetary control system enables the management of a business
concern to conduct its business activities in the efficient manner.
[Link] on It is a powerful instrument used by business houses for the control of their
expenditure expenditure. It in fact provides a yardstick for measuring and evaluating the
performance of individuals and their departments.
3. Finding It reveals the deviations to management, from the budgeted figures after
deviations making a comparison with actual figures.
[Link] Effective utilisation of various resources like— men, material, machinery
utilization of and money—is made possible, as the production is planned after taking them
resources into account.
[Link] of plans It helps in the review of current trends and framing of future policies.
[Link] It creates suitable conditions for the implementation of standard costing
of Standard system in a business organisation.
Costing system

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7. Cost Budgets are studied by outside fund providers also such as banking and
Consciousness financial institutions, realising that management encourages cost
consciousness and maximum utilisation of available resources.
[Link] Rating Management which have developed a well ordered budget plans and which
operate accordingly, receive greater favour from credit agencies.
DISADVANTAGES
Points Description
1. Based on Budgets are based on series of estimates which are based on the conditions
Estimates prevailed or expected at the time budget is established. It requires revision in plan
if conditions change.
2. Time factor Budgets cannot be executed automatically. Some preliminary steps are required
to be accomplished before budgets are implemented. It requires proper attention
and time of management. Management must not expect too much during the
development period.
3. Co- Staff co-operation is usually not available during budgetary control exercise. In
operation a decentralised organisation each unit has its own objective and these units enjoy
Required some degree of discretion. In this type of organisation structure, coordination
among different units are required. The success of the budgetary control depends
upon willing co- operation and teamwork,
4. Expensive Its implementation is quite expensive. For successful implementation of the
budgetary control, proper organisation structure with responsibility is
prerequisite. Budgeting process start from the collection of requirements to
budget and performance analysis. It consumes valuable resources for these
purpose, hence, it is an expensive process.
5. Not a Budget is only a managerial tool and must be applied correctly for management
substitute for to get benefited. Budgets are not a substitute for management.
management
6. Rigid Budgets are considered as rigid document. But in reality, an organisation is
document exposed to various uncertain internal and external factors. Budget should be
flexible enough to incorporate ongoing developments in the internal and external
factors affecting the very purpose of the budget.
BUDGETS
• A project budget is a financial commitment for actions, an instrument for delegation of
responsibility, a means of communication, an aid of coordination, a tool for motivation, an
authority for implementation and a device for controlling performance.
• A budget fixes a target in terms of rupees or quantities against which the actual performance
is measured.
• A budget can, therefore, be taken as a document which is closely related to both the
management function as well as the accounting function of an organization.
• Budgets are means of communication. Ideas of top management are given the shape of a
budget and are passed on to the subordinates who are to give them the practical shape.
• The activities of various departmental heads are coordinated at the preparation of a budget.

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• A budget is necessary to plan for future, to motivate the staff associated, to coordinate the
activities of different departments and to control the performance of various persons
operating at different levels.
• A budget is a financial plan for a defined period, often one year.
• It may also include planned sales volumes and revenues, resource quantities, costs and
expenses, assets, liabilities and cash flows.
• Based on a future plan of actions
• Prepared in advance
• Based on objectives to be attained
• Expressed in monetary/physical units
• Prepared for the implementation of policy formulated by the management
ESSENTIALS OF A BUDGET
1) It is a plan expressed in monetary terms but it can also contain physical units.
2) It is prepared prior to a defined period of time (budget period) during which it will operate.
3) It is related to a definite future period.
4) It is approved by the management for implementation.
5) It usually shows the planned income to be generated and expenditure to be incurred.
6) It also shows capital to be employed during the period.
7) It is prepared for the purpose of implementing the policy formulated by the management
and the objective to be achieved during the period.
DIFFERENT TYPES OF BUDGETS

Classification on the basis of Capacity or Flexibility:

These types of budgets are prepared on the basis of activity level or utilization of capacity.
These are also known as “Budgets on the basis of flexibility”.

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(i) Fixed Budget:

• According to CIMA, “a fixed budget, is a budget designed to remain unchanged
irrespective of the level of activity actually attained”.
• A fixed budget shows the expected results of a responsibility center for only one activity
level.
• Once the budget has been determined, it is not changed, even if the activity changes. Fixed
budgeting is used by many service companies and for some administrative functions of
manufacturing companies, such as purchasing, engineering, and accounting.
• Fixed Budget is used as an effective tool of cost control.
• It is also known as a static budget.
(ii) Flexible Budget:
• According to CIMA, “a flexible budget is defined as a budget which, by recognizing the
difference between fixed, semi-variable and variable costs is designed to change in relation
to the level of activity attained.”
• Unlike static (fixed) budgets, flexible budgets show the expected results of a responsibility
center for different activity levels.
Classification on the basis of Function
A functional budget is one which is related to function of the business as for example,
production budget relating to the manufacturing function. Functional budgets are prepared for
each function and they are subsidiary to the master budget of the business.
The various types of functional budgets to be prepared will vary according to the size and
nature of the business.
The various commonly used functional budgets are:
(i) Sales budget
(ii) Production budget
(iii) Plant utilisation budget
(iv) Direct-material usage budget
(v) Direct-material purchase budget
(vi) Direct-labour (personnel) budget
(vii) Factory overhead budget
(viii) Production cost budget
(ix) Ending-inventory budget
(x) Cost-of-goods-sold budget
(xi) Selling and distribution cost budget
(xii) Administration expenses budget
(xiii) Research and development cost budget
(xiv) Capital expenditure budget
(xv) Cash budget
• Sales Budget:
Sales forecast is the commencement of budgeting and hence sales budget assumes
primary importance. The quantity which can be sold may be the principal budget factor in
many business undertakings. In any case in order to chalk out a realistic budget programme,
there must be an accurate sales forecast. The sales budget indicates for each product:
1. the quantity of estimated sales and

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2. the expected unit selling price. These data are often reported by regions or by sales
representatives.
In estimating the quantity of sales for each product, past sales volumes are often used as a
starting point. These amounts are revised for factors that are expected to affect future sales.
Once an estimate of the sales volume is obtained, the expected sales revenue can be
determined by multiplying the volume by the expected unit sales price.
(ii) Production Budget:
Production budget shows the production for the budget period based upon:
1) Sales budget,
2) Production capacity of the factory,
3) Planned increase or decrease in finished stocks, and
4) Policy governing outside purchase.
Production budget is normally stated in units of output. Production should be carefully
coordinated with the sales budget to ensure that production and sales are kept in balance during
the period. The number of units to be manufactured to meet budgeted sales and inventory needs
for each product is set forth in the production budget. The production facility available and the
sales budget will be compared and coordinated to determine the production budget.
(iii) Plant Utilisation Budget:
Plant utilisation budget represents, in terms of working hours, weight or other convenient units
of plant facilities required to carry out the programme laid down in the production budget.
The main purposes of this budget are:
1. To determine the load on each process, cost or groups of machines for the budget
period.
2. To indicate the processes or cost centres which are overloaded so that corrective action
may be taken such as: (i) working overtime (ii) sub- contracting (iii) expansion of
production facility, etc.
3. To dovetail the sales production budgets where it is not possible to increase the capacity
of any of the overloaded processes.
4. Where surplus capacity is available in any of the processes, to make effort to boost sales
to utilise the surplus capacity.
(iv) Direct Material usage Budget:
The steps involved in the compilation of direct materials usage budget are as under:
1. The quality standards for each item of material have to be specified. In this connection,
standardisation of size, quality, colour, etc., may be considered.
2. Standard requirement of each item of materials required should also be set. While
setting the standard quality consideration should be given to normal loss in process.
The standard allowance for normal loss may be given on the basis of past performance,
test runs, technical estimates etc.
3. Standard prices for each item of materials should be set after giving consideration to
stock and contracts entered into.
After setting standards for quality, quantity and prices, the direct materials budget can be
prepared by multiplying each item of material required for the production by the standard price.
(v) Purchase Budget:

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• The production budget is the starting point for determining the estimated quantities of
direct materials to be purchased.
• Multiplying these quantities by the expected unit purchase price determines the total
cost of direct materials to be purchased.
Two important considerations that govern purchase budgets are as follows:
(i) Economic order quantity.
(ii) Re-order point with safety stocks to cover fluctuations in demand.
• The direct material purchases budget helps management maintain inventory levels
within reasonable limits, for this purpose, the timing of the direct materials purchases should
he coordinated between the purchasing and production departments.
(vi) Personnel (or Labour cost) Budget:
• Once sales budget and Production budget are compiled and thereafter plant utilisation
budget is settled, detailed amount of the various machine operations involved and services
required can be arrived at. This will facilitate preparation of an estimate of different grades of
labour required.
(vii) Production or Factory overhead Budget:
• Production overheads consist of all items such as indirect materials, indirect labour and
indirect expenses. Indirect expenses include power, fuel, fringe benefits, depreciation etc.
These estimated factory overhead costs necessary for production make up the factory
overhead cost budget.
• This budget usually includes the total estimated cost for each item of factory overhead.
• The production overhead budget is useful for working out the pre- determined overhead
recovery rates.
• A business may prepare supporting departmental
(viii) Production Cost Budget:
Production cost budget covers direct material cost, direct labour cost and manufacturing
expenses. After preparing direct material, direct labour and production overhead cost
budget, one can prepare production cost budget.
(ix) Ending Inventory Budget:
This budget shows the cost of closing stock of raw materials and finished goods, etc. This
information is required to prepare cost-of-goods-sold budget and budgeted financial statements
i.e., budgeted income statement and budgeted balance sheet.
(x) Cost of Goods Sold Budget:
This budget covers direct material cost, direct labour cost, manufacturing expenses and cost of
ending inventory of finished products.
(xi) Selling and Distribution Cost Budget:
• Selling and distribution are indispensable aspects of the profit earning function. At the
same time, the pre-determination of these costs is also very difficult.
Selling cost is defined as the cost of seeking to create and stimulate demand and of securing
orders. These costs are, therefore, incurred to maintain and increase the level of sales. All ex-
penses connected with advertising, sales promotion, sales office, salesmen, credit collection,
market research, after sales service, etc. are generally grouped together to form part of the
responsibility of the sales manager.

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(xii) Administrative expenses Budget:

• The administrative expenses are mostly policy costs and are, therefore, fixed in nature.
The most practical method to follow in preparing estimate of these expenses is to follow
the past experience with due regard to anticipated changes either in general policy or
the volume of business. To bring such expenses under control, it is necessary to review
them frequently and to determine at regular intervals whether or not these expenses
continue to be adjusted. Examples of such expenses are: audit fees, depreciation of
office equipment, insurance, subscriptions, postage, stationery, telephone, telegrams,
office supplies, etc.
(xiii) Research and Development expense Budget:
• Research is required in order to develop and/or improve products and methods. When
research results in definite benefit to the company, development function begins. After
development, formal production can commence on commercial scale and then
production function starts. Since the areas of research and development cannot be
precisely defined, the costs incurred under both the functions are clubbed together as
research and development costs. Research and Development (R & D) plays a vital role
in maintaining the business. For example, automobile manufacturers, and those who
produce drugs, spend considerable sums on R & D to improve the products.
(xiv) Capital expenditure Budget:
The capital expenditure budget represents the planned outlay on fixed assets like land, building,
plant and machinery, etc. during the budget period. This budget is subject to strict management
control because it entails large amount of expenditure. The budget is prepared to cover a long
period of years and it projects the capital costs over the period in which the expenditure is to
be incurred and the expected earnings.
(xv) Cash Budget:
• Cash budget represents the cash requirements of the business during the budget period.
It is the plan of receipts and payments of cash for the budget period, analysed to show
the monthly flow of cash drawn up in such a way that the balance can be forecasted at
regular intervals.
• The cash budget is one of the most important elements of the budgeted balance sheet.
Information from the various operating budgets, such as the sales budget, the direct
materials purchases budget, and the selling and administrative expenses budget, affects
the cash budget.
• In addition, the capital expenditures budget, dividend policies, and plans for equity or
long-term debt financing also affect the cash budget.
Project Master Budget
• When all the necessary functional budgets have been prepared, the budget officer will
prepare the master budget which may consist of budgeted profit and loss account and
budgeted balance sheet. These are in fact the budget summaries.
• When the master budget is approved by the board of directors, it represents a standard
for the achievement of which all the departments will work.
• On the basis of the various budgets (schedules) prepared earlier in this study, we prepare
below budgeted income statement and budgeted balance sheet.

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Classification on the basis of Period:

These types of Budgets are classified on the basis of time periods. These types of budgets
reflect the planning period of the organization.
1. Long term Budget: - The Budgets are prepared to depict long term planning of the
business. The period of long term Budgets varies between three to ten years. These
budgets are useful for those industries where gestation period is long i.e., machinery,
electricity etc.
2. Short term Budget: - These budgets are generally for one or two years and are in the
form of monetary terms. The consumer’s good industries like Sugar, Cotton, and textile
use short term budgets.
3. Current Budgets: - The period of current budgets is generally of months and weeks.
These budgets relate to the current activities of the business. According to CIMA
London “Current budget is a budget which is created which is established for use over
a short period of time and is related to current conditions”.
Project Budget Preparation Guidelines
• Prepared after project plan crystallized
• Prepared by team not by individual
• Prepared systematically using scientific techniques.
• Prepared in format
• Prepared as a total document
• Keeping in mind that it is used as a tool for budgetary control.
Importance of project budget
• It’s a planning document
• A project budget is the total sum of money allocated for the particular purpose of
the project for a specific period of time.
• The goal of budget management is to control project costs within the approved budget and
deliver the expected project goals
• Provide an organized procedure for planning
• Outlines the financial plan of the project.
• Depicts the management vision for the future.
• Without budget there can be no budgetary controls
• Supply information on the basis of which corrective action may be taken
CHARACTERISTICS OF BUDGET
• A budget is concerned for a definite future period.
• A budget is a written document.
• A budget is a detailed plan of all the economic activities of a business.
• All the departments of a business unit co-operate for the preparation of a business budget.
• Budget is a mean to achieve business and it is not an end in itself.
• Budget needs to be updated, corrected and controlled every time when circumstances
change. Therefore, it is a continuous process.
• Budget helps in planning, coordination and control.
• Different types of budgets are prepared by industries according to business requirements.
• Budget is usually prepared in the light of past experiences.

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NEW APPROACHES FOR BUDGETING

1. ZERO – BASED BUDGETING (ZBB)
• Zero-based Budgeting (ZBB) is an emergent form of budgeting which arises to overcome
the limitations of incremental (traditional) budgeting system.
• Zero- based Budgeting (ZBB) is defined as ‘a method of budgeting which requires each
cost element to be specifically justified, although the activities to which the budget relates
are being undertaken for the first time, without approval, the budget allowance is zero’.
• ZBB is an activity based budgeting system where budgets are prepared for each activities
rather than functional department.
• Justification in the form of cost benefits for the activity is required to be given.
• The activities are then evaluated and prioritized by the management on the basis of factors
like synchronisation with organisational objectives, availability of funds, regulatory
requirement etc.
• ZBB is suitable for both corporate and non-corporate entities.
• In case of non- corporate entities like Government department, local bodies, not for profit
organisations, where these entities need to justify the benefits of expenditures on social
programmes like mid-day meal, installation of street lights, provision of drinking water etc.
STAGES IN ZERO-BASED BUDGETING:
ZBB involves the following stages:
• Identification and description of Decision packages
• Evaluation of Decision packages
• Ranking (Prioritisation) of the Decision packages
• Allocation of resources
Identification and description of Decision packages: Decision packages are the programmes
or activities for which decision is required to be taken. The programmes or activities are
described for technical specifications, financial impact in the form of cost benefit analysis and
other issues like environmental, regulatory, social etc.
Evaluation of Decision packages: Once Decision packages are identified and described, it is
evaluated against factors like synchronisation with organisational objectives, availability of
funds, regulatory requirement etc.
Ranking (Prioritisation) of the Decision packages: After evaluation of the decision
packages, it is ranked on the basis priority of the activities. Because of this prioritization feature
ZBB is also known as Priority-based Budgeting.
Allocation of resources: After ranking of the decision packages, resources are allocated for
decision packages. Budgets are prepared like it is done first time without taking reference to
previous budgets.
ADVANTAGES OF ZERO-BASED BUDGETING:
• It provides a systematic approach for the evaluation of different activities and rank
them in order of preference for the allocation of scarce resources.
• It ensures that the various functions undertaken by the organization are critical for
the achievement of its objectives and are being performed in the best possible way.
• It provides an opportunity to the management to allocate resources for various
activities only after having a thorough cost-benefit-analysis.
• The areas of wasteful expenditure can be easily identified and eliminated.

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• Departmental budgets are closely linked with corporation objectives.

• The technique can also be used for the introduction and implementation of the system
of ‘management by objective.’ Thus, it cannot only be used for fulfillment of the
objectives of traditional budgeting but it can also be used for a variety of other purposes.
DIFFERENCE BETWEEN TRADITIONAL BUDGETING AND ZERO- BASED
BUDGETING:
• Traditional budgeting is accounting oriented. Main stress happens to be on previous level
of expenditure. Zero-based budgeting makes a decision oriented approach.
• In traditional budgeting, first reference is made to past level of spending and then demand
for inflation and new programmes. In zero- based budgeting, management focuses attention
to only on decision packages, which enjoy priority to others.
• In tradition budgeting, some managers deliberately inflate their budget request so that after
the cuts they still get what they want. In zero-based budgeting, a rationale analysis of budget
proposals is attempted. The managers, who unnecessarily try to inflate the budget request,
are likely to be caught and exposed.
• Traditional budgeting is not as clear and as responsive as zero- base- budgeting is.
• In traditional budgeting, it is for top management to decide why a particular amount should
be spent on a particular decision unit. In Zero-based budgeting, this responsibility is shifted
from top management to the manager of decision unit.
• Traditional budgeting makes a routine approach. Zero-based budgeting makes a very
straightforward approach and immediately spotlights the decision packages enjoying
priority over others.
LIMITATIONS OF ZERO- BASED BUDGETING:
• The work involves in the creation of decision-making and their subsequent ranking has to
be made on the basis of new data. This process is very tedious to management.
• The activity selected for the purpose of ZBB are on the basis of the traditional functional
departments. So the consideration scheme may not be implemented properly.
PERFORMANCE BUDGETING (PB)
• Performance Budgeting provide a meaningful relationship between estimated inputs and
expected outputs as an integral part of the budgeting system.
• A performance budget is one which presents the purposes and objectives for which funds
are required, the costs of the programmes proposed for achieving those objectives, and
quantitative data measuring the accomplishments and work performed under each
programme.
• Thus PB is a technique of presenting budgets for costs and revenues in terms of functions.
• Programmes and activities are correlating the physical and financial aspect of the individual
items comprising the budget.
TRADITIONAL BUDGETING VS. PERFORMANCE BUDGETING
• The traditional budgeting gives more emphasis on the financial aspect than the physical
aspects or performance. PB aims at establishing a relationship between the inputs and the
outputs.
• Traditional budgets are generally prepared with the main basis towards the objects or items
of expenditure i.e. it highlights the items of expenditure, namely, salaries, stores and

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materials, rates, rents and taxes and so on. In the PB emphasis is more on the functions of
the organisation, the programmes to discharge these function and the activities which will
be involved in undertaking these programmes.
RESPONSIBILITY ACCOUNTING
• Responsibility accounting is a system of management accounting under which
accountability is established according to the responsibility delegated to various levels of
management and a management information and reporting system instituted to give
adequate feedback in terms of the delegated responsibility.
• In an organization, the responsibilities of each and every level of management should
clearly be communicated so that accountability should be ascertained. This technique of
deciding responsibility on the basis of responsibility centres performance is known as
responsibility accounting.
• Under this system, divisions or units of an organisation under a specific authority in a
person are developed as responsibility centres & evaluated individually for their
performance.
• It is used to measure performance of divisions of an organisation rather than organisation
as a whole.
• Responsibility Accounting is a system of control where responsibility is assigned for the
control of costs. The persons are made responsible for the control of costs.
• Proper authority is given to the persons so that they are able to keep up their performance.
In case the performance is not according to the predetermined standards then the persons
who are assigned this duty will be personally responsible for it.
• In responsibility accounting the emphasis is on men rather than on systems.
• Responsibility Accounting collects and reports planned and actual accounting information
about the inputs and outputs of responsibility centres
Nature/Characteristics Of Responsibility Accounting
The key features of responsibility accounting can be explained as under:
• It is related to costs and revenue of an organization.
• In responsibility accounting, costs are divided into controllable and non controllable costs.
• The division of costs is done on the basis of cost centres.
• In responsibility accounting, comparison of actual and budgeted performance is done to
determine the success or failure.
Significance of Responsibility Accounting
Accountability: It decides the responsibilities of each level of management and the managers
are responsible for their particular area or activity. If performance is unsatisfactory, the
particular manager is held accountable for the failure.
Improves performance: Every manager performs his activity with special care because in
case of failure he has to answer the reasons of gaps.
Cost control: It also helps in controlling the cost by dividing the work in to different
responsibility centres.
Effective delegation: Delegation of authority and responsibilities becomes easier because of
creation of different responsibility centres.

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Quick decisions: When every manager know his/her limits and activities, it becomes easier to
take a decision.
Management by exception: Management by exception principle is also followed because
work is divided in effective manner and only key activities are handed over to top management.
Disadvantages of Responsibility Accounting
Difficulty in cost categorization: It becomes more complex to categorize the controllable and
uncontrollable costs.
Delay in decision making: Due to various responsibility centres and their numerous managers,
it is not easy to take prompt decisions.
Conflicts: Every manager wants to show his performance more than other centres which
creates conflicts among various centres
RESPONSIBILITY CENTRE
• The main focus of responsibility accounting lies on the responsibility centres.
• A responsibility centre is a sub unit of an organization under the control of a manager who
is held responsible for the activities of that centre.
• It is like a small business to achieve the objectives of a large organisation
Types of Responsibility Centres
The most common types of responsibility centres are given as under:
Cost Centre: A cost or expense centre is a centre in which managers are accountable for the
costs or expenses rather than revenues such as accounting department, HR department, research
and development department, production and service department, etc. Here budget is prepared
only to estimate or control the cost for a particular period.
Revenue Centre: A revenue centre is a centre in which managers are accountable for the
revenue rather than costs such as sales department. Here the actual and budgeted sales are
compared to increase the share of revenue by focusing on each segment of market.
Profits Centre: The centre in which manager is accountable for both cost as well as
revenue is known as profit centre. The main objective of this centre is to acquire profits
for which manager fixes the selling price, focuses on effective marketing programme and
performs other activities to boost the profits.
Investment Centre: Here the manager is accountable for capital expenditure decision as well
as cost and revenues. The manager decides to investment in an alternative manner after
analyzing the different options on the basis of risk and return.
Process of Responsibility Accounting
Responsibility Accounting is a mechanism to achieve the organisational goals by dividing
responsibilities. The steps involved in this process are as follow:
Determining the Responsibility Centre: First, creation of responsibility centres is done for
whole organization and responsibilities of each manager of responsibility centres are decided.
Determining the Goals: The targets or goals of each responsibility centre are fixed with the
help of the experts on the basis of facts and figures so that activities can be performed in the
direction of achieving
the goals.
Recording the actual performance: Actual work of every responsibility centre is noted down
and is to be reported to the managers of each centre.

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Finding out the deviations: The next step is to find out the variations by comparing the actual
figures by budgeted ones and tried to find out the reasons of that particular gap.
Corrective measures: If variation exists, then necessary corrective measures are taken to
combat these variations.
PROFIT CENTRE
• Also called business centre
• It is a segment of an organisation whose manager is responsible for both revenues and
costs.
• The centre in which manager is accountable for both cost as well as revenue is known as
profit centre. The main objective of this centre is to acquire profits for which manager fixes
the selling price, focuses on effective marketing programme and performs other activities
to boost the profits.
• In a profit centre, the manager has the responsibility and the authority to make decisions
that affect both costs and revenues (and thus profits) for the department or division.
• The managers are encouraged to act as if they were running their own separate business
• The main purpose of a profit centre is to maximise profit by making decisions relating to
production volume, product mix, selling price, marketing strategy.
• Profit centre managers aim at both the production and marketing of a product.
FINANCIAL MANAGEMENT
• No business activity can be undertaken without finance
• Finance is the lifeblood of business. A business cannot even be started without finance.
• Every kind of business organization, whether it is small, medium or big, it needs finance.
• Every business activity is an economic activity and these activities require finance.
• There arises the need for arranging and managing finance in the business.
Meaning and Definition of Financial Management
• Financial management is concerned with the acquisition of funds and their optimum
utilization.
• It is all about acquiring funds at minimum cost and generate optimum return by its
optimum utilization.
• Funds are acquired to meet financial aspects of business activity.
Objectives of Financial Management
• Effective procurement and efficient use of finance lead to proper utilization of the finance
by the business concern.
• It is the essential part of the financial manager.
• Hence, the financial manager must determine the basic objectives of the financial
management.
• Objectives of Financial Management may be broadly divided into two parts such as:
1. Profit maximization
2. Wealth maximization
Profit Maximization
• Main aim of any kind of economic activity is earning profit.
• A business concern is also functioning mainly for the purpose of earning profit. Profit is
the measuring techniques to understand the business efficiency of the concern.

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• Profit maximization is also the traditional and narrow approach, which aims at, maximizes
the profit of the concern.
• Profit maximization consists of the following important features.
✓ Profit maximization is also called as cashing per share maximization. It leads to
maximize the business operation for profit maximization.
✓ Ultimate aim of the business concern is earning profit, hence, it considers all the
possible ways to increase the profitability of the concern.
✓ Profit is the parameter of measuring the efficiency of the business concern. So it shows
the entire position of the business concern.
✓ Profit maximization objectives help to reduce the risk of the business.
The profit is an absolute number which is equal to revenue minus expenses.
If a company has 200 in revenue and 180 expenses, its profit is 20.
Profitability is a relative number (a percentage) and expresses the ratio between profit and
revenue.
Profitability = profit divided by revenue multiplied with 100.
In the above case, Profitability = 20 / 200 * 100 = 10%
So you have 20 profit and a 10% profitability.
Wealth Maximization
• Wealth maximization is one of the modern approaches, which involves latest innovations
and improvements in the field of the business concern.
• The term wealth means shareholder wealth or the wealth of the persons those who are
involved in the business concern.
• Wealth maximization is also known as value maximization or net present worth
maximization. This objective is an universally accepted concept in the field of business.
Nature of Financial Management
1. It is an indispensable organ of management. It is an integral part of business decision-
making process.
2. It is a continuous process.
3. It is centralised nature of finance function i.e., investment, financing an dividend decision.
4. Helpful in the decision making of top management.
5. It helps in measurement of performance.
6. It is pervasive. All form of business organisation, big or small needs to manage finance.
7. It has a wide scope.
Scope Of Financial Management
1. Financial Management and Human Resource
2. Financial Management and Marketing
3. Financial Management and Production Management
4. Financial Management or Mathematics
5. Financial Management and Accounting
6. Financial Management and Economics
1. Financial Management and Human Resource
• Financial management is also related to the human resource department, which provides
power to all the functional areas of the management.

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• The financial managers should carefully evaluate the requirement of manpower to each
department and allocate the finance to the human resource department as wages, salary,
remuneration, commission, bonus, pension, and other monetary benefits to the human
resource department. Hence, financial management is directly related to human resource
management.
2. Financial Management and Marketing
• Produced goods are sold in the market with innovative and modern approaches. For this,
the marketing department needs finance to meet its requirements.
• The financial manager or finance department is responsible for allocating adequate finance
to the marketing department. Therefore, marketing and financial management are
interrelated and interdependent.
3. Financial Management and Production Management
• Production management is the operational part of the business’s concern, helping many of
the money to profit.
• The benefit of concern depends on production performance. Production performance
requires finance. Because the production department needs raw materials, machinery,
wages, operating expenses, etc.
• These expenditures are decided by the financial department, and estimates are made. And
finance managers allocate appropriate finance to the production department.
• The financial manager must be aware of the operational process and finances required for
each process of production activities.
4. Financial Management or Mathematics
• Modern approaches to financial management applied a large number of mathematical and
statistical tools and techniques.
• They are also called econometrics.
• Economic order quantity, discount factor, time value of money, the present value of money,
cost of capital, capital structure theories, dividend theories, ratio analysis, and working
capital analysis are used as mathematical and statistical tools and techniques in the field of
financial management.
5. Financial Management and Accounting
• Accounting records include the financial information of the business concern. Hence, we
can easily understand the relationship between financial management and accounting. In
the olden periods, both financial management and accounting are treated as the same
discipline.
• Then it has been merged as Management Accounting because this part is very much helpful
to finance managers to take decisions. But nowadays’s financial management and
accounting discipline are separate and interrelated.
6. Financial Management and Economics
• Economic concepts like micro and macroeconomics are directly applied to financial
management approaches. Investment decisions, micro, and macro-environmental factors
are closely associated with the functions of a financial manager.
• Financial management also uses economic equations like money value discount factor,
economic order quantity, etc.

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• Financial economics is one of the emerging areas, which provides immense opportunities
to finance, and economical areas.
FINANCIAL STATEMENT ANALYSIS
• Financial Statement Analysis will help business owners and other interested people to
analyse the data in financial statements to provide them with better information about
such key factors for decision making and ultimate business survival.
• Financial statements refer to at least two statements which the accountant prepares at the
end of a given period.
• These statements are profit and loss account (Income statement) and Balance Sheet
(Position statement).
• 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 Income
Statement showing the results of operations during a certain period”.
Financial Statements include
✓ Profit and Loss Account (Income Statement)
✓ Balance Sheet
✓ Statement of Retained Earnings
✓ Fund Flow Statement
✓ Cash Flow Statement
✓ Schedules
1. Profit and Loss Account (Income Statement)
• Profit and loss (P&L) statement refers to a financial statement that summarizes the
revenues, costs, and expenses incurred during a specified period, usually a quarter or fiscal
year.
• These records provide information about a company’s ability or inability to generate profit
by increasing revenue, reducing costs, or both.
• P&L statements are often presented on a cash or accrual basis.
• Company managers and investors use P&L statements to analyze the financial health of a
company.
2. Balance sheet
• A balance sheet is a financial statement that reports a company's assets, liabilities, and
shareholder equity.
• The balance sheet is one of the three core financial statements that are used to evaluate a
business.
• It provides a snapshot of a company's finances (what it owns and owes) as of the date of
publication.
3. Statement of Retained Earnings:
• It is also known as Profit and Loss Appropriation Account.
• It shows the appropriation of earnings like dividend paid, transfer to reserve etc.
• The balance in this account will show the amount of profit retained and carried forward.
4. Fund Flow Statement:
• The fund flow statement is designed to analyze the changes in the financial condition of a
business enterprise between two periods.

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• This statement will show the sources from which the funds are received and uses to which
these have been put
5. Cash Flow Statement:
• The cash flow statement summarizes the causes of changes in cash position of a business
enterprise between two Balance Sheet dates.
• It focuses attention on cash changes only.
• It describes the sources of cash and its uses.
6. Schedules
• A number of schedules are prepared to supplement the information supplied in the Balance
Sheet.
• The schedules of investments, fixed assets, debtors etc are prepared to give details about
these transactions.
• All these statements are used as part of financial statements.
Importance and Users of Financial Statements
1. Management
2. Creditors
3. Bankers
4. Investors
5. Government
6. Others: Trade associations, Stock Exchange etc
ANALYSIS OF FINANCIAL STATEMENTS
• Financial analysis is the process of determining the significant operating and financial
characteristics of a firm from accounting data.
• The term financial analysis is applied to almost any kind of detailed enquiry into financial
data.
Purpose of Financial Statement Analysis
• To use financial statements to evaluate an organisation’s
• Financial performance
• Financial position.
• To have a means of comparative analysis across time in terms of:
• Intracompany basis (within the company itself)
• Intercompany basis (between companies)
• Industry Averages (against that particular industry’s averages)
• To apply analytical tools and techniques to financial statements to obtain useful information
to aid decision making.
There are two key factors for business survival:
• Profitability
• Solvency
Profitability is important if the business is to generate revenue (income) in excess of the
expenses incurred in operating that business.
Solvency of a business is important because it looks at the ability of the business in meeting its
financial obligations.
Financial statement analysis involves analysing the information provided in the financial
statements to:

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– Provide information about the organisation’s:

• Past performance
• Present condition
• Future performance
– Assess the organisation’s:
• Earnings in terms of power, persistence, quality and growth
• Solvency
Effective Financial Statement Analysis
• To perform an effective financial statement analysis, you need to be aware of the
organisation’s:
• business strategy
• objectives
• annual report and other documents like articles about the organisation in
newspapers and business reviews.
• These are called individual organisational factors.
Effective Financial Statement Analysis requires that:
• Understand the nature of the industry in which the organisation works. This is an
industry factor.
• Understand that the overall state of the economy may also have an impact on the
performance of the organisation.
OBJECTIVES OF FINANCIAL ANALYSIS
1. To estimate the earning capacity of the firm
2. To gauge the financial position and financial performance of the firm
3. To determine the long term liquidity of the funds
4. To judge the solvency of the firm
5. To determine the debt capacity of the firm
6. To decide about the future prospects of the firm
7. To know the progress of the firm
8. To measure the efficiency of operations
TYPES OF FINANCIAL ANALYSIS

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Types of
Financial
analysis

According According to According

to material objectives of to modus
used analysis operandi

Long
External Internal Short term Horizontal Vertical
Term
analysis Analysis analysis Analysis Analysis
analysis

1) According to Material used

A) External analysis:
• External analysis of financial statement is made by those who do not have access to the
detailed accounting records of the company.
• Eg: Banks, creditors, and general public
• These people depend almost entirely on published financial statements.
B) Internal Analysis:
• This analysis is made by the finance and accounting department to help the top
management.
• These people have direct approach to the relevant financial records. So they can peep
behind the two basic financial statements and narrate the inside story.
2) According to modus operandi
A) Horizontal Analysis:
• When the financial statements for a number of years are reviewed and analyzed, the
analysis is called horizontal analysis.
• The preparation of comparative statements is an example of horizontal analysis.
• It is also known as Dynamic Analysis.
B) Vertical analysis:
• Vertical analysis is also known as Static Analysis.
• When ratios are calculated from the Balance Sheet of one year, it is called vertical
analysis.
• It is not very useful for long term planning as it does not include the trend study for
future.
3) According to objectives of analysis
A) Long term analysis:
• In the long term company must earn a minimum amount sufficient to maintain a suitable
rate of return on the investment to provide for the necessary growth and development
of the company and to meet the cost of capital.

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• Thus, in long run analysis the stress is on the stability and earning potentiality of the
concern.
• In long term analysis the fixed assets, long term debt structure and the ownership
interest is analyzed.
B) Short term analysis:
• It is mainly concerned with working capital analysis.
• In the short run a company 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 the current liabilities are analysed and cash
position of the concern is determined.
TOOLS OF FINANCIAL ANALYSIS OR METHODS OF FINANCIAL ANALYSIS
1) Ratio Analysis
2) Comparitive Finanical And Oeprating Statements
3) Common Size Statements
4) Trend Analysis
5) Cost Volume Profit Analysis
6) Cash Flow Analysis
7) Fund Flow Analysis
FINANCIAL RATIOS ANALYSIS
• Financial ratios are basic calculations using quantitative data from a company’s financial
statements.
• They are used to get insights and important information on the company’s
performance, profitability, and financial health.
• Common financial ratios come from a company’s balance sheet, income statement, and
cash flow statement.
• Businesses use financial ratios to determine liquidity, debt concentration, growth,
profitability, and market value.
• Financial Ratios are mathematical assessments of financial statement accounts.
• Financial Ratio Analysis is performed by comparing two items in the financial statements.
The resulting ratio can be interpreted in a way that is not possible when interpreting the
items alone. In simple words, we are analyzing interrelationships.
• The connections between the financial statement accounts assist shareholders, creditors,
and internal company management to understand how well a business is performing and
which parts of the business needing improvement.
• Financial ratios are the most well-known and extensive tools. It is used to analyze a
business’ financial standing.
• Ratios are simple to calculate and easy to understand for top level management. Ratios can
also be used to compare different companies in different industries.
• Subsequently, a ratio is just a mathematically comparison based on proportions, large and
small companies can use ratios to compare their financial information.
• Ratios let us compare companies across industries, to recognize their strengths and
weaknesses.
• The CEO/Proprietory of an organization don’t have enough time to read the lengthy
numeric financial statements (profit loss & balance sheet) and it takes a lot of their time to

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understand and analyzed the whole financial statements so they always preferred Financial
Ratio Analysis to keep an eye on their business’ financial position.
• The Financial ratios can be categorized into Five main ratios that are:
Purpose & Importance of Financial Ratio Analysis
• Ratios help in analyzing the performance trends over a long period of time.
• They also help a business to compare the financial results to those of competitors.
• Ratios assist the management in decision making.
• They also point out the problem and weak areas along with the strength areas.
• Ratios to help to develop relationships between different financial statement items.
• Ratios have the advantage of controlling for differences in size. For example, two
businesses may be quite different in size but can be compared in terms of profitability,
liquidity, etc., by the use of ratios.
Users of Financial Ratios
• Financial ratio analysis is aimed to measure the financial performance of a company and to
define the financial position of a company through relevant indicators/ratio. There are many
groups and individuals who want to know about their business performance.
1. Bankers and Money Lenders: They Use profitability, liquidity, and investment ratio
because they want to know the ability of the borrowing business in regularly scheduled interest
payments and repayments of a principal loan amount.
2. Investors: They Use profitability and investment ratio because they are more interested in
profitability performance of business and safety & security of their investment and growth
potential of their investment.
3. Management: They use almost all ratios because management is interested in all aspects of
organization i.e., both financial performance and financial condition of the business.
4. Employees: They use profitability, liquidity, and activity ratio because employees will be
worried about job security, bonus, and continuation of business and wage rate negotiating.
5. Suppliers: They use liquidity ratio because suppliers are more interested in knowing the
ability of the business to relax its short-term duties as and when they are due.
6. Customers: They use liquidity ratio because customers will search for comfort that the
business can stay alive in the short term and continue to supply.
7. Government: They Use profitability ratio because the government may use profit as a basis
for taxation, grants, and subsidies.
Financial Ratios:
• LIQUIDITY RATIO
• CURRENT RATIO
• ACID TEST / QUICK RATIO
• CAPITAL STRUCTURE RATIO
• LEVERAGE RATIO
• DEBT EQUITY RATIO
• DEBT ASSET RATIO
• COVERAGE RATIO
• INTEREST COVERAGE RATIO
• DIVIDENT COVERAGE RATIO
• PROFITABILITY RATIO

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• PROFIT RATIO
• EXPENSE RATIO
• INVESTMENT RELATED RATIO
• ACTIVITY RATIO
• INVENTORY TURNOVER RATIO
• RECEIVABLE TURNOVER RATIO
• ASSETS TURNOVER RATIO
• SUPPLEMENTARY RATIO
• PERIODS OF CREDIT
• PRODUCTIVITY RATIO
1. LIQUIDITY RATIO
• LIQUIDITY-financial term to refer the ease with which assets can be converted to cash to
pay off debts, meet an expense ,etc.
• Cash in hand has the highest liquidity, followed by, say, bank deposits in saving account ,
fixed deposits ,etc.
• LIQUIDITY RATIO - It is the measure of the ability of a firm to meet its short-term
obligations and reflects its short term financial strength
• 2 TYPE
a) Current ratio
b) Acid test / quick / liquid ratio
CURRENT RATIO
• It is the measure of short-term financial liquidity and indicates the ability of the firm to
meet in short-term liabilities.
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
Current ratio = 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
• Current ratio in excess of 1:3:1 is generally considered as satisfactory for organizations
• Current ratio less than 1:1 would certainly be undesirable in any organization, , as some
safety margin is required to protect the creditor’s interest at least
ACID TEST OF LIQUIDITY OR QUICK RATIO
• It includes only the cash and bank balances, short-term marketable securities, and liabilities
• Measure of a firms ability to service short term liabilities
𝑞𝑢𝑖𝑐𝑘 𝑎𝑠𝑠𝑒𝑡𝑠
Acid ratio = 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
2. CAPITAL STRUCTURE RATIO
When a firm wishes to make a long term borrowing, it needs to commit to,
➢ Pay the interest regularly and
➢ Repay the principal when it is due (in instalments at due dates, or in a single payment
at the time of maturity)
For long term creditors, both the criteria are important and they often base their judgement on
the (long term) financial soundness on the capital structure ratios, which reflects the long term
solvency of a firm.

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1. Leverage Ratio
➢ A leverage ratio is any kind of financial ratio that indicates the level of debt incurred
by a business entity against several other accounts in its balance sheet, income
statement, or cash flow statement.
It provides an indication of how much assets are coming from loans to finance business
operations.
The source document for computing leverage is the balance sheet.
A. Debt Equity Ratio
➢ This ratio is computed to better understand the financial structure and integrity of a firm,
as it reflects the relative contribution of creditors and owners of business in financing.
➢ Depending upon the relationship between creditor’s claims and owner’s capital, there can
be several variants of the debt equity ratio as given below
➢ Debit Equity Ratio DE1
➢ Debit Equity Ratio DE2
Debit Equity Ratio DE2
𝐿𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡
Debit Equity Ratio DE1 = 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝑒𝑞𝑢𝑖𝑡𝑦
➢ long term debt excludes the current liabilities and shareholder’s equity includes both
ordinary and preference capital, besides past accumulated profits ( reserves and credit
balance of the profit and loss account).
➢ Shareholders equity so defined is also referred to as ‘net worth’ and the debt equity ratio
computed on this basis may also be called as debt to net worth ratio.
Debit Equity Ratio DE2
𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡
Debit Equity Ratio DE2 = 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝑒𝑞𝑢𝑖𝑡𝑦
In above expression
➢ Total debt is the sum of the short term and long term debts
➢ Neither a very high nor very low debt equity ratio is desirable, and each firm needs to
determine an optimum level where the debt and equity are properly balanced.
B. Debt asset ratio

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➢ This ratio relates the total debt to the total assets of the firm
𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡
Debt asset ratio = 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑠𝑡𝑠

In the above expression,

➢ Total debt comprises long term debt and current liabilities
➢ Total assets consists of all assets minus fictitious assets (ie. total debt plus shareholder’s
equity)
2. Coverage Ratio
➢ This ratio is calculated from the profit and loss account
➢ Coverage ratio measures the relation between what is ‘normally 'available from operations
of the firms and the outsider’s claims.
➢ Some of the important coverage ratios are given below:
➢ Interest Coverage Ratio
➢ Dividend Coverage Ratio
➢ A. Interest Coverage Ratio
𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥 (𝐸𝐵𝐼𝑇)
Interest coverage ratio = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
➢ This ratio measures the debt servicing capacity of a firm
➢ It shows how large EBIT is, compared to the interest charges
➢ Ratio like interest coverage ratio reveals the safety margin available to the preference
shareholders
➢ And in principle , a higher value of ratio is considered better from point of view of
shareholders
➢ B. Dividend coverage ratio
➢ This ratio is a measure of the ability of a firm to pay dividend on preference shares that
carry a stated rate of return.
3. PROFITABILITY RATIO
• The entire exercise of proper management is directed to maximize profitability without
compromising on other parameters
• It is measured of efficiency and indicates public acceptance of the product
• Profit provide funds for repaying debts incurred
1. PROFIT RATIOS
• These ratios are a measure of relation between pofit and sales of a firm
The ratios are
𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡𝑠
1. Gross profit ratio = 𝑥 100
𝑠𝑎𝑙𝑒𝑠
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡𝑠
2. Net profit ratio = x 100
𝑠𝑎𝑙𝑒𝑠
• Net profit ratio is calculated after deducting all operating and non operating expenses
2. EXPENSES RATIOS
• These ratios are based on the expenses rather than profits
• There are different variants of expenses ratios
𝑡𝑜𝑡𝑎𝑙 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑐𝑜𝑠𝑡
Operating ratio = 𝑠𝑎𝑙𝑒𝑠
x 100
𝑐𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑 𝑠𝑎𝑙𝑒𝑠
Cost of goods sold ratio = x 100
𝑠𝑎𝑙𝑒𝑠

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The cost of goods sold ratio shows the percentage share of sales consumed by cost of goods
sold
3. INVESTMENT RELATED RATIO
• This ratio measures the return on the owners funds in a firm
𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠 𝑎𝑛𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
Return on assets (ROA) = x 100
𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠 𝑎𝑛𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑠
Return on capital employed (ROCE) = 𝑛𝑒𝑡 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠
Return on stakeholder’s equity = 𝑡𝑜𝑡𝑎𝑙 𝑠𝑡𝑎𝑘𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝑒𝑞𝑢𝑖𝑡𝑦
4. ACTIVITY RATIO
• Activity ratios measure the efficiency or effectiveness with which a firm manages its
resources. These ratios are also called turnover ratios because they indicate the speed at
which assets are converted or turned over in sales.
• Some of the important activity ratios are :
• (i) Stock turnover ratio
• (ii) Debtors turnover ratio
• (iii) Asset turnover ratio
STOCK TURNOVER RATIO
• Stock turnover ratio is a ratio between cost of goods sold and the average stock or inventory.
It evaluates the efficiency with which a firm is able to manage its Inventory.
• Stock Turnover Ratio = Cost of Goods Sold/Average Stock
• Cost of goods sold = Opening stock + Purchases + Direct expenses –
Closing Stock
• Cost of goods sold = Sales – Gross Profit
• Average stock = (Opening stock + closing stock)/2
DEBTORS TURNOVER RATIO
• This ratio establishes a relationship between net credit sales and average account
receivables. The objective of computing this ratio is to determine the efficiency with which
the trade debtors are managed.
• Debtor turnover = credit sales/ Average Debtor
• Average debtor = (Opening Debtor + Closing Debtor)/2
If opening debtor are not available then closing debtor and bills receivable are taken as average
debtors
ASSET TURNOVER RATIO
• Measures how efficiently a company is using its
• Calculated by dividing net sales by average total assets.
• Total asset turnover = Cost of goods sold/ Total assets
• Fixed assets turnover = Cost of goods sold/ fixed assets
• Current asset turnover = Cost of goods sold/ Current assets
• Working capital turnover ratio = Cost of goods sold/ Working capital
• In asset turnover ratio the numerator in all the cases is same (total cost of goods sold), the
definition of the asset is depending on the difference in denominator.
• The higher the ratio, the more efficient is the management and utilization of the assets.
5. SUPPLEMENTARY RATIOS

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• Supplementary ratio measure the productivity and ratios related to periods of credit offered
by the firm.
• Some of the important supplementary ratios are,
• Period of credit
• Productivity Ratios
PERIOD OF CREDIT
𝑑𝑒𝑏𝑖𝑡𝑜𝑟𝑠
• Period of credit offered by firm = 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 x 12, if ratio is preferred in months.
𝑐𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠
• Period of credit enjoyed by firm = 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 x 12
If the ratio is preferred in days or weeks multiply by 356 and 52
• Both the ratios indicates the credit control of the firms
PRODUCTIVITY RATIO
• It is the ratio of output to a given input
• Many variants of productivity ratios are possible based on the numerator and denominators
considered
Types of productivity ratios
• Turnover to number of employees
• Turnover to subcontractors
• Turnover to plant and equipments
• Profit to number of employees
• Plant and equipment values to number of employees Turnover to plant and equipment's
• Profit to number of employees
• Plant and equipment values to number of employees
FUND FLOW STATEMENT
 Fund flow statement is one of the important management tools for decision making.
 The statement is prepared taking into account revenue statement and position statement of
the organization.
 It is a comparative analytical statement between two consecutive years.
 The statement reveals the funds inflow and outflow during an accounting period.
 In order to measure the soundness and solvency of business, preparation of fund flow is a
must.
 By preparing fund flow statement, management will be able to know how much funds are
available and where exactly they can be deployed.
 It is a statement which portrays the sources from which funds are obtained and the uses to
which they are being put.
PREPARATION OF FUND FLOW STATEMENT
 A funds flow statement is prepared on the basis of information contained in the
consecutive two years Balance Sheet and that is based on the Profit and Loss Account
for the period concerned.
 This statement consists of two parts:
– Sources of funds
– Application of funds
SIGNIFICANCE OF FUND FLOW STATEMENT
• Analytical Tool

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• Design Policies
• Control Device
• Reflect Financial Position
• Uses for Working Capital
• Help to Lenders
• Direction for Business
NEED FOR THE FUND FLOW STATEMENT
• Profit and Loss A/c shows book profits for specific period of time and Balance sheet shows
the financial position of the concern at particular point of time.
• It does not show the flow of funds (increase / decrease in funds) of concern during year.
Hence separate fund flow statement need to be prepared.
• Thus another statement has to be prepared to show the changes in assets and liabilities
from the end of one period of time to the end of another period of time.
• That statement is called a “Statement of Changes in Financial Position or a Funds Flow
Statement”.

Meaning of Funds
• In Narrow Sense: Only cash
• In Broader Sense: Money values in whatever form it may exist. Funds means all financial
resources, used in business whether in the form of men, materials, money, machinery etc
• In Popular Sense: Funds means working capital.
RULES/FLOW OF FUNDS CHART
• 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 effect of a transaction results in the increase of funds, it is called a source of funds
and it results in the decrease of funds, it is known as application of funds.
• If any transaction results in the increase in working capital, it is said to be source or
inflow of funds and if it is results in the decrease of working capital it is said to be an
application or outflow of funds.

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Current
Current
Assets
Liabilities
And
And
Long term
Fixed Assets
liability

Current
Current Liabilities
Assets
Flow of And
And Long term
Funds
Fixed Assets liabilities
(Inflow or
Outflow of
Funds)

DEFINITION OF FUNDS FLOW STATEMENT

According to Anthony “The funds flow statement describes the sources from which additional
funds were derived and the use to which these sources were put”
SOURCES OF FUNDS
• Funds from operation
• Issue of share capital
• Issue of debentures and raising of loans
• Sale of fixed assets and long term or trade investments
• Non trading receipts: dividend received, refund of tax, rent received etc
• Decrease in working capital
APPLICATION OR USES OF FUNDS
1) Funds lost in operation
2) Redemption of preference shares
3) Repayment of loans and advances
4) Purchase of fixed assets.
5) Payment of dividend and tax
6) Non trading payments
7) Increase in working capital
METHODS
1. BACK WARD METHOD- NET PROFIT APPROACH
(Net Profit + Non Operating Expenses And Losses)-non Operating Incomes
2. FUNDS FROM OPERATION- SALES APPROACH –FORWARD APPROACH( If
Net Profit Is Not Given)
Sales +
Closing stock +
Operating income +
LESS
(Opening Stock+ Net Purchases+ Direct Expenses+ Operating Expenses)
3. FUNDS FROM OPERATION-CAPITAL APPROACH (If profit /sale is not given)
Capital+Drawings - (Capital in the beginning + Additional capital introduced during the year
+ selling, distribution, operating expenses)

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LIMITATIONS OF FUND FLOW STATEMENT

 It ignores non-fund items.
 It ignores to project future operations.
 It also ignores transactions when they occur between current accounts and non-current
accounts.
 This is not ideal tool for financial analysis.
 It does not provide any additional information to the management because financial
statements are simply rearranged and presented.
WORKING CAPITAL
• Working capital is the capital available for conducting the day-to-day operations of the
business and consists of current assets and current liabilities.
Current assets Current liabilities

Inventories Trade payables

Trade receivables Bank overdrafts
Cash
Short term investments
• Working capital can either be:
✓ Positive – Current assets are greater than current liabilities
✓ Negative – Current assets are less than current liabilities
• There has been considerable growth in the construction industry in the recent past, which
has led to proliferation of small, medium and large construction companies.
• This has introduced stiff competition amongst all types of companies with different
financial structures to win contracts for lesser profit margins.
• However, it is important that a company has sufficient working capital or access to funds
to meet its short-term obligations.
• Too little may result in avoidable consequences such as cash flow problems and failure to
pay suppliers, labour, subcontractors etc, on time.
• Similarly too much of working capital would make the fund idle, thereby hitting the
profitability of the company.
WORKING CAPITAL MANAGEMENT
• Working capital management is the administration of current assets and current
liabilities.
• Effective management of working capital ensures that the organisation is maximising the
benefits from net current assets by having an optimum level to meet working capital
demands.
• Working capital management thus, seeks to arrive at a balance between liquidity and
profitability, which are inversely related and hence lead towards opposite directions.
• Further, it is at ascertaining the optimum level of cash and inventory that can be maintained
and the optimum credit that should be allowed.
• Stated simply, working capital or gross working capital refers to the current assets.
• When the term “net capital” is used, it basically refers to the difference in current asset and
current liability.

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• It is said that working capital is to business what blood is to the body.

• Moreover, working capital is costly and by suitably managing it, the profitability of
business can be improved.
• Managing the working capital means, managing the key components ie, cash, inventory
and creditors.
• The various factors that affect the working capital include:
✓ Nature of business
✓ Nature of raw materials used
✓ Process technology used in the business
✓ Nature of finished goods
✓ Degree of competition in the market
✓ Paying habits
NEED FOR WORKING CAPITAL
▪ The objective of financial decision making is to maximise the shareholders wealth.
▪ To achieve this, it is necessary to generate sufficient profits.
▪ The extent to which profits can be earned will naturally depend upon the magnitude of
sales, among other things.
▪ However sales do not convert into cash instantly, there is invariably a time lag between
the sales of goods and the receipt of cash.
▪ There is, therefore, a need for working capital in the form of current assets to deal with the
problem arising out of the lack of immediate realization of cash against goods sold.
▪ Therefore, sufficient working capital is necessary to sustain sales activities.
Important Decisions in Working Capital Management
• Working capital management has two main decisions at two consecutive stages. They are
as follows:
1. The level of Current Assets – How much to invest in Current Assets to achieve the
Targeted Revenue?
2. Means of Financing Current Assets – How should the above Current Asset Investment be
financed, i.e., the mix of long and short-term finance?
POLICY FOR WORKING CAPITAL
• The working capital policy of a company refers to the level of investment in current
assets for attaining their targeted sales.
• It can be of three types: restricted, relaxed, and moderate.
• The relaxed policy has higher and restricted has lower levels of current assets, whereas
moderate places itself between relaxed and restricted.
• Commonly, these policies are also named aggressive, conservative, and hedging policies.
Types of Working Capital Policies
• Based on the attitude of the finance manager towards risk, profitability, and liquidity, the
working capital policies can be divided into the following three types.
1. Restricted Policy
2. Relaxed Policy
3. Moderate Policy
1. Restricted Policy

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• In restricted policy, the estimation of current assets for achieving targeted revenue is done
very aggressively without considering any contingencies and provisions for any
unforeseen event.
• After deciding, these policies are forcefully implemented in the organization without
tolerating any deviations.
• In the diagram, point R represents the restricted policy that attains the same revenues level
with the lowest current assets.
• Adopting this policy would benefit the lower working capital requirement due to the lower
level of current assets.
• This saves the interest cost to the company, which produces higher profitability, i.e., higher
return on investment (ROI).
• On the other hand, there is a disadvantage in the form of high risk due to a very aggressive
policy. That is why; it is also called an aggressive working capital policy.

2. Relaxed Policy
• The relaxed policy is just the opposite of a restricted policy.
• In this policy, the estimation of current assets for achieving the targeted revenue is prepared
after carefully considering uncertain events such as seasonal fluctuations, a sudden change
in the level of activities or sales, etc.
• After the reasonable estimates, a cushion to avoid unforeseen circumstances is left to
prevent the maximum possible risk.
• The diagram represents the point Rx which uses the highest level of current assets for
achieving the same level of sales.
• Companies with relaxed working capital policies assume the advantage of almost no risk
or low risk.
• This policy guarantees the entrepreneur of the smooth functioning of the operating cycle.
We know that earnings are more important than higher earnings.
• On the other hand, there is a disadvantage of lower return on investment because higher
investment in the current assets attracts higher interest costs, reducing profitability.

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• Because of its conservative nature, this policy is also called a conservative working capital
policy.
3. Moderate Policy
• The moderate policy balances the two policies, i.e., restricted and relaxed. It assumes the
characteristics of both policies.
• To strike a balance, moderate policy assumes the risk to be lower than restricted and higher
than conservative. In the profitability front also, it lies between the two.
• The biggest benefit of this policy is that it has reasonable assurance of smooth operation of
working operating capital cycle with moderate profitability.
OPERATING CYCLE
• The operating cycle is said to be at the heart of the need for working capital.
• The continuing flow from cash to suppliers, to inventory, to accounts receivable and back
to cash is called the operating cycle.
• It is a continuous process
• In other words, the term operating cycle refers to the length of time necessary to complete
the process of movement from cash to inventory (raw materials, consumables, other
stocks), to finished goods, to receivables and to cash again.
• A typical operating cycle (working capital cycle) is as shown :

▪ A construction company is awarded a contract.

▪ The company may or may not receive mobilization in advance.
▪ However, the company gets monthly payment for the workdone during a particular month,
and thus, cash is realized.
▪ The cash so obtained is spent in procuring inventory (materials, consumables and other
stocks).
▪ The inventory is utilized in the production process of some construction activities of the
contract.
▪ The inventories may be procured either in cash or on credit.
▪ In the later case, the supplier of inventory is treated as creditors of the company.
▪ The cash is also utilized in paying labour wages and equipment supplier and in meeting
overhead expenses.
▪ Upon completing the billing cycle, the company raises the bill for different activities carried
out during billing period.

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▪ Further the receipt of the payment against the bill completes the operating cycle.
▪ The provision for taxes, bad debts and expenses towards general overheads also needs to
be considered in the cycle.
▪ A company operating profitably is generally cash-surplus.
▪ Failure to do so makes the company short of cash and eventually leads to its failure.
▪ Business activity doesnot come to an end after the realization of cash from customers.
▪ For a company the process is continuous, and hence the need for a regular supply of
working capital.
▪ The magnitude of working capital will not be constant, but will fluctuate.
▪ The changes in the level of working capital occur for three basic reasons:
▪ Changes in the level of sales / operating expenses
▪ Policy changes
▪ Changes in technology
▪ To carry on the business, a certain minimum level of working capital is necessary on a
continuous and uninterrupted basis.
▪ For practical purposes, this requirement will have to be met permanently as in the case
with other fixed assets.
▪ This requirement is referred as the permanent or fixed working capital.
▪ Any amount over and above the permanent level of working capital is temporary,
fluctuating or variable working capital.
COMPONENTS OF WORKING CAPITAL
• There are several components of working capital. These are broadly classified under current
assets and current liabilities
• Current assets include cash/bank balance, inventories, sundry debtors and loans and
advances
• These assets will usually change their forms, time and time again, during the course of a
year
• Such assets in the ordinary and natural course of business move onward through the various
processes of production, distribution, and payment of goods until they become cash or
equivalent, by which debts may be readily and immediately paid.
• Current liabilities are those liabilities that are falling due within a period of 12 months.
• The liabilities consists of sundry creditors, advances received from customers, overdraft
facilities (unsecured) and provisions
• The provisions are mainly proposed dividends, corporate taxes, miscellaneous Owing by
the company etc.
• In order to minimize the requirement of working capital, contracting organizations attempt
to avail the maximum credit facility extended by suppliers.
• However contracting organization should meet the payment commitments made to
suppliers on the due date.
• The components of working capital in the context of a construction company are given
below
Current Assets
• Stock at sites/main depot
• Outstanding's(including retention)

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• Work in Progress
• Other current assets
• Excess cost over invoicing
• Work done unbilled
• Cash and Bank Balance
Current Liabilities
• Unadjusted advance-----H
• Vendor credit-----I
• Other current liabilities-----J
• Net working capital =A+B+C+D+E+G-H-I-J
DETERMINATION OF WORKING CAPITAL
• Some companies monitor only a few important components such as stock of materials, as
well as customer outstanding from among current assets and advances provided by the
customer or owner from among current liabilities
• A budgetary norm is fixed for each of these three components and they are monitored
accordingly.
• In order to calculate the net working capital, the revised formula then becomes:
Net working capital = A+B-H
• The proportion of current asset to fixed asset depends on the manager dealing with the
working capital.
• An aggressive manager would prefer less of current assets than fixed assets
• On the other hand, a conservative manager would stress more on the current assets than
fixed assets
• An average manager would follow the intermediate path
• The proportion of current asset to fixed asset impacts the return on assets employed and is
evident
NO DESCRIPTION CONSERVATIVE AVERAGE AGGRESSIVE
APPROACH APPROACH APPROACH

1 SALES (LAKH) 150 150 150

2 EARNING BEFORE 15 15 15
INTEREST AND
TAX (LAKH)

3 FIXED ASSET 50 50 50
(LAKH)

4 CURRENT ASSET 60 50 40
(LAKH)

5 TOTAL ASSET 110 100 90

(LAKH)

6 RATIO OF CA TO 1.2:1 1.11:1 0.8:1

FA (4/3)

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7 RETURN ON 13.60% 15% 16.70%

INVESTMENT (2/5)
ESTIMATING WORKING CAPITAL NEEDS
• Three widely used methods for estimating working capital requirements of a firm are:
1. Percentage of sales Method
2. Regression Analysis Method
3. Operating Cycle Method
1. Percentage of Sales Method:
• In this method, the level of working capital requirement is decided on the basis of past
experience.
• The past relationship between sales and working capital is taken as a base for determining
the size of working capital requirements for future.
• It is, however, presumed that the relationship between sales and working capital that has
existed in the past has been stable.
• Percentage of sales method is a simple and easily understood method and practically used
for ascertaining short-term changes in working capital in future.
• However, this method lacks reliability in as much as its basic assumption of linear
relationship between sales and working capital does not hold true in all the cases. As such,
this method cannot be recommended for universal application.
2. Regression Analysis Method:
• This is a statistical method of determining working capital requirements by establishing the
average relationship between sales and working capital and its various components in the
past years.
• In this regard the method of least squares is employed and the relationship between
sales and working capital is expressed by the equation –

3. Operating Cycle Approach:

• According to this approach, the size of working capital requirements of a firm is determined
by multiplying the duration of the operating cycle by cost of operations.
• The duration of the operating cycle may be found with the help of the following
formula:

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• Duration of raw materials reflects the number of days for which raw materials remain in
inventory before they are issued for production.
FINANCING SOURCES OF WORKING CAPITAL
• Important issue in working capital management is to decide on the sources of
finances for the working capital.
• The finances may be arranged from short term sources or long term sources.
• Arranging short term finances are less costlier than long term finances.
• Here also, the proportion in which short term finances and long term finances
are arranged is dependent on the managers approach.
• The 3 common approaches adopted in working capital finance are;
✓ Matching approach
✓ Aggressive approach and
✓ Conservative approach
PERMANENT VARIABLE PART RISK LEVEL
PART OF WC OF WC PART OF WC

Matching Long Term Funds Short Term Funds MODERATE

approach

Aggressive Short Term Funds Short Term Funds HIGH

approach

Conservative Long Term Funds Long Term Funds LOW

approach
CAPITAL INVESTMENT DECISION
CAPITAL BUDGETING
• Investment decisions are very popularly known as Capital Budgeting, which means
applying the principles of budgeting for capital investment.
• In simple terms, Capital Budgeting involves: -
• Identification of investment projects that are strategic to business’ overall objectives;
• Estimating and evaluating post-tax incremental cash flows for each of the investment
proposals; and
• Selection of an investment proposal that maximizes the return to the investors.
PURPOSE OF CAPITAL BUDGTETING
• Substantial expenditure: Investment decisions are related with fulfillment of long term
objectives and existence of an organization. To invest in a project or projects, a substantial
capital investment is required. Based on size of capital and timing of cash flows, sources

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of finance are selected. Due to huge capital investments and associated costs, it is therefore
necessary for an entity to make such decisions after a thorough study and planning.
• Long time period: The capital budgeting decision has its effect over a long period of time.
These decisions not only affect the future benefits and costs of the firm but also influence
the rate and direction of growth of the firm.
• Irreversibility: Most of the investment decisions are irreversible. Once the decision
implemented it is very difficult and reasonably and economically not possible to reverse
the decision. The reason may be upfront payment of amount, contractual obligations,
technological impossibilities etc.
• Complex decisions: The capital investment decision involves an assessment of future
events, which in fact is difficult to predict. Further it is quite difficult to estimate in
quantitative terms all the benefits or the costs relating to a particular investment decision.
CAPITAL BUDGETING PROCESS
• Planning: The capital budgeting process begins with the identification of potential
investment opportunities. The opportunity then enters the planning phase when the
potential effect on the firm's fortunes is assessed and the ability of the management of the
firm to exploit the opportunity is determined. Opportunities having little merit are rejected
and promising opportunities are advanced in the form of a proposal to enter the evaluation
phase.
• Evaluation: This phase involves the determination of proposal and its investments,
inflows and outflows. Investment appraisal techniques, ranging from the simple payback
method and accounting rate of return to the more sophisticated discounted cash flow
techniques, are used to appraise the proposals. The technique selected should be the one
that enables the manager to make the best decision in the light of prevailing circumstances.
• Selection: Considering the returns and risks associated with the individual projects as well
as the cost of capital to the organisation, the organisation will choose among projects so
as to maximise shareholders’ wealth.
• Implementation: When the final selection has been made, the firm must acquire the
necessary funds, purchase the assets, and begin the implementation of the project.
• Control: The progress of the project is monitored with the aid of feedback reports. These
reports will include capital expenditure progress reports, performance reports comparing
actual performance against plans set and post completion audits.
• Review: When a project terminates, or even before, the organisation should review the
entire project to explain its success or failure. This phase may have implication for firms
planning and evaluation procedures. Further, the review may produce ideas for new
proposals to be undertaken in the future.
TYPES OF CAPITAL INVESTMENT DECISIONS

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On the basis of firm’s existence

• Replacement and Modernisation decisions: The replacement and modernisation
decisions aim at to improve operating efficiency and to reduce cost.
• Generally, all types of plant and machinery require replacement either because of the
economic life of the plant or machinery is over or because it has become technologically
outdated.
• The former decision is known as replacement decisions and latter is known as
modernisation decisions. Both replacement and modernisation decisions are called cost
reduction decisions.
• Expansion decisions: Existing successful firms may experience growth in demand of their
product line. If such firms experience shortage or delay in the delivery of their products
due to inadequate production facilities, they may consider proposal to add capacity to
existing product line.
• Diversification decisions: These decisions require evaluation of proposals to diversify into
new product lines, new markets etc. for reducing the risk of failure by dealing in different
products or by operating in several markets.
• Both expansion and diversification decisions are called revenue expansion decisions.
On the basis of decision situation
• Mutually exclusive decisions: The decisions are said to be mutually exclusive if two or
more alternative proposals are such that the acceptance of one proposal will exclude the
acceptance of the other alternative proposals.
• For instance, a firm may be considering proposal to install a semi-automatic or highly
automatic machine. If the firm installs a semi-automatic machine it excludes the acceptance
of proposal to install highly automatic machine.
• Accept-reject decisions: The accept-reject decisions occur when proposals are
independent and do not compete with each other. The firm may accept or reject a proposal
on the basis of a minimum return on the required investment. All those proposals which
give a higher return than certain desired rate of return are accepted and the rest are rejected.
• Contingent decisions: The contingent decisions are dependable proposals. The
investment in one proposal requires investment in one or more other proposals. For

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example, if a company accepts a proposal to set up a factory in remote area it may have to
invest in infrastructure also e.g. building of roads, houses for employees etc.
Steps of Capital Budgeting Procedure
• Estimation of Cash flows over the entire life for each of the projects under consideration.
• Evaluate each of the alternative using different decision criteria.
• Determining the minimum required rate of return (i.e. WACC) to be used as Discount rate.
CAPITAL BUDGETING TECHNIQUES
• In order to maximise the return to the shareholders of a company, it is important that the
best or most profitable investment projects are selected.
• Results of making a bad long-term investment decision can be devastating in both financial
and strategic terms.
• There are a number of techniques available for appraisal of investment proposals and can
be classified as below

TRADITIONAL OR NON-DISCOUNTING TECHNIQUES

• These techniques of capital Budgeting does not discount the future cash flows.
• There are two such techniques namely Payback Period and Accounting Rate of Return
1. Payback Period
• Time required to recover the initial cash-outflow is called pay-back period.
• The payback period of an investment is the length of time required for the cumulative total
net cash flows from the investment to equal the total initial cash outlays.
• At that point in time, the investor has recovered the money invested in the project.
Steps in Payback period technique: -
• The first steps in calculating the payback period is determining the total initial capital
investment (cash outflow) and
• The second step is calculating/estimating the annual expected after-tax cash flows over the
useful life of the investment.
• When the cash inflows are uniform over the useful life of the project, the number of years
in the payback period can be calculated using the following equation:

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2. Accounting (Book) Rate of Return (ARR) or Average Rate of Return (ARR)

• The accounting rate of return of an investment measures the average annual net income
of the project (incremental income) as a percentage of the investment

• The numerator is the average annual net income generated by the project over its useful
life.
• The denominator can be either the initial investment (including installation cost) or the
average investment over the useful life of the project.
• Average investment means the average amount of fund remained blocked during the
lifetime of the project under consideration.
Advantages of ARR
• This technique uses readily available data that is routinely generated for financial reports
and does not require any special procedures to generate data.
• This method may also mirror the method used to evaluate performance on the operating
results of an investment and management performance. Using the same procedure in both
decision-making and performance evaluation ensures consistency.
• Calculation of the accounting rate of return method considers all net incomes over the entire
life of the project and provides a measure of the investment’s profitability.
Limitations of ARR
• The accounting rate of return technique, like the payback period technique, ignores the time
value of money and considers the value of all cash flows to be equal.
• The technique uses accounting numbers that are dependent on the organization’s choice of
accounting procedures, and different accounting procedures, e.g., depreciation methods,
can lead to substantially different amounts for an investment’s net income and book values.
• The method uses net income rather than cash flows; while net income is a useful measure
of profitability, the net cash flow is a better measure of an investment’s performance.
• Furthermore, inclusion of only the book value of the invested asset ignores the fact that a
project can require commitments of working capital and other outlays that are not included
in the book value of the project.
DISCOUNTING TECHNIQUES
• Discounting techniques consider time value of money and discount the cash flows to their
Present Value.
• These techniques are also known as Present Value techniques.
• These are namely Net Present Value (NPV), Internal Rate of Return (IRR) and
Profitability Index (PI).
1. Net Present Value Technique (NPV)

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The net present value technique is a discounted cash flow method that considers the time value
of money in evaluating capital investments. An investment has cash flows throughout its life,
and it is assumed that an amount of cash flow in the early years of an investment is worth more
than an amount of cash flow in a later year.
The net present value method uses a specified discount rate to bring all subsequent cash inflows
after the initial investment to their present values (the time of the initial investment is year 0).
The net present value of a project is the amount, in current value of amount, the investment
earns after paying cost of capital in each period.
Net present value = Present value of net cash inflow - Total net initial investment

Where,
C=Cash flow of various years K = discount rate
N=Life of the project
I=Investment
Steps to calculating Net Present Value (NPV):
The steps to calculating net present value are: -
• Determine the net cash inflow in each year of the investment
• Select the desired rate of return or discounting rate or Weighted Average Cost of Capital.
• Find the discount factor for each year based on the desired rate of return selected.
• Determine the present values of the net cash flows by multiplying the cash flows by
respective discount factors of respective period called Present Value (PV) of Cash flows
• Total the amounts of all PVs of Cash Flows
Decision Rule:
If NPV ≥ 0 Accept the Proposal

If NPV ≤ 0 Reject the Proposal

The NPV method can be used to select between mutually exclusive projects; the one with the
higher NPV should be selected
Advantages of NPV
➢ NPV method takes into account the time value of money.
➢ The whole stream of cash flows is considered.
➢ The net present value can be seen as the addition to the wealth of shareholders. The
criterion of NPV is thus in conformity with basic financial objectives.
➢ The NPV uses the discounted cash flows i.e., expresses cash flows in terms of current
rupees. The NPVs of different projects therefore can be compared. It implies that each
project can be evaluated independent of others on its own merit.
Limitations of NPV
➢ It involves difficult calculations.
➢ The application of this method necessitates forecasting cash flows and the
discount rate. Thus accuracy of NPV depends on accurate estimation of
these two factors which may be quite difficult in practice.

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➢ The decision under NPV method is based on absolute measure. It ignores

the difference in initial outflows, size of different proposals etc. while
evaluating mutually exclusive projects.
2. Profitability Index /Desirability Factor/Present Value Index Method (PI)
➢ In certain cases we have to compare a number of proposals each involving different
amounts of cash inflows.
➢ One of the methods of comparing such proposals is to work out what is known as the
‘Desirability factor’, or ‘Profitability index’ or ‘Present Value Index Method’.

Decision Rule:
If PI ≥ 1 Accept the Proposal

If PI ≤ 1 Reject the Proposal

In case of mutually exclusive projects; project with higher PI should be selected
Advantages of PI
• The method also uses the concept of time value of money and is a better project evaluation
technique than NPV.
• In the PI method, since the present value of cash inflows is divided by the present value of
cash outflow, it is a relative measure of a project’s profitability.
Limitations of PI
• Profitability index fails as a guide in resolving capital rationing where projects are
indivisible.
• Once a single large project with high NPV is selected, possibility of accepting several small
projects which together may have higher NPV than the single project is excluded.
• Also situations may arise where a project with a lower profitability index selected may
generate cash flows in such a way that another project can be taken up one or two years
later, the total NPV in such case being more than the one with a project with highest
Profitability Index.
3. Internal Rate of Return Method (IRR)
• The internal rate of return method considers the time value of money, the initial cash
investment, and all cash flows from the investment.
• But unlike the net present value method, the internal rate of return method does not use the
desired rate of return but estimates the discount rate that makes the present value of
subsequent cash inflows equal to the initial investment.
• This discount rate is called IRR.
IRR Definition: Internal rate of return for an investment proposal is the discount rate that
equates the present value of the expected cash inflows with the initial cash outflow.
This IRR is then compared to a criterion rate of return that can be the organization’s desired
rate of return for evaluating capital investments.
Acceptance Rule

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The use of IRR, as a criterion to accept capital investment decision involves a comparison of
IRR with the required rate of return known as cut off rate. The project should the accepted if
IRR is greater than cut-off rate. If IRR is equal to cut off rate the firm is indifferent. If IRR
less than cut off rate the project is rejected. Thus,
If IRR ≥ Cut-off Rate - Accept the Proposal
If IRR ≤ Cut-off Rate - Reject the Proposal
Multiple Internal Rate of Return
• In cases where project cash flows change signs or reverse during the life of a project
e.g. an initial cash outflow is followed by cash inflows and subsequently followed by a
major cash outflow, there may be more than one IRR.
• In such situations if the cost of capital is less than the two IRR’s, a decision can be made
easily, however otherwise the IRR decision rule may turn out to be misleading as the project
should only be invested if the cost of capital is between IRR1 and IRR2.
• To understand the concept of multiple IRR it is necessary to understand the implicit re-
investment assumption in both NPV and IRR techniques.
Advantages of IRR
• This method makes use of the concept of time value of money.
• All the cash flows in the project are considered.
• IRR is easier to use as instantaneous understanding of desirability can be determined by
comparing it with the cost of capital
• IRR technique helps in achieving the objective of maximisation of shareholder’s wealth.
Limitations of IRR
• The calculation process is tedious if there are more than one cash outflows interspersed
between the cash inflows, there can be multiple IRR, the interpretation of which is difficult.
• The IRR approach creates a peculiar situation if we compare two projects with different
inflow/outflow patterns.
• It is assumed that under this method all the future cash inflows of a proposal are reinvested
at a rate equal to the IRR. It is ridiculous to imagine that the same firm has a ability to
reinvest the cash flows at a rate equal to IRR.
• If mutually exclusive projects are considered as investment options which have
considerably different cash outlays. A project with a larger fund commitment but lower
IRR contributes more in terms of absolute NPV and increases the shareholders’ wealth. In
such situation decisions based only on IRR criterion may not be correct.
4. Modified Internal Rate of Return (MIRR)
• The MIRR addresses some of these deficiencies e.g., it eliminates multiple IRR rates; it
addresses the reinvestment rate issue and produces results which are consistent with the
Net Present Value method.
• This method is also called Terminal Value method.
• Under this method, all cash flows, apart from the initial investment, are brought to the
terminal value using an appropriate discount rate (usually the Cost of Capital). This results
in a single stream of cash inflow in the terminal year.
• The discount rate which equates the present value of the terminal cash inflow to the zeroth
year outflow is called the MIRR.

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• The decision criterion of MIRR is same as IRR i.e. you accept an investment if MIRR is
larger than required rate of return and reject if it is lower than the required rate of return.
5. Discounted Payback Period Method
• Some accountants prefer to calculate payback period after discounting the cash flow by a
predetermined rate and the payback period so calculated is called, ‘Discounted payback
period’. One of the most popular economic criteria for evaluating capital projects also is
the payback period. Payback period is the time required for cumulative cash inflows to
recover the cash outflows of the project.
• This is considered superior to simple payback period method because it takes into account
time value of money.
Summary of Decision Criteria of Capital Budgeting Techniques
Techniques For Independent Project For Mutually Exclusive
Projects
Non- Pay Back (i) When Payback period ≤ Project with least
Discounted Maximum Acceptable Payback period should be
Payback period: Accepted selected
(ii) When Payback period ≥
Maximum Acceptable
Payback period: Rejected
Accounting (i) When ARR≥ Minimum Project with the
Rate of Acceptable Rate of Return: maximum ARR should be
Return(ARR) Accepted selected.
(ii) When ARR ≤ Minimum
Acceptable Rate of Return:
Rejected
Discounted Net Present (i) When NPV > 0: Accepted Project with the highest
Value (NPV) (ii) When NPV < 0: Rejected positive NPV should be
selected
Profitability (i) When PI > 1: Accepted When Net PresentValue
Index(PI) (ii) When PI<1:Rejected is same project with
Highest PI should be
selected
Internal (i) When IRR >K: Accepted Project with the
Rate of (ii) When IRR <K: Rejected maximum IRR
Return Should be selected
(IRR)
LONG TERM FINANCING WORKING OF FINANCIAL INSTITUTIONS IN INDIA
AND ABROAD
LONG TERM FINANCING WORKING OF FINANCIAL INSTITUTIONS IN INDIA
• A well-integrated structure of financial .institutions has evolved in the country comprising
11 institutions at the national-level and 46 at the state-level.
• These institutions provide a variety of financial products and services to suit the varied
needs of the corporates.

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• The national-level institutions comprise five All-India Development Banks (AIDBs), three
Specialised Financial Institutions (SFls) and 3 Investment Institutions (IIs).
• At the state-level, there are 18 State Financial Corporations (SFs) and 28 State Industrial
Development Corporations (SIDCs).
DEVELOPMENT BANKING
• The first development bank, set up in India in 1948, was the Industrial Finance Corporation
of India.
• Its objective was "to make medium and. long-term credit more readily available to
industrial concerns in India, particularly in circumstances where normal banking
accommodation was inappropriate or recourse to capital issue method was impracticable."
Development Banking differs from commercial banking in several ways.
• Commercial Banking is primarily concerned with short-term lending for financing working
capital requirements of a concern.
• Development banking, on the other hand, is concerned with lending funds for medium to
long-term for financing the investments in fixed assets of the company.
• Commercial Banking is security-oriented, while development banking is project-oriented.
• Development banks also finance large-scale projects jointly with commercial banks.
INDUSTRIAL DEVELOPMENT BANK OF INDIA (IDBI)
• IDBI was established in 1964 as a wholly owned subsidiary of the Reserve Bank of India
(RBI)
• Industrial Development Bank of India is one of the four All India Development Banks in
India.
• In addition, it is the apex banking institution in the field of long-term industrial finance and
thus, it functions as the principal financial institution for coordinating the functions and the
activities of other All India Financial Institutions.
INDUSTRIAL FINANCE CORPORATION OF INDIA (IFCI)
• Industrial Finance Corporation of India (IFCI) was the first development bank
established in India in the year 1948.
• It was established as a statutory corporation under the IFCI Act, 1948 with the objective of
making medium and long-term funds more readily available to industrial concerns in India.
• IFCI was converted into public limited company on July 1, 1993 and is now known as the
Industrial Finance Corporation of India Ltd.
• As a joint stock company IFCI is now able to enter the capital market for resources, through
debt and equity instruments.
INDUSTRIAL CREDIT AND INVESTMENT CORPORATION OF INDIA LTD.
(ICICI)
• Industrial Credit and Investment Corporation of India Ltd. (ICICI) was the first
development bank set-up as a joint stock company in India in 1955.
• The necessity to establish another institution in the private sector was felt primarily to
channelize the World Bank funds to the Indian industry and also to build up a capital market
in India.
• Initially, its entire share capital was held by commercial banks and insurance companies
and other financial institutions, but with the nationalisation of banks, major portion of its
share capital was later held by these nationalised institutions.

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• The core business activity of the ICICI has traditionally been the business of providing
project finance.
• But over the years, it has undertaken many non-projects based activities and has diversified
into new but allied activities through the establishment of its subsidiaries.
INDUSTRIAL INVESTMENT BANK OF INDIA (IIBI)
• Industrial Investment Bank of India (IIBI) was originally setup as Industrial Reconstruction
Bank of India under the Industrial Reconstruction Bank of India Act, 1084, as a principal-
credit and reconstruction agency for industrial revival by undertaking modernisation,
expansion, reorganization, diversification or rationalisation of industry.
• IIBI undertakes all the functions of a development bank.
• These functions include providing long/medium-term loan/ assistance to medium and large
industrial units, and providing under-writing support to, issuing of shares and bonds.
SMALL INDUSTRIES DEVELOPMENT BANK OF INDIA (SIDBI]
• SIDBI is the principal institution in the country for promotion, financing and development
of industries in the tiny and small-scale sectors.
• It co-ordinates the functions of other institutions engaged in similar activities.
• SIDBI undertakes both financing activities as well as promotional activities and provides
support services.
• SIDBIs financing activities are broadly classified into two categories:
A) Direct Assistance
• Project Financing
• Equipment Finance Scheme
• Technology Development and Modernisation Fund Scheme
• Bill Financing Scheme
• Equity Assistance Scheme
• Venture Capital Assistance
B) Indirect Assistance.
• Refinance of term loans granted by Banks, State Finance Corporations (SFCs) and State
Industrial Development Corporations (SIDCs)
• By rediscounting of bills of small-scale industries.
NATIONAL BANK FOR AGRICULTURE AND RURAL DEVELOPMENT
(NABARD)
• National Bank for Agriculture and Rural Development (NABARD) is the apex financial
institution, in the area of agricultural finance and rural development.
• It was set up in July 1982 by merging the Agriculture Credit Department and Rural
Planning and Credit cell of the Reserve Bank of India and the entire undertaking of
Agriculture Refinance and Development Corporation.
• NABARD undertakes the following functions:
• Credit to Farm Sector
• Developmental Activities
• Regulatory Function
INTERNATIONAL FINANCIAL INSTITUTIONS

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• At the Bretton Woods Conference in 1944 it was decided to establish a new monetary order
that would expand international trade, promote international capital flows and contribute
to monetary stability.
• The IMF and the World Bank were borne out of this Conference of the end of World War
II.
• One major source of financing is international non-profit agencies.
• There are several regional development banks such as the Asian Development Bank, the
African Development Bank and Fund and the Caribbean Development Bank.
• The primary purpose of these agencies is to finance productive development projects or to
promote economic development in a particular region.
THE WORLD BANK
• The World Bank group is a multinational financial institution established at the end of
World War II (1944) to help provide long-term capital for the reconstruction and
development of member countries.
• The group is important to multinational corporations because it provides much of the
planning and financing for economic development projects involving billions of dollars for
which private businesses can act as contractors and suppliers of goods and engineering
related services.
• The World Bank is the International Bank for Reconstruction and Development (IBRD)
and the International Development Association (IDA).
• The IBRD has two affiliates, the International Finance Corporation (IFC) and the
Multilateral Investment Guarantee Agency (MIGA).
• The Bank, the IFC and the MIGA are sometimes referred to as the “World Bank Group”.
• The purpose for the setting up of the Bank are:
• To assist in the reconstruction and development of territories of members by facilitating the
investment of capital for productive purposes, including the restoration of economies
destroyed or disrupted by war, the reconversion of productive facilities to peacetime needs
and encouragement of the development or productive facilities and resources in less
developed countries.
• To promote private foreign investment by means of guarantees or participation in loans and
other investments made by private investors; and when private capital is not available on
reasonable terms, to supplement private investment by providing, on suitable conditions,
finance for productive purposes out of its own capital, funds raised by it and its other
resources.
• To promote the long-range balanced growth of international trade and the maintenance of
equilibrium in balance of payments by encouraging international investment for the
development of the productive resources of members, thereby assisting in raising
productivity, the standard of living and condition of labour in their territories.
• To arrange the loans made or guaranteed by it in relation to international loans through
other channels so that the more useful and urgent projects, large and small alike, can be
dealt with first.
• To conduct its operations with due regard to the effect of international investment on
business conditions in the territories of members and, in the immediate post-war years, to
assist in bringing about a smooth transition from a wartime to a peacetime economy.

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1. INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

• The IBRD was set up in 1945 along with the IMF to aid in rebuilding the world economy.
• It was owned by the governments of 151 countries and its capital is subscribed by those
governments
• It provides funds to borrowers by borrowing funds in the world capital markets, from the
proceeds of loan repayments as well as retained earnings.
2. INTERNATIONAL DEVELOPMENT ASSOCIATION (IDA)
• The IDA was formed in 1960 as a part of the World Bank Group to provide financial
support to LDCs on a more liberal basis than could be offered by the IBRD.
• The IDA has 137 member countries, although all members of the IBRD are free to join the
IDA.
• IDA’s funds come from subscriptions from its developed members and from the earnings
of the IBRD.
• Credit terms usually are extended to 40 to 50 years with no interest.
• Repayment begins after a ten-year grace period and can be paid in the local currency, as
long as it is convertible.
• Loans are made only to the poorest countries in the world, those with an annual per capita
gross national product of $480 or less.
• More than 40 countries are eligible for IDA financing.
3. INTERNATIONAL FINANCE CORPORATION
• The IFC was established in 1956.
• There are 133 countries that are members of the IFC and it is legally and financially separate
from the IBRD, although IBRD provides some administrative and other services to the IFC.
• The IFC’s main responsibilities are
(i) To provide risk capital in the form of equity and long-term loans for productive private
enterprises in association with private investors and management;
(ii) To encourage the development of local capital markets by carrying out standby and
underwriting arrangements; and
(iii) To stimulate the international flow of capital by providing financial and technical
assistance to privately controlled finance companies.
4. THE MULTILATERAL INVESTMENT GUARANTEE AGENCY (MIGA)
• The MIGA was established in 1988 to encourage equity investment and other direct
investment flows to developing countries by offering investors a variety of different
services.
• It offers guarantees against non-commercial risks; advises developing member
governments on the design and implementation of policies, programmes and procedures
related to foreign investments; and sponsors a dialogue between the international business
community and host governments on investment issues.
INTERNATIONAL MONETARY FUND
• The International Monetary Fund (IMF) came into official existence on December 27,
1945, when 29 countries signed its Articles of Agreement (its Charter) agreed at a
conference held in Bretton Woods, New Hampshire, USA, from July 1-22, 1944.
• The IMF commenced financial operations on March 1, 1947.
• Its current membership is 182 countries.

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• Its Total Quotas are SDR 212 billion (almost US$300 billion), following a 45 per cent quota
increase effective from January 22, 1999.
• IMF lends money to members having trouble meeting financial obligations to other
members, but only on the condition that they undertake economic reforms to eliminate
these difficulties for their own good and that of the entire membership.
• The IMF has no effective authority over the domestic economic policies of its members.
• The IMF has authority to its member to disclose information on its monetary and fiscal
policies and to avoid, as far as possible, putting restrictions on exchange of domestic for
foreign currency and on making payments to other members
SOURCES OF SHORT TERM & LONG-TERM FINANCE
Sources of short term finance
• 2 categories: Spontaneous and negotiated.
• Spontaneous type does not require any formal arrangement on the part of the company
availing them and come up automatically in the normal course of business.
Eg - Trade credit
• Negotiated category requires formal arrangements and is largely obtained from commercial
banks.
Eg - bank finances and some other sources such as commercial papers
Trade credit:
• common in construction industry
• Fewer restrictions and is known for its simplicity and flexibility.
• Suppliers, vendors and subcontractors extend credit to Construction Company.
• This form of financing does have benefits, but at the same time, it involves certain implicit
and explicit costs.
• The cost of paying late in the form of reduced credit standing of the company is an example
of implicit cost, while the cost of foregoing discount is an example of explicit cost.
Bank finance:
• Banks are one of the important sources of finance.
• Bank finances could be of different types: overdraft facility, cash credit, purchase or
discounting of bills, letter of credit, working capital loan etc.
• Credits extended by banks could be either unsecured or against some collateral.
• The collaterals could be in the form of hypothecation, pledge, mortgage or lien.
• The interest rate depends on whether interest is paid upfront or at maturity.
Other sources:
• Other sources for short term funds include commercial papers, forfaiting, factoring and
inter-corporate deposits.
• Commercial paper (CP): The concept of CP originated in USA on the pattern of short
term notes. Blue chip companies in need of short term funds could issue CP. In India, it
came into existence in 1987. The maturity of CP lies between 15days and less than one
year.
• Factoring: It is a process whereby a firm sells its receivables for cash to another firm
known as the factor, which specializes in their collection and administration. In a broader
sense, factoring is a type of bill discounting.

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• The factor buys the client’s receivables and controls the credits and collects the same at
maturity. In factoring, the seller of the goods informs the factor about an order received by
the seller. The factor, in turn, evaluates the customer’s credit worthiness and approves the
deal. The approval means that the factor has purchased the accounts receivables and now
it is his responsibility to provide coverage for any bad dept. loss. Factor offers this service
for a certain commission.
• Forfaiting: This is an extension of factoring in the area of international trade. In forfaiting,
an exporter discounts the bill with an agency known as forfeiter. Once the export deal is
finalized, the exporter intimates the forfeiter. The forfeiter then scrutinizes the deal. Once
the forfeiter is satisfied, it quotes the discount rate and if it is agreeable to the exporter, the
deal is signed.
Sources of long term finance
• Period - 5 to 10 years
• Usually arranged to start a new business or to expand the existing business. interest rate are
usually high in the view of the large risks involved
• Sources are
• Retained earnings
• Clearing bank loan facility
• Shares
• Merchant bank
• Industrial and commercial finance corporation
• Debentures
• Government grants
• Retained earnings: they are those portions of earnings (usually between 30% and 80% of
earning after tax) of a company which are ploughed back into the business. These are also
sometimes referred to as internal equity. It is an important source of long term finance.
• Debentures: They are made to the company at fixed interest rates repayable at a set time.
A company’s reputation plays an important role in raising this type of loan. They can be
secured by mortgage on the firm’s property as well. In case of liquidation or bankruptcy of
the firm, those holding debentures can exercise their almost ahead of all creditors.
• Shares: Equity shares are issued to the promoters of a company at the formation stage of
the company. Subsequently, the company issues share privately to the promoter’s relatives,
friends, business partners, employees etc. once the company grows, it raises capital from
the public in the form of issue of equity shares.
• Rights issue: Existing shareholders are offered new shares in exchange for their present
shares, at some discount. The left out shares are put up for sale.
• Merchant bank: they also provide loan at some fixed interest charges, which are
negotiable. They usually attract higher interest charges. The loan is flexible in the sense
that capital and interest repayment can be arranged to suit the company’s future cash flow
position.
• Loans: long term loans are difficult to raise by construction companies, especially for new
entrants in the business. This is because of the high risk involved in such loans for long
terms.

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• Financial instruments: Bonds, floating rate notes, bills of exchange and promissory notes
are also increasingly used for raising long term finance for a company.
• Venture capital: These funds are an important source of finance for new companies.
However, venture capital investors are specific to a business and they are very small in
number.
Purpose of long term finance:
Long term finance is required for the following purposes:
1. To Finance fixed assets:
• Business requires fixed assets like machines, Building, furniture etc.
• Finance required to buy these assets is for a long period, because such assets can be used
for a long period and are not for resale.
2. To finance the permanent part of working capital:
• Business is a continuing activity. It must have a certain amount of working capital which
would be needed again and again. This part of working capital is of a fixed or permanent
nature. This requirement is also met from long term funds.
3. To finance growth and expansion of business:
Expansion of business requires investment of a huge amount of capital permanently or for a
long period.
Factors determining long-term financial requirements:
• The amount required to meet the long term capital needs of a company depend upon many
factors. These are :
(a)Nature of Business:
• The nature and character of a business determines the amount of fixed capital. A
manufacturing company requires land, building, machines etc. So it has to invest a large
amount of capital for a long period. But a trading concern dealing in, say, washing machines
will require a smaller amount of long term fund because it does not have to buy building or
machines.
(b)Nature of goods produced:
• If a business is engaged in manufacturing small and simple articles it will require a smaller
amount of fixed capital as compared to one manufacturing heavy machines or heavy
consumer items like cars, refrigerators etc. which will require more fixed capital.
(c)Technology used:
• In heavy industries like steel the fixed capital investment is larger than in the case of a
business producing plastic jars using simple technology or producing goods using labour
intensive technique.
SELF FINANCING
• Self-financing is the procedure in which the company or an individual spends his own
money for the completion of ongoing projects in case of unavailability of funding sources.
• Self-financing is one of the main sources of funding for a company, together with capital
and credits. Self-financing occurs if the activity is profitable and if a decision is made not
to distribute the profits.
• In accounting terms, self-financing corresponds to the net profit after tax, not distributed,
which is found in the liabilities on the balance sheet in terms of reserves and results
recorded.

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• Self-financing is a particularly strategic source of financing for a company, as it allows said

company to:
✓ Increase its equity and thus its value
✓ Possibly increase its capital by integrating accumulated amounts
✓ Improve most of its financial ratios
✓ Provide the resources that it may freely allocate
✓ Finance its growth, its investments or repay debts, without having recourse to external
funds
✓ Reduce its dependence on financial backers
✓ Provide a source of its own funds to obtain credit
✓ Promote the profitability of the business model
✓ Improve its credibility in the eyes of third parties and partners
Sources of funding
There are many sources which can provide funding to the concerned agencies and organizations
for the purpose of accomplishment and completion of their projects. In order to start any new
big level project, it is important to confirm the funding sources because if any project is left in
the middle just because of the lack of funds, it all goes wasted. Therefore it is advised to all the
project runners and agencies to have enough of the self-financing sources which could help
them a lot in case of the blockage or non-availability of the funding and finances.
Official funding sources
Usually there are many official sources which provide funding to the agencies on contract basis
and in this regard they also make certain pacts from the agencies regarding the funding. Usually
the financing is in the form of assistance in case of official development. This assistance is
provided from the donor governments and in this way they get their budget allocations
according to their demands. It is better to make the budget appropriations in case if there is any
need to switch towards the self-financing procedure in case the financing is not available or not
sufficient. In these cases it is very important to consider the proper estimate of the self-
financing patterns so that there may not be any problem afterwards.
Non-budgetary sources
Sometimes the projects and agencies also receive funds from the non-budgetary sources for the
projects. Sometimes the capital is provided by the donor on semi commercial terms. This
sometimes becomes for the acceptors to get these loans and funds. Still there are some examples
when these finances and funds are provided on the joint basis and parallel. In al the cases self-
financing is the procedure which has its own worth and one should go for keeping an option
all the time if in case the foreign funding is not reaching at all or in time.
There are many cases when the self-financing is merged with the co-financing. Usually the
self-finance funds are kept separate and this can be of extra significance for the project
managers.
FINANCIAL MECHANISM
• A financial mechanism refers to the way in which a business, organization, or
program receives the funding necessary for it to remain operational.
• Private companies, for example, typically receive such funding through a variety of means,
including revenue generated from the sale of services and products as well as from loans
or the sale of stock.

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• Other organizations typically receive funding through various means, such as donations
provided by individuals and companies as well as fund-raising events.
• The financial mechanism for government typically comes from taxes or other means of
acquiring resources from the populace, which is then used as funding for various agencies
and programs.
• Revenue is one of the most common forms of financial mechanism for a business.
✓ This is typically generated through the sale of various products or services that the company
manufacturers or otherwise provides for customers.
✓ Large companies, especially corporations, may use the creation and sale of stocks as a form
of financial mechanism, to allow for a greater influx of resources based on the perceived
value of the company.
✓ Businesses can also take out loans from banks and other institutions that ultimately have to
be paid back, but which provide that company with initial capital for development.
✓ Organizations, such as charities and other non-profit groups, can use different mechanisms
to generate the resources necessary for ongoing operations.
✓ Donations from businesses and private individuals are quite common.
✓ An additional financial mechanism can come in the form of fund-raising through events
and campaigns, and some groups may receive funding from governmental bodies.
• The government of a country often relies on the populace of that country as a financial
mechanism.
✓ Funds are typically raised through taxes levied upon the citizens of a country, though loans
from private organizations and other countries may also be necessary.
✓ These resources are then used to fund individual agencies, departments, and programs
within the government, allowing the government itself to become a mechanism for those
subsections.

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