FINANCIAL MANAGEMENT STUDY MATERIAL ,VI SEM BBA

SOUNDARYA INSTITUTE OF MANGEMENT AND SCIENCE

DEPARTMENT OF BUSINESS ADMINISTRATION

FINANCIAL MANGEMENT STUDY MATERIAL

IV SEMESTER BBA

Contents

Chapter 1 – Introduction to financial management

Chapter 2 – Capital structure and leverages
Chapter 3 – Capital budgeting

Chapter 4 – Dividend policy

Chapter 5 – Working capital management

Chapter 1 – Introduction to financial management

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 FINANCIAL MANAGEMENT STUDY MATERIAL ,VI SEM BBA

Finance is mainly concerned with 1) The provision of money at the time it is

required 2) Management of flow of money through an organization 3)
Application of skills in the manipulation use and control of money.
Without finance, no activity can be carried out finance is known as the life blood of
a business and the success of a business depends on the flow of finance.
At may also be defined as the administrative area as set of administrative functions
in an organization, which relates with the arrangement of cash and credit find so that
the organization may have the means to carry out its objective as satisfactorily as
possible.
Finance as the life blood of a business:

1. Life :- without finance, there is no life for an undertaking just like blood gives
life to an individual, finance gives life to an organization. This is the same case
for both trading and non trading concerns charitable concerns.
2. Flow:- If there is finance, but no flow of finance through the organization by
way of different elements, then the organization is dead just like in the case of
human’s, when there must be a circulation of blood.
3. Donation:- Finance should be capable of being donated from one organization
which of has a suspires to another organization which feels a difficult. The
blood of humans is also capable of being donated.
4. Quality:- The health of a person depends in the quality or pureness of blood
flowing
through him, IIIly, the health of a organization depends on the quality of finance
which in turn depends on.
1) The cost of finance: - The cost of capital must be minimum.
2) The source of finance: - The cost of source finance adopted must be feasible to
the organization.
3) Quantity: - If there is surprises deficient blood in the human body. It May give
rise to many deficiencies and diseases. III ly in an organization if the co is under
capitalized or over capitalized; the c.o is likely to face many problems.

Financial Management: - Is that part of management activity which is concerned

with the planning and controlling of firms financial resources. It involves financial
planning acquisition of funds, use and allocation of funds and financial controls.

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Financial Engineering: - Refers to the design, development and implementation of

new, innovation financial instruments and their formulation of creative optimal
solutions to problems in finance.

Users/Importance of Financial Management

1. Financial Planning and successful promotion of an enterprise: - The

changes of future growth and expansion are all considered and thereby the
requirements of finance is made.
2. Requisition of funds at the min possible cost: - The various sources of
funds are appraised and evaluated and the best one which is the most
economical to the organization is selected.
3. Proper allocation of funds: - There is an optimum allocation of the funds
raised it the funds raised are, allocated or distributed in such a manner that
they give the max returns to the organization.
4. Taking sound financial decisions: - In the complete worked of today, good,
proper, stable and sound financial decision are very necessary and financial
management helps in this.
5. Improving Profitability through financial controls: - Proper and
efficient financial controls are established through financial management in
order to ensure that the company reaps profits in the future.
6. Increasing the wealth of the investors: - Proper financial management
ensures that the investors of the concern get a reasonable return on their
investments and this in turn increases the wealth of the nation.

Finance Function: Refers to the raising of cap funds and bringing them for
generating return and paying returns to the supplier of the fund. [Guttmann & this is
the most important of all sun gal] functions since the starts with the setting up of an
enterprise and remains there at all times the inflows & outflows must properly
matched

Finance function

The classification of finance function can be studied in 2 different way’s

1) As traditional & modern finance functions.

2) As managerial & routine finance functions.

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1) Traditional approach: - Under this, the scope of the finance function was
confined only to the procurement of funds needed by the business and utilization of
funds was considered beyond the preview of the function. But financial institutions
form a part of the functions.
Limitations

1) Utilization of funds was not considered.

2) Only long term sources were considered, working cap not considered.
3) Day to day financial problems is not analyzed.

2) Modern approach: It included both the raising as well as proper utilization of

funds. The cost of raising funds and their returns are also compared here and modern
financial engineering techniques are used for this financial problems are considered.
Managerial functions: These are functions which involve executive, professional
skills and is mainly concerned with vital decision making. This can be done only by
the top level management. This is further divided into.
1) Investment function (Asset min) this consists of mainly project appraisal and
selections. Project evaluation is made here through IRN, NPX, payback etc once the
best project is selected, and turns the cap fund requirements workings
(the relation b/w fix & current assets)capital requirements. The asset
requirements etc are decided here. The credit policy is also decided here
2) Financing function (cap mix): In this stage, the total fund requirements are
decided, the various sources of raising funds are evaluated and the best method is
selected this firms the basis for determining the end structure of the firm.
(relationship b/w the develop equity in the total capitalization).
Here the cost of capital of each element of capital is considered and the weighted
and cost of capital is found out. This is in turn concepts with the return in investment
and then the capital structure is determined. The row should be equal to or more than
the avg. weighted cost of the capital.
2. Appropriation [payout ratio] Under this, the payout ratio is determined i.e.

pay out ratio Dividend per share: - This ratio determines earning per share.

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What should be the dividend paid and what should be the retained earning etc. The
effect of such decisions on the cost of capital and the market price is also analyzed.
If we pay more dividend, the market price of shares will be increased. IIIly,
expansion programmes may induce the co to keep more amount as retained
earnings, provided the cost of outside borrowing is more and this reduces the cost
of capital.
Routine functions: - These functions do not require any special skill since they do
not involve much of vital decision making these are usually performed by the
clerical staff. This includes.
1) Managing cash: - The inflow, outflow etc cash should be managed and the surplus
deficit etc should be determined. For this cash budgets are prepared. The surplus cash
is usually invested in marketable securities. The deficits are meet from cheaper
sources of funds.
They usually prepare

a. Cash book (shows actual receipts & payments)

b. Cash budget (expected receipts & payments)

2) Safe custody of valuables & securities: The accountant has to keep safe the
valuables & securities and he is responsible or accountable for it.
3) Record keeping: The office manager has to maintain proper records giving the
entire details of all the transactions.
4) Reporting: The clerical staff will have to give the timely reports to the top level
management.

5) The details from the various sources from which the finance is raised must also
be specially mentioned.
Financial management: also refers to the acquisition of funds and its effective
utilization .

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Scope/Functions of finance manager/Mgmt/Elements of financial management

1. Estimating the financial requirements: - This is done after the selection of the
project through various evaluation techniques such as NPX,INX etc. The
requirements vary from project to project. Once the project is selected, both
long terms and short term financial requirements are determined long term
financial requirements determine what amount of money should be invested in
fixed assets such as land, building etc. The short term financial requirement
deal with the min bal of cash, stock etc that should be matained. The short term
liabilities are deducted from this to get the working capital requirements, which
in turn are added to the long term requirement funds.
Short term liabilities include supplier’s credit institutional credit etc.

2) Determining the capital structure: - Once the financial requirements are decided,
the various sources of raising finance are analyzed and the capital structure is decided.
This is decided on the basis of ex. The relationship b/w debt & equity is decided.
1) Comparing the cost of capital of each element of fund and the Rol.
The Rol should always be more than the Rol.
2) The availability of the source of fund: - The fund must be quickly
and readily available without any difficult and lengthy formalities.
3) The purpose of the fund: - The purpose of the fund also determines
the source of fund ie. If fixed assets need to be financed, then irredeemable
sources are preferred [which need not be paid during the life time of the
company].
3) Selecting the sources of finance: - After preparing a capital structure an
appropriate source of finance is selected. Various sources of finance may be raised
such as share cap, debentures, public deposits etc. If finances are needed for short
periods, then banks and public
deposits may be appropriate on the other hand if long term finances required then sh
cap & debentures are [Link] effect of each item on the control of the co, the
market price of The shares etc are considered -> this is for ownership securities
[Link] eq. shares my change the present control ratio. The debt fund can be raised
by comparing the cost of each item of Debt capital to its risk business. Negoliations
are conducted with various parties and thereby the terms & conditions are fixed.
4) Selecting a pattern of investment: -Here what all fixed and current assets and the
w.c are

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decided. Also the various elements of fixed and current assets are decided. Risk
return profitability is taken into consideration while selecting the pattern of invest me
at this forms a part of project implementation. The funds will have to spent just on
fixed assets and then an appropriate portion will be retained for working capital.
5) Proper cash management: - Cash may be required to (1) purchase raw materials
make (2) payments to creditors (3) meet wage bills (4) meet day to day expenses.
The usual sources of cash may be (1) cash sales(2) collection of debits (3) short
term arrangements with banks etc.
There must be a proper management b/w the inflow and outflow of cash for this
cash budgets, cash flow statements etc are prepared. Cash flow statements shows
the inflow & outflow of cash and the reasons for a difference in th op. and etc. Bal
of cash. Cash management is needed for keeping safe liquidity positions, Minimize
cost also to prevent the misappropriation of cash, fund etc., this is done through
preparation of cash budgets, cash books, comparing the balances of cash book with
the actual physical cash.
6) Working capital management: - Working capital is one of the factors that is
essential for the smooth functioning of a business. Here the various levels of
individual current assets must be fixed taking into consideration the lead time of the
assets ie. Time required for the replenishment of current assets. The availability of the
short term and long term of sources of financing is decided here.
7) Financial Control: - Proper control must be established in finance to ensure that
the exp do not exceed the revenue and the following tools helps in this
1. Budgetary control
2. Break even analysis
3. Ratio analysis
4. Standard costing
5. Other financial tools
6. Ratio analysis
These tools ensure better financial performance and keeps in taking
corrective measures also

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8) Proper use of surplus: - This can take place only through proper profit
planning and controlling or through proper appropriate decisions. These
decisions depend on: -
1) Need for internal financing: - Ploughing back of profits will be done
only if there are expansion programmes and the cost of external
borrowing is high.
2) Trend of earnings: - If the earnings show an increasing trend the chances
of profits are likely to be high and there is no need to keep Aside any
amt in the form of dividend equalization fund etc.
3) Effect of layout ratio on the value of the firm sometimes the market
Price of shares depend to a large extent on the payout ratio. ie., on the
EPS. In this case more dividend is paid than keeping aside a retained
profits.
9) Dividend policy: - The policy regarding declaration of dividend should also be
take by the finance manager. There are many method of declaring dividend such
as: -
a. Regular dividend: - If such a policy is followed, then in
all yes. A Dividend is declared.
b. Uniform dividend: - Under this policy, the same rate of
dividend, is Declared for all the years irrespective of the
earnings.
Irregular dividend: - Here dividend is declared on the basis of the
Earnings earned and hence its irregular and also the rate of dividend may
vary from year to year

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Objectives/Concepts of Financial Management

The three main objectives of financial management

1. To maximize the profitability of the firm.

2. To maximize wealth of shareholders.
3. To maintain liquidity of the firm.
These objectives are based on 2 different concepts namely.

1. Profit maximization
2. Wealth maximization
Some experts favour the Ist concept and some the second but the basic
Objective is to maximize economic welfare of the owners. According to the 1 st group
of experts, economic welfare can be increased only by increasing the profitability
whereas the others believe it can be increased only by increasing the wealth.
Concept of profit maximization.

Profit is maximized by increasing the sales turnover and minimizing the cost of
manufacturing, administration and financing. According to this concept business is
an economic activity and the basic objective is the generation or creation of profit
and so the objective of the business must be profit maximization and since financial
management forms a part of business its objective must also be profit generation or
maximization.
The efficiency of the management of the business depends on the profitability or
return ie., profitability is the basic measure to check the efficiency of the
management means increased profit generation
Basic arguments in favour of profit maximization

1. Aim of business: The basic aim of a business is to earn profit and not the
maximization of wealth and hence the aim of fm should also be profit
maximization. This can be done in many ways:-
a. reducing the cost of finance by carrying out the finance by means ofploughing
back of profits but this reduces the wealth of the share holders since if its declared
as dividend, they can invest it in outside securities and there earn a higher return
on investment.
b. The additional fund or cap required may be saved using additional eq cap
since they are cheaper compared to pref. shares or debentures. This also
reduces the cost of financing.

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 FINANCIAL MANAGEMENT STUDY MATERIAL ,VI SEM BBA

2. Rationality:- Says that management ie. Efficient only if the profit are
maximized and not if wealth is maximized. Taking decisions based on specific
reasons. A rational investor will invest in the business only if it has the
maximum profitability. Wealth is an internal of matter and its not fully disclosed
and so profit forms a major criteria to the investors for taking investment
decisions so rationality calls for profit mass.
2. Survival: - A prudent management always focuses on profit maximization when
situations are for this may be done by ploughing back the profits. This profit will
be made use of during bad times or periods of depression. Then , the business
firms can survive. Hence for the business to survive, profit maximization is very
important.
3. Growth& development: - For the growth and development of a concern, retained
earnings is essential and retained earnings can be generated or increased only by
profit maximization.
4. Social objectives of the business: - For social, economic welfare, profit
maximization is required because of a reasons social economic welfare is takes
place in the form of
1) Increased employment
2) Increased remuneration
3) Increased standard of living
Wealth maximization is not reflected at all in the economy.

Criticisms against profit maximization

1. Lack of clarity: - According to the concept of profit maximization, max of

economic welfare can take place only through profit maximization but there are
no specific directions as to this correct meaning of profit. Does it mean short term
profits or long term profits does it mean total profits or earnings per share. Should
we take profits before or after tax etc?

2. Ignores time value of money: - This concept ignores the time value of money is
the concept is purely based on the comparison b/w cash inflows and outflow and
the net inflows are tried to be maximized without any references to the change in
money value. It does not consider the magnitude and timing of earnings. It treats
all earnings as equal even though they occur in different periods. “A rupee earned
today is better than a rupee earned tomorrow is ignored here”.

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3. Conflicting interest of parties: - The owners of the business are interested in

maximizing their wealth while the management is interested in maximizing the
profit while the creditors are concerned with their safety only. Therefore when the
profit maximization is taken as the sale objective, the interest of various parties are
conflicted. Hence this concept is considered inadequate.

4. Ignores risk factors: - Risk and profit are positively related. More risk may
result in more return and hence to get more return, the finance manager may
take huge risks and this may affect the future or survival of the concern. The
risks of the prospective earnings stream are ignored.

5. Exploitation: - The concept of profit maximization supports exploitation supports

since profit is possible only if some classes of the society such as customers (in the
form of cheap goods), employers (low wages), govt (non payment of taxes) are
exploited.

6. Corrupt practices: - The concept of profit maximization may care for illegal
activities or corrupt practices. Also profit maximization cannot be the
legitimate objective of firms in present situations and thereby profit
maximization would mean embracing illegitimate practices.
7. Ignoring human values: - This involves increasing profit by the nonpayment of
due payments to the various factors of production. It leads to closed inequalities
and lowers human values which are an essential part of an ideal social system.

8. Profit maximization is possible only in a situation where perfect competition

prevails.

Concept of wealth maximization

As per this concept, the economic welfare of the owners can be maximized only by
maximizing the wealth of the owners. The wealth can be both current wealth and
long term wealth. Wealth maximization is the single substitute for a stock holders
utility

Wealth maximization aims at selecting the best project whereas profit

Maximization aims at maximizing cash inflows. Also discounting of cash inflows
takes place here unlike in profit maximization.

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Arguments in favor of wealth maximization

1. Considers the time value of money: - The long run wealth is obtained by Adding
up the NPv of different projects under consideration due consideration is given to
the changes in money value ie. Future cash inflows are discounted to get the
NPv. [NPv means the rate at which the wealth of the investors increase ie. It
refers to the increase in the initial investment]. This is based on the concept of
cash inflows generated by the decision rather than accounting profit. This avoids
ambiguity.

2. Considers both quality and quantity dimensions of benefits: The quality of

benefits has a reference to the certainty with which benefits are expected to be
received in future. The more certain the cash inflow, the better the quality of
benefits and higher the value.

3. Consider risk factors: Unlike profit maximization where only return is considered
and not the element of risk. He take into consideration the risk factor also. This is
because the basis of taking decisions here is the NPv.

4. Optimization of source resources: The scare resources are effectively allocated

because here we take into consideration the appreciation is wealth and this is
possible only if an optimum utilization of productive resourcesare made. The
resources may be financial resources, material resources etc.

5. Beneficial to owners: The wealth is reflected either in the form of Po or NPv and
this is very essential for determining the economic welfare of the owners. Profit
maximization may favour the investors only if there is a 100% payout [Link] is
important because it will determine how much the owner will get on selling his
investments and NPv is important because it’s the factor which determines the
rate of appreciation

Arguments against favor of wealth maximization

1. Difficult to calculate because

a. The project may not continue.

b. Future inflows may be different.
c. The discount rate is not correct.

2. Not socially desirable: - The concept is not socially desirable because the
objective of a business under this is to max wealth and the social

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responsibilities of the business is completely ignored. Some benefits are not

emphasized here.

3. Controversy as to wealth maximization: - There is a conflict regarding the

concept of wealth is whether the wealth of the owners or investors have to
be maximized. The ownership fund, sometimes may be high. In this case,
even if the wealth of the owners are maximized, the risk of the creditors
may not be reduced.

4. Conflicting interests: - The owners are interested in maximizing their wealth

the management is interested in profit maximization and the creditors are
interested in their safety. Hence there is a conflict b/w the interests of various
parties.

5. Projects of social needs are ignored: - Projects of social needs are ignored
since NPv is the sale criteria for selection. Projects which are required
socially may have a low NPv and hence these projects may not be preferred
and projects with high NPv may not be very beneficial to the society

Meaning of Financial Plan

• A plan that estimates the amount of funds required and decides the proportion of
debt-equity.

Objectives of Financial Plan

• Ensure availability of sufficient funds

• Balances risk and costs
• Simplicity
• Flexibility
• Liquidity
• Optimum use
• Economy
Characteristics of Sound Financial Plan
• Simplicity
• Foresight
• Flexibility
• Liquidity

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• Economy
• Contingencies
• Optimum risk

Process of Financial planning

• Projection of financial statements
• Determinants of funds needed
• Forecast the availability of funds
• Establish and maintain system of controls
• Establish performance based management compensation system
•
Long-term Financial Plan

• Long-term Financial Plans: Layout a firm’s financial action, and anticipated

impact of those actions over a long-term plan
•
Short-term Financial Plan

• Short-term Financial Plans: Specify short-term (1 to 2 years) financial

actions and the anticipated impact on those action
•
Factors Affecting Financial Plan
• Nature of Industry
• Company Status
• Alternative Sources of Finance
• Management’s attitude towards Control
• Magnitude of external capital requirements
• Capital structure
• Flexibility
• Government policy

•
Limitations of Financial Plan
• Difficulty in accurate forecasting
• Absence of Co-ordination
• Rigidity
• Rapid Technological changes and customer preferences

Chapter 2 – Capital structure and leverages

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Meaning of Capital Structure

Capital Structure: Include only long-term debt and total stockholder

investment Capital Structure = Long-term Debt + Preferred
Stock + Net worth (or) Capital Structure = Total Assets –
Current Liabilities

Optimum Capital structure

The level of debt equity proportion where market value of share is maximum, and cost
of capital is minimum

Features:
• Profitability
• Solvency
• Flexibility
• Conservatism
• Control

Determinants of Capital structure

• Financial leverege or trading on equity

• Flexibility
• Control
• Growth and stability of sales
• Cost of capital
• Debt servicing ability
• Nature and size of firm
• Requirement of investors
• Cost of floatation
• Asset structure
• Corporate tax rate
• Period of finance
• Purpose of finance
• Legal requirements

Patterns of Capital Structure

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• Complete equity share capital;

• Different proportions of equity and preference share capital;
• Different proportions of equity and debenture (debt) capital
• Different proportions of equity, preference and debenture (debt) capital.

Leverage

Leverage:
The action of a lever and mathematical advantage gained by it. It refers to the use of a
fixed element and gaining the benefits from it. It can either be a fixed cost or a fixed
charge bearing security. Use of fixed cost will result in operating leverage and use of
fixed charge bearing securities will result in financial leverage.

Types of Leverages:

Operating leverage
Financial leverage
Combined leverage

Operating Leverage = Contribution / EBIT

Degree of operating leverage = Change in EBIT/ Change

in sales Financial Leverage = EBIT / EBT

Degree of financial leverage = change in EPS / change in EBIT

Combined Leverage = Contribution / EBT

Degree of combined leverage = Change in EPS / Change in sales

Chapter 3 – Capital budgeting

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DEFINITION:

According to Charles T. Horngreen has defined Capital Budgeting as, “Capital

budgeting is long term planning for making and financing proposed capital outlays”.
According to Lynch. “Capital budgeting consists in planning development of
available capital for the purpose of maximizing the long term profitability of the
concern’’.
FEATURES OF CAPITAL BUDGETING:

The important features of Capital budgeting are:-

1. Capital budgeting involves huge funds.

2. Capital budgeting decisions involve the exchange of current

funds for the benefits to be achieved in future.

3. The future benefits are expected to be realized over a series of years.

4. The funds are invested in non-flexible and long term activities.

5. They have long term and significant effect on the profitability of the concern.

6. It also involves irreversible decisions.

7. They are ‘strategic’ investment decisions, involving large sums of money,

change in the past practices of the firm, significant change of the firm’s
expected earnings and which involves high degree of risks.

NEED AND IMPORTANCE OF CAPITAL BUDGETING:

Capital budgeting means planning for capital assets. Capital budgeting decisions are
vital to any organization as they include the decisions as to:
• Whether or not funds should be invested in long term project such as setting
of an industry, purchase of plant and machinery etc.
• Analyse the proposal for expansion or creating additional capacities.
• To decide the replacement of permanent assets such as building and
equipment.

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• To make financial analysis of various proposals regarding capital

investments so as to
choose the best out of many alternative proposals.
The importance of capital budgeting can well be understood from the fact that an
unsound investment decision may negatively affect the way the existing of the
company. The following points highlights the significance of the capital budgeting;
• Large investment:- Capital budgeting involves large investment of funds but
the Availability of finance is always limited. Hence it is important to plan and
control Capital expenditure.
• Long – term Commitment of funds:- Investment in capital assets involves
large investment of funds which are for long- term and more or less
permanent in nature. This increases the financial risk of the business hence
capital budgeting requires Proper planning.

• Irreversible decision:- The capital expenditure decisions are of irreversible

nature. Once the decision for acquiring a permanent asset is taken, it
becomes very difficult To dispose of these assts without incurring heavy
losses

• Long – term effect on profitability:- Capital budgeting involves investment

in capital assets which are the sources of income. Hence not only the present
profitability but also future survival and growth depend upon efficient
capital budgeting and unwise decision in this regard may be disastrous.

• Difficulties of Investment Decisions:- The long term investment decisions

are difficult to be taken because it involves future period, uncertainty and
high degree of risk.

• National Importance:- Investment decision though taken by individual

concern is of national importance because it determines employment,
economic activities and economic growth.

CAPITAL BUDGETING PROCESS:

Capital budgeting is a complex process as it involves decisions relating to the

investment of current funds for the benefit to be achieved in future and the future is
always uncertain. However, the following procedure may be adopted in the process of
capital budgeting;

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• Identification of Investment Proposals : The capital budgeting process begins

with the identification of investment proposals. The proposals or th idea about
potential investment opportunities are identified by the top management of the
organization. The

departmental analyses the various proposals in the light of the company’s

objectives and strategies in the processes of the long -term investment
decisions.
• Screening the proposals ; The finance committee screens all the proposals from
various angles to ensure that they are within the limits set by the company, its
policies, strategies, and finance.
• Evaluation proposals: Here the profitability of various proposals is evaluated.
Many Techniques are available to evaluate investment proposals. Eg. Pay
backperiod . Average rate of return. Net present value ,Internal rate of return
etc.

• Fixing Priorities: After evaluating the proposals, they are ranked in the order of
priority after considering, urgency, risk and profitability involved therein. The
unprofitable or uneconomic proposals may be rejected.

• Final approval and implementations of proposals : Proposals meeting the

evaluation and other criteria are finally approved to be included in the capital
Expenditure Budget. A request for authorities to spend the amount should
further be made to the capital Expenditure committee which may review the
profitability of the project in the change circumstances.

• Performance Review: The last stage in the process of capital budgeting is the
evaluation of the performance of the project. The evaluation made through post
completion audit by way of comparison of actual expenditure on the project
with budgeted one, and also by comparing the actual return from the
investment with the anticipated return,

KINDS OF ALL CAPITAL BUDGETING DECISIONS.

Capital budgeting decisions may be classified as :

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• Accept reject decisions.

• Mutually Exclusive Project Decisions
• Capital Rationing Decision

1. Accept Reject Decisions: Accept Reject Decisions relate to independent

projects which do not compete with one another. Such decisions are generally taken
on the basis of minimum return on investment. All those proposals which yield a rate
of return higher than the minimum required rate of return or the cost of capital are
accepted and the rest are rejected . If the proposal is accepted the firm makes
investment in it, and if it is rejected the firm does not invest in the same.

2. Mutually Exclusive project Decision :Such decisions related to proposals which

compete with one another in such way that acceptance of one automatically excludes
the acceptance of the other. Thus, one of the proposals is selected at the cost of the
other. For example, a company may have the option of buying a new Machine, or a
second hand machine, or taking an old machine on hire or selecting a machine out of
more than one brands available in the market. In such a case, the company may select
one best alternative out of the various options by adopting some suitable technique or
method of capital budgeting. Once one alternative is selected the others are
automatically rejected.

3. Capital Rationing Decisions: A firm may have several profitable investment

proposals but only limited funds invest. In such a case, these various
investment proposals compete for limited funds and, thus, the firm has to ration
them. The firm selects the combination of proposals that will yield the greatest
profitability by ranking them in descending order of their profitability.
METHODS OF CAPITAL BUDGETING

There are many methods of evaluating profitability of capital investment

proposals. The various methods which are commonly used are :
TRADITIONAL METHOD :

Paybackperiod :Payback period is also known as Pay out period or Pay off period.
This method represents the period in which the total investment in fixed assets is
recovered
Advantages :

• It is simple to understand and easy calculate.

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• A project with a shorter pay-back period is preferred to the one having a longer
pay back period, hence, it reduces the loss through obsolescence.
• It is suitable to those firms which have short term planning and liquidity is a
problem

Disadvantages:

• It does not take in to account the cash inflows earned after the payback period
and hence the true profitability of the project cannot be assessed.
• This method ignores the time value of money and does not consider the
magnitude and timing of cash inflows. It treats all cash flows as equal though
they occur in different periods
• It does not consider the cost of capital which is a very important factor in
making sound investment decisions.
• Payback period method does not measure the true profitability of the project as
the period considered under this method is limited to a short period only and
not the full life of the asset.

Average Rate of Return:

ARR is a method of project appraisal where the relative profitability is considered as
base. If there are more than two projects, then, that project which has maximum ARR
is chosen.
Advantages:
• It is simple to understand and easy to operate.
• It uses the entire earnings of a project in calculating rate of return and also
gives a better view of profitability as compared to pay back period.
• As this method is based upon accounting concept of profits, it can be readily
calculated from the financial data.
• This method through the concept of net earnings ensure a compensation as
expected profitability of the profit.

Disadvantages:
• This method also ignores the time value of money as the profits earned at
different points of time are given equal weight by averaging the profits.
• It does not consider the cash inflows which are more important than the
accounting profits.
• This method cannot be applied to a situation where investment in aproject is to
be made in parts.

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• Accounting information is not suitable for investment decision

• Ignorance on yearly raise of return of the project
• Ignores reinvestment concept
• Does not consider the length of life of the projects

TIME – ADJUSTED OR DISCOUNTED CASH FLOW MEHTODS:

Net Present Value Method: This method takes into consideration the time value of
money and attempts to calculate the return on investments by introducing the factor of
time element. In simple words, net present value is the difference between the present
value of cash inflow and present value of cash outflow. If the present value of cash
inflow is higher than the present value of cash outflow, the project is accepted. When
there are two more projects which gives maximum NPV is chosen.
Advantages:

• It recognizes the time value of money

• It takes into account the earnings over the entire life of the project and the true
profitability of the investment proposal can be evaluated,
• It fulfils the principle of profit maximization.
• Consider cash inflow of the entire project
• Consistent with the objective of maximising the welfare of owner
• One of the most acceptable & adoptable method of capital budgeting
evaluation.

Disadvantages:

• It is not dependable when two projects have to be compared which have

unequal lives.
• It is also not dependable when projects have different investments.
• It is difficult to determine an appropriate discount rate.
• It does not consider the magnitude of the initial outlay & cash benefits together.

Internal Rate of Return method: This method is also a modern technique of capital
budgeting that takes into account the time value of money. It is also known as “time
adjusted rate of return “, “yield method” and “trial and error yield method”. Under this
method, the cash flows of a project are discounted at a suitable rate by hit and trial
method, which equates the net present value so calculated to the amount of the

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investment. In this method, since the discount rate is deternmined internally, this
method is called as the internal rate of return method.

Advantages:
• Internal rate of return method takes into account the time of money.
• It considers the profitability of the project for its entire economic life and hence
enable evaluation of true profitability.

• The determination of cost of capital is not a pre-requisite for the use of this
method and hence it is better than net present value method.
• It provides uniform ranking of various proposals due to the percentage rate of
return.
• This method is also compatible with the objective of maximum profitability.
Disadvantages:
• It is difficult understand and is the most difficult method of evaluation of
investment proposals.
• This method is based on the assumption that the earnings are reinvested at the
internal rate of return for the remaining life of the project.
• The results of NPV method and IRR method may differ when the projects
under evaluation differ in their size, life and timings of cash flows.

Profitability Index method or Benefit cost Ratio: Profitability index also called as
Benefit – Cost Ratio (B/C) or “Desirability factor” is the relationship between present
value of cash inflows and the present value of cash outflows.
P.I. = P.V. of cash
inflows

Initial Cash Outlay

The Profitability index may be found from net present values of inflow

P.I. = Net present value

Initial Cash Outlay

The proposal is accepted is accepted if the profitability index is more than one and is
rejected in case the profitability index is less than one.

COMPARISON BETWEEN NPV AND IRR (NPV Vs. IRR)

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The net present value method and the Internal Rate of Method are similar as both as
are modern techniques of capital budgeting and both take into account the time value
of money. In fact both the methods are discounted cash flow techniques. However,
there are certain basic differences between these two methods f capital budgeting:

• In the NPV method, the present value is determined by discounting the future
cash flows of a project at a predetermined or specified rate called the cut off
rate based on cost of capital. But under the internal rate or return method, the
cash flows are discounted at a suitable rate by hit and trial method which
equates the present value so calculated to the amount of the investment.

• The NPV method recognizes the importance of market are rate of interest or
cost of capital. It arrives at the amount to be invested in a given project so that
its anticipated earnings would recover the amount invested in the projects at
market rate. Contrary to this, the maximum ate of interest at which funds
invested in any project could be repaid with the earnings generated by the
project.

• The basic assumption of NPV method is that intermediate cash inflows are
reinvested at the cut off rate, whereas, in the case of IRR method, intermediate
cash flows are presumed to be reinvested at the internal rate of return.

• The results shown by NPV & IRR are sometimes similar and sometimes
contradictory under certain circumstances. However, NPV method is more
reliable due to predetermined cut-off rate than IRR method for ranking two or
more capital in to consideration investment proposals.

LIMITATIONS OF CAPITAL BUDGETING

• All the techniques of capital being assume that various investment proposals
are mutually exclusive.
• The techniques of capital budgeting require estimation of future cash inflows
and outflows. The future is always uncertain and the data collected for the
future may not be exact and so are the results arrived from that too.

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• There are certain factors like morale of the Employees, good will of the firm,
etc, which cannot be correctly quantified but which substantially influence the
capital decision.
• Urgency is another limitation to the techniques in the evaluation of capital
investment decision.
• Uncertainty and risk pose the biggest limitation to the techniques of capital
budgeting.

FACTORS INFLUENCING CAPITAL EXPENDITURE DECISIONS

There are many factors , financial as well as non-financial, which influence the capital
expenditure decisions. The crucial factor that influences the capital expenditure
decisions is the profitability of the proposal. Yet, there are many other factors which
have to be taken into consideration while taking a capital expenditure decision. They
are:
• Urgency: Sometimes and investment is to be made due to an urgency for the
survival of the firm or to heavy losses. In such circumstances, the proper evaluation of
the proposal cannot be made through profitability tests. The examples of such an
urgency are: breakdown of some plant and machinery, fire, accident etc.
• Degree of Certainty: Profitability is directly related to risk, higher the profits,
greater is the risk or uncertainly. Sometimes, a project with some lower profitability
may be selected due to constant flow of income as compared to another project with
an irregular and uncertain flow of income as compared to another project with an
irregular and uncertain flow of income.
• Intangible factors: Sometimes a capital expenditure has to be made due to certain
emotional and intangible factors such as safety and welfare of workers, prestigious
project, social welfare, goodwill of the firm, etc.
• Legal factors: An investment which is required by the provisions of law is solely
influenced by this factor and although the project may not be profitable yet the
investment has to be made.
• Availability of funds: As the capital expenditure requires large funds, the
availability of funds is an important factor that influences the capital budgeting
decisions. A project, howsoever profitable, may not be taken for want of funds and a
project and a project with a lesser profitability may be sometimes preferred due to
lesser pay – back period for want of liquidity.
• Future earnings: A project may not be profitable as compared to another project
for today, but it may promise better future earnings.

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• Obsolescence: There are certain projects, which have greater risk of obsolescence
than others. In case of projects with high rate of Obsolescence, the project with a
lesser pay-back period may be preferred than one that may have higher profitability
but still longer pay-back period.
• Research and Development project: It is necessary for the long term survival of
the business to invest in Research and Development projects though it may not look to
be profitable investment.
• Cost consideration: Cost of the capital project, cost of production, opportunity
cost of capital, etc. are other considerations involved in the capital budgeting
decisions.

Chapter 4 – Dividend policy

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Dividend is “that part of profit distributed among share holders which includes normal
rate of interest plus a return for the risk assumed”.
A firms dividend policy affects both the long term financing and the wealth of the
shareholders.

Forms of Dividend:

• Cash Dividend: Most companies pay the dividends in cash sometimes cash
dividend may be supplemented by a stock dividend A company should have
enough cash in its bank account when cash dividends are declared. The cash
account and the reserves account of a company will be reduced when cash
dividend is paid.

• Stock Dividend: A Stock dividend represents a distribution of shares in lieu of or

in addition to the cash dividend to the existing share holders in proportion to the no
of shares held by them. This has the effect of increasing the number of outstanding
shares of the company.

Advantages of stock dividend:

• Tax Benefit to the share holders: One of the advantages to the shareholders in the
receipt of stock dividends is the beneficial treatment of such dividends with regard
to income taxes since cash dividend is liable to be taxed.
• Indication of higher future profits: the payment of stock dividend is normally
intercepted by shareholders as an indication of higher profitability since stocks
dividends are usually declared only when they expect a rise in earnings.
• Future dividends may increase of a company has been following a policy of paying
a fixed amount of dividend per share, the total dividend of the share holder is
likely to increase since the no of shares increase.
• Psychological Value: The declaration of stock dividend has a favourable
psychological effect on the share holders. The receipt of stock dividend gives them
a chance to sell their shares to make capital gains.
• Conservation of cash to the co: the declaration of stock dividend allows the
company to preserve or conserve cash that may be needed to finance the profitable
investment opportunities within the company dividend can be declared as well as
the earnings can be maintained.
• Only means to pay dividend under financial difficulty and contractual restrictions .
In some situations even if the company’s intention is not to retain earnings, the
stock dividend is the only way to declare dividend and satisfy the share holders.

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• More attractive share price: sometimes the co declares stock dividend to reduce the
market price of the share and to make it more attractive to the investors.
• Stock split is a method to increase the no of o/s shares through a proportional
reduction in the par value of the share. In stock dividend, earnings and reserves a/c
decreases but par value remains the same and vice versa.

Limitations of stock dividend:

• Reduction in eps: if a co with normal or low eps declared stock dividend the eps
will further reduce and this ______ the market price of the shares.
• Costly extra admn. Exp. Has to be increased unlike cash dividend where there are
no separate or extra formalities.
• Legal Problems: there are a lot of legal problems and formalities like the
permission from court, comptroller of capital issues etc have to be obtained.
• Reduce MPS: due to the reduction in EPS of the company, the MPS of the shares
of the company also gradually, decreases and this is not very advantages to the co.
• Scrip Dividend: means disbursement of dividend in the form of serip or
promissory notes. The dividend is declared but the payment of the dividend is on a
future date and such payments are in the promissory notes on the actual payment
of dividend is postponed here the control of cash outflow is done here.
Thus this method is a method which postpones the actual payment to a date
mentioned on the promissory note.
OCCASSIONS IN WHICH SCRIP DIVIDEND IS DECLARED:

• There are sufficient earnings but cash position is weak – in such cases, the
dividends can be declared but payment can be made only on a future date.
• When the company follows a regular dividend policy without immediate
realisation or payment of the dividend in cash.
• When the company is unable to go for stock dividend since it has a low or normal
eps for the payment of dividend.

Bond Dividend:Here the company issues its own bonds to the share holders carrying a
specified rate of interest equal to the dividend due to them. This is almost similar to
the scrip dividend except that here the postponement of the dividend is for a long
period of time and hence for this long period, they offer interest the maturity of the
scrip is lower than the maturity of the bond.
This is also declared when the co has sufficient earnings but a weak liquidity position.

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Property Dividend: Here the co pays the dividend in the form of assets or properties
and not in
the form of cash or credit instruments. The assets or properties include:-
• Goods manufactured
• Goods in excess
• Goods which are low useless to the co.

Dividend Policy:

Refers to the guidelines for the declaration and management of dividend and retained
earnings of the company.
“it refers to the attitude of the management concerning how much of the profit should
be distributed as dividend, and when and how it shall be distributed”. The mgmt
should decide all these within the framework specified.
DETERMINANTS OF DIVIDEND POLICY:

• Payout ratio: determines the percentage of profits to be distributed as dividend

and what % to be kept as retained earnings. Payout ratio can be kept at high
normal or low basis. In high payout ratio, major portion is declared as dividend
and only a less amount is kept as reserves and vice versa if a low payout ratio is
maintained. if our payout ratio is normal earnings are equally distributed as
dividend and reserve of the shareholders prefer instant earnings, then a high payout
is fixed and if the share holders prefer a maximisation wealth, a lower payout ratio
is fixed.

• Stability of dividend:- Dividend policy of a company may be:

• Constant fixed DPS in this policy the same amount of declared for all the years
and changes in earnings do not affect the amount of dividends.
• Constant dividend payout ratio: here the portion of earnings declared as
dividend will be the same. Dividend per share varies in direct proportion with
the EPS.

•
• Constant dividend per share and extra dividend: the company declares constant
dividend per year every year plus extra dividend for earnings beyond a certain
prefixed limit.

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• No Immediate Dividend: here the actual payment of dividend of any year can
be postponed to a future date by the issue of scrip or bond dividend.
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o
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• Irregular dividend: this case, the company is not having a regular dividend
policy and dividend may vary from year to year.

• Legal, Contractual and internal constraints :

a. legal constraints:- companies Act, the central govt. and state Govt may
impose some restrictions on the co regarding the declaration of dividend in
India, companies are not allowed to declare dividends.
b. Contractual constraints: There is contractual constraints because of the
agreement with parties that have provided funds to the organisation other than
the shareholders, of not declaring dividend till the re-imbursement of full loan
amount etc.
c. Internal Constraints: it is the problem of internal financing like raising fund for
expansion funds for new projects, funds for replacement etc., for all the above
needs the co should go in for more retained earnings by reducing the pay out
ratio.

• Owner’s consideration: nature of owners. Their financial position and needs are a
major determinant of dividend policy of shareholders belong to a high tax bracket
going and they prefer wealth maximisation, lesser dividend is declared and a major
part of profit is kept as retained earnings of the shareholders prefer regular income
on their investment, a higher dividend needs to be declared.

• Status of Cap Market: of the market is in a boom period, we need to declared a

higher dividend but on the other hand, if the market faces a depression, we should
declare less dividend and keep a large part of the income as retained earnings.

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• Business Cycle of the economy is in a boom period. We need declared lesser

dividend because of the demand for more funds. At time of economic depressions we
can declare high dividend as more retained earnings may lead to over capitalisation.
• Trends in earnings: Dividend policy is affected by the trends in earnings from
year to year of the earnings are likely to change, the company cannot go in for a stable
dividend policy.

• Nature of industry: of others companies in the industry follows a stable dividend

policy, we also need to follow the same in order to retain our image and in order to
compete with them.

• Age of Business: of our company is a newly established one, we can declare only
less dividend and keep more retained earnings. They cannot adopt a stable
dividend policy. If our company is an old one, high dividend can be declared and a
stable policy if our company is an old one, high dividend can be declared and a
stable policy can be adopted.

• Govt., Tax and economic policy: here we compare the individual tax rate with
the corporate tax rate. If the individual tax rate is less than corporate tax rate, we
keep less earnings and declare high dividend but if individual tax rate is higher
than corporate tax, we declare only a lesser dividend.

• Liquidity position: if we face a temporary liquidity position, we declare serip or

bond or stock dividend, but if there is no liquidity problem, cash dividend can be
declared with constant pay out ratio.

• Control: if the share holders have to retain their control on company, less dividend
is declared and a higher amount is declared as retained earinings. Again they wont
go for fresh issue of shares.

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Chapter 5 – Working capital management

WORKING CAPITAL

INTRODUCTION

Working Capital Management is concerned with the problems that arise in attempting
to manage the Current Assets, the Current Liabilities and the inter-relationship that
exists between them. The term Current Assets refers to those Assets which in the
ordinary course of business can be, or will be, converted into Cash within one year
without undergoing a diminution in value and without disrupting the operations of the
firm. The Major Current Assets are Cash, Marketable Securities, Accounts
Receivables and Inventory.
Current Liabilities are those Liabilities, which are intended at their inception, to be
paid in the ordinary course of business, within a year out of the current assets or the
earnings of the concern
.The basic Current Liabilities are Accounts Payable, Bills Payable, Bank Overdraft
and outstanding [Link] goal of Working Capital Management is to manage the
firm's Assets and Liabilities in such a way that a satisfactory level of working capital
is maintained. This is so because if the firm cannot maintain a satisfactory level of
working capital, it is likely to become insolvent and may even be forced into
bankruptcy.

WORKING CAPITAL=CURRENT ASSETS – CURRENT

LIABILITIES Concept of working capital

Working capital may be regarded as lifeblood of a business. Its effective provision can
do much to ensure the success of a business, while its inefficient management can
lead not only to loss of profits but also to the ultimate downfall of a promising
concern. The cost increased by organization due to wrong planning of working capital
is immeasurable. A study of working capital is of major importance to internal and
external analysis because of its close relationship with the current day-to-day
operations of a business.
Definition

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“Working capital is the difference between the inflow and outflow of funds. In other
words, it is the net cash flow. It is defined as the excess of current assets over current
liabilities and provision”.
SCOPE OF WORKING CAPITAL

The field of working capital comprising of capital management, inventory

management, receivable, cash and work in progress system. Analysis of financial
performance with reference to working capital with the help of tables, ratios and
graphs and suggestions for improving working capital procedures and capacity
utilization system of the firm.

NEED FOR WORKING CAPITAL

The need for working capital or current assets cannot be over emphasized. Given
the objectives of financial decision making to maximize the shareholder’s wealth, it is
necessary to generate sufficient profits. The extent to which profits can be earned will
naturally depend, among other things, upon the magnitude of the sales. A successful
sales programmer is in other words, necessary for earning profits by any business
enterprise. However, sales do not convert into cash instantly; there is invariably a time
lag between the sale 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 activity.

Different types of working capital

• Gross working capital: Gross working capital is the amount of funds invested
in the various components of current assts.
• Net working capital: The net working capital is the difference between current
assets and current liabilities. The concept of net working capital enables a firm
to determine how much amount is left for operational requirements.
• Negative working capital: Negative working capital emerges when current
liabilities exceed current assets. Such situation is not absolutely theoretical, and
occurs when a firm is nearing a crisis of some magnitude.
• Permanent working capital: Permanent working capital is that amount of
capital which must be in cash or current assets for continuing the activities of

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business. It also shows the minimum amount of all current assets that is required at all
times to ensure a minimum level of uninterrupted business operations.
• Variable working capital: Sometime, it may possible that we have to pay
fixed liabilities, at that time we need working capital which is more than
permanent working capital, then this excess amount will be temporary working
capital. In normal working of business, we don’t need such capital.
FACTORS AFFECTING THE WORKING CAPITAL
• Nature of business: The working capital requirements of an enterprise basically
depend upon the nature of its business. A trading concern, for instance, requires
large amount of working capital for investment in stocks, receivables and cash etc.
It requires less investment in fixed assets. A business where the proportion of cost
of raw material to be consumed to total cost of production is high, the amount of
working capital required is large, shipbuilding for instance.
• Size of the business: The amount of working capital needed depends upon the
scale of operation of the business. The larger the size of the business unit,
generally the larger is the requirement of working capital and vice versa.
• Production cycle:The term production cycle refers to the time involved in the
manufacture of goods. It covers the time span between the procurement of the raw
materials and the completion of the manufacturing process leading to the
production of goods. The longer the time span of production cycle, the larger will
be the funds tied up and therefore the larger the working capital needed and vice
versa.

• Seasonality of Operation: Firms which have marked seasonality in their

operations usually have highly fluctuating working capital requirement. For example,
consider firm manufacturing air conditioners. The sale of air conditioners reaches the
peak during summer months and drops sharply during winter season. The working
capital need of such a firm is likely to increase considerably in summer months and
decrease significantly during winter period. On the other hand , a firm manufacturing
consumer goods like soaps , oil , tooth pastes etc. which have fairly even sale round
the year , tends to have a stable working capital need.

• Business cycle: Business cycles affect the requirement of working capital. At

times, when the prices are going up and boom conditions prevail, the tendency is to
pile up a large stock of materials and to maintain a large stock of finished goods with
an expectation to earn more profits. The other type of business cycle, i.e. depression

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involves in locking up of a big amount in working capital as the inventories remain

unsold and book debts uncollected.
• Production policy: A firm marked by pronounced seasonal fluctuation in its sale
may pursue a production policy which may reduce the sharp variations in working
capital requirements. For example a manufacturer of air conditioners may maintain
steady production throughout the year rather than intensify the production activity
during the peak business season. Such decision may dampen the fluctuations in
working capital requirements.

• Credit policy:The level of the working capital is also determined by the credit
policy, as the firm’s credit policy determines the amount of receivables. If the firm
has a liberal credit policy, then the firm needs high working capital and the firm
needs low working capital if the company’s credit policy does not allow it to
extend credit to the buyers.

• Growth and expansion of business: Growing concerns require more working

capital than those which are static. It is logical to expect larger amount of working
capital in a growing concern to meet its growing needs of funds for its expansion
and/or diversification programmers though it varies with economic conditions and
corporate practices.
• Profit Appropriation: Some firms enjoy dominant position in the market due to
quality product or good marketing. On the other hand, a firm facing extremely
tough competition may earn low margins of profits. A high net profit margin
contributes towards working capital provided it is earned in cash. The working
capital requirement will be estimated on how the cash available is used rightfully.
The contribution towards working capital is affected by the way in which profits
are appropriated and therefore it is affected by taxation, depreciation, reserve
policy, etc.
• Dividend policy: There is a well-established relationship between dividend and
working capital in companies where conservative dividend policy is followed. The
changes in working capital position bring about an adjustment in the dividend
policy.
• Price level changes: The financial manager should also anticipate the effect of
price level changes on working capital requirements of the firm. Generally, rising
price levels will require higher amount of working capital since to maintain the

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 FINANCIAL MANAGEMENT STUDY MATERIAL ,VI SEM BBA

same level of current assets, higher investment will be required. The effects of
rising price levels will be different for different firms depending upon their price
policies, nature of the product, ability to pass on the increase to the customer, etc
• Operation efficiency: The operating efficiency of the management is also
important determinants of the level of working capital. A firm enjoying operating
efficiency can eliminate wastage and use its resources efficiently and thereby
reduce its working capital needs considerably.
• Operating cycle: operating cycle refers to the length of time necessary to
complete the following cycle of events:
• Conversion of cash into inventory.

• Conversion of inventory into receivables.

• Conversion of receivables into cash.

If the operating cycle is lengthy then the working capital requirement will be
more and vice versa.
• Market Conditions: When competition is keen, larger inventory of finished goods
is required to promptly serve the customers who may not be inclined to wait
because other manufacturers are ready to meet their needs. Further generous credit
terms may have to be offered to attract customers in highly competitive market.
Thus, working capital needs tend to be high because of greater investment in
finished goods inventory and accounts receivable. If the market is strong and
competition is weak, a firm can manage with smaller inventory of finished goods
because customers can be served with delay.
• Conditions of Supply: The inventory of raw material, spares and stores depends
on the conditions of supply. If supply is prompt and adequate, the firm can manage
with small inventories. However if the supply is unpredictable and scant then the
firm , to ensure continuity of production , would have to acquire stocks as and
when they are available and carry large inventories on an average . A similar
policy may have to be followed when the raw material is available only seasonally
and production operations are carried out round the year.
Advantage of adequate working capital

Adequate Working capital is very essential to maintain the smooth running of the
business. No business can run successfully without an adequate amount of working
capital.

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• Solvency of the business: Adequate working capital helps in maintaining the

solvency of the business by providing uninterrupted of production.
• Goodwill: Sufficient amount of working capital enables a firm to make prompt
payments and maintain the goodwill.
• Easy loan: Adequate working capital leads to high solvency and credit
standing can arrange loans from banks and other on easy and favorable terms.
• Cash discount: Adequate working capital also enables a concern to avail cash
discounts on the purchases and hence reduces cost.
• Regular supply of material: Sufficient working capital ensures regular supply
of raw material and continuous production.
• Regular payment of salaries and other day to day commitments:

It leads to the satisfaction of the employees and raises the morale of its
employees, increases their efficiency, reduces wastage and costs and enhances
production and profits.
• Exploitation of favorable market condition: If a firm is having adequate
working capital then it can exploit the favorable market conditions such as
purchasing its requirements in bulk when the prices are lower and holdings its
inventories for higher prices.
• Ability to face crises: A concern can face the situation during the depression.

• Quick and regular return on investments: Sufficient working capital enables

a concern to pay quick and regular of dividends to its investors and gains
confidence of the investors and can raise more funds in future.
• High morale: Adequate working capital brings an environment of securities,
confidence, high morale which results in overall efficiency in a business.
Disadvantage of inadequate working capital

Inadequate amount of working capital may create a lot of financial problems in

business. Sometimes, inadequate working capital may be the major causes for closing
down the business organization. Due to shortage of working capital, raw materials
cannot be purchased on time and payment of labor and other expenses cannot be
made on time. The disadvantages suffered by a firm with insufficient working capital
are as follows:

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1. The firm is unable to take advantages of new opportunities or adapt to change.

2. Trade discounts are lost. A firm with sufficient working capital is able to
finance larger stocks and can therefore place large orders.
3. Cash discounts are lost.
4. Some firms will try to persuade their debtors to pay early.
5. The advantages of being able to offer a credit line to customers are forgone.
6. Financial reputation is lost due to non-payment of trade creditors on time.

Disadvantage of excessive working capital

1. Excessive working capital means ideal funds which earn no profit for the firm and
business cannot earn the required rate of return on its investments.
2. Redundant working capital leads to unnecessary purchasing and accumulation of
inventories. Thus chances of inventory mishandling, waste, theft and losses increase.
3. Excessive working capital implies excessive debtors and defective credit policy
which causes higher incidence of bad debts.
4. It may reduce the overall efficiency of the business.
5. If a firm is having excessive working capital then the relations with banks and other
financial institution may not be maintained.
6. Due to lower rate of return on investments, the values of shares may also fall.
7. The redundant working capital gives rise to speculative transactions.

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 FINANCIAL MANAGEMENT STUDY MATERIAL ,VI SEM BBA

WORKING CAPITAL MANAGEMENT

Introduction

Decisions relating to working capital and short term financing are referred to as working
capital management. These involve managing the relationship between a firm's short-
term assets and its short-term liabilities. The goal of working capital management is to
ensure that the firm is able to continue its operations and that it has sufficient cash flow
to satisfy both maturing short-term debt and upcoming operational expenses.
Definition

The process of managing activities and processes related to working capital. This level
of management serves as a check and balances system to ensure that the amount of cash
flowing into the business is enough to sustain the company's operations. This is an
ongoing process that must be evaluated using the current level of assets and liabilities.
Working capital management may involve implementing short-term decisions that may
or may not carry over from one earnings period to the next.
Objective of working capital management

Working capital management involves the relationship between a firm's short-term

assets and its short-term liabilities. The goal of working capital management is to ensure
that a firm is able to continue its operations and that it has sufficient ability to satisfy
both maturing short-term debt and upcoming operational expenses. The management of
working capital involves managing inventories, accounts receivable and payable, and
cash.
Principles of working capital management

• Principle of risk variation: Risk here refers to the inability of a firm to maintain
sufficient current assets to pay for its obligation. If working capital is varied
relative to sales, the amount of risk that a firm assumes is also varied, and the
opportunity for gain or loss is increased. As a firm assumes more risk, the
opportunity for gain or loss increases. As the level of working capital relative to
sales decreases, the degree of risk increases.
• Principle of cost of capital: This principle emphasizes the different sources of
finance, for each source has a different cost of capital. It should be remembered
that the cost of capital moves inversely with risk. Thus, additional risk capital
results in the decline in the cost of capital.

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• Principal of Equity Position: according to this principle, the amount of

working capital invested in component should be adequately justified by a
firm’s equity position. Every rupee invested in the working capital should
contribute to the new worth of the firm.
• Principle of Maturity of Payment: A company should make every effort to
relate maturities of payment to its flow of internally generated fund. There
should be the least disparity between the maturities of a firm
Sources of working capital

• Loans from financial institutions: The option is normally ruled out because
financial institutions do not provide finance for working capital requirements.
Further, this facility is not available to all companies, for small companies, this
option is not practical.
• Floating on debentures: The probability of a successful floatation of
debentures seems to be rather meager. In the Indian capital market, floating of
debenture has still to gain popularity. Debenture issue of companies in private
sector not associated with certain reputed and well-known groups generally fail
to attract investors to invest their funds in companies.
• Accepting public deposits: The next alternative is public deposits. The issue of
tapping public deposits ids directly related to the image of the company seeking
to invite public deposits. But the problem of low profitability in many industries
is very common.
• Issue of shares: With a view to financing additional working capital needs,
issue of additional shares could be one way to raise the equity base. Indian
company find themselves in a bad shape in this context too. Low profit margin
as well as lack of knowledge about the company makes the success of a capital
issue very dim.
• Raising funds by internal financing: Raising equity by operational profits
poses problems for many companies, because prices of their end products are
controlled and do not permit companies to earn profits sufficient to pay
reasonable dividend and retain profits to cover margin money requirements to
finance additional working assets.

COMPONENTS OF WORKING CAPITAL MANAGEMENT

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1 INVENTORY MANAGEMENT

2 CASH MANAGEMENT

3 RECEIVABLES MANAGEMENT

INVENTORY MANAGEMENT

Meaning: Inventory management is one of the components of working capital

management. It refers to stock, raw material, components, spares or working progress
maintained in an organization to have continuous production and sales. More than 60%
of the working capital will be normally being invested in the inventory. Hence,
management of inventory has gained considerable recognition in the subject of financial
management.
Objects of inventory management

• To provide continuous supply of raw materials to carry out uninterrupted

production.

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

• To exploit the opportunities available and to reduce the cost of purchase.

• To introduce scientific inventory management technique.

• To provide right material at right time, from right sources and at right prices.

• To meet the demand for goods of ultimate consumers on time.

• To avoid excess and inadequate storing of material.

Tools of inventory management

• Fixation of levels: It is a tool through which the inventories are maintained by

fixing different levels namely; Maximum level, Re-order level, Minimum level
and Danger level. Fixation levels are made by considering different factors viz.,
nature of raw material, cost, availability, lead time, storage space and cost etc.

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• Maximum level: It is a level set for materials beyond which it should not be
stored. Materials stored beyond maximum level create several financial and
managerial problems to the firm.
Maximum stock level = Re-order level + Re-ordering quality – (Minimum
consumption x Minimum Re-order Period)
• Re-order level: Re-order is that level fixed for the materials to indicate the
urgency of procuring them from the market. Once the material reaches this level,
stores controller places his request to purchase the materials. So that he can
maintain storage items to maximum level.

Re-order level = Maximum consumption x Maximum Re-order period

• Minimum level: it is level at which stores controller takes immediate action in

procuring of materials. Any negligence on the part of the in-charge of stores may
lead to stoppage of production.
Minimum stock level = Re-order level – (Normal consumption x Normal Re-
order period)
• Danger level: it is the level beyond which storage of material should not fall. It
also indicates the necessity to arrange for quick purchase of materials.
Danger level = Average consumption x Maximum Re-order period for
emergency purchases
• ABC analysis: under this method, classifications are being made by grading the
materials as AB and C. Grade A materials are costly high in value but less in
number and are supervised and controller closely. Grade C materials are cheap in
value but more in quality and least attention are given. Grade B materials are
moderate in value and moderate number of such items are maintained with
moderate control.
• Economic order quantity: is that quantity of materials to be ordered where it
will have minimum order placing and carrying cost. Carrying cost refers to the
cost of capital, cost of storage, insurance cost and cost of spoilage.
• Perpetual inventory system: it is also referred as continuous stock checking.
Under this system, different registers are maintained for materials, entries are
made as and when the materials are received and issued. The physical verification

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of materials is conducted throughout the year. Hence it is identified as a costly

technique of inventory control.
• VED analysis: it is the most suitable method for automobile industries specially
to maintain spare parts. All the parts are classified into
• Vital: for manufacturing of a product will be closely monitored.

• Essential: materials that are essential, but its level of stocks is moderately
low.

• Desirable: components may or may not be maintained.

• FSN analysis: under this method, materials are grouped according to the
movements.

• Fast moving items: are stored in large quantity and a close watch on the
movement of such items is kept.
• Slow moving items: are not frequently needed by the production
department hence moderate supervision will be maintained.
• Non moving items: are rarely required by the production department.
Hence a small stock is kept with less importance.
• Periodical inventory valuation: under this method inventory valuation with
checking will be carried out at different intervals, generally twice or thrice in a
year. During this period of checking normal functioning of the organization will
be closed for one or two days and complete stock valuation will be done.

CASH MANAGEMENT

Meaning: Cash is the most liquid asset that a business owns. In includes money,
cheque, money orders and bank drafts. Cash management means ensuring that the cash
held by a concern is neither excessive nor inadequate, but sufficient for meeting its
requirement. In short it means planning and control of cash.
Objectives of cash management

• To make cash payments: objective of holding is to meet the various types of

expenditure to be incurred in the business operations. The firm should remain
liquid to meet the obligations.

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• To maintain minimum cash reserve: in the process of meeting obligations on

time, the firm should not unnecessarily maintain heavy cash reserves. Excess
cash balance should be made productive.

Motives of holding cash

1. Transaction motive – for the day to day transactions relating to purchases,

payment, expenses, dividend etc.
2. Precautionary motive – for meeting unforeseen contingencies.
3. Speculative motive- for investing in profitable opportunities as and when they
arise.

Importance of cash management

Cash management assumes more importance than other current assets because cash is
the most significant and the least productive asset that the firm holds. It is significant
because it is used to pay firm obligations. However, cash is unproductive and as such,
the aim of cash management is to maintain adequate cash position to keep the firm
sufficiently liquid to use excess cash in some profitable way. Management of cash is
also important because it is difficult to predict cash flows accurately and that there is no
perfect coincidence between inflow and outflows of cash.

RECEIVABLES MANAGEMENT

Meaning of receivables: Receivables represent amounts owed to the firm as a result of

sale of goods or services in the ordinary course of business. These are claims against its
customers and form part of its current assets. Receivables are also known as account
receivables, trade receivables, customer receivables or book debts. The receivables are
carried for the customers. The period of credit and extent of receivables depends upon
the credit policy followed by the firm. The purpose of maintaining or investing in
receivables is to meet competition, and to increase the sales and profits.
Account receivable management
Account receivable is a permanent investment and is an above rolling account.
The finance manager has to determine the level of this account suitably so that there will
be easy flow of working capital. All this, viz, maintenance of debtors at optimum level,

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the degree of credit, sales to be made, making the debtors turn fast, involves, the
“account receivable management”.
Determinants of account receivables.
• Credit Sales Volumes: In order to increase the profit and push sales, many firms
will have “Credit Sales”. Higher the volume of credit sales, higher will be
accounts receivable. The level of credit sales will also be determined by the
custom that exists in that business. If the business needs the credit sales to push
the product, it becomes inevitable that the firm has to adopt credit policy on a
large scale.

• Credit Policies: Another important factor which determines the volume of

“Accounts Receivable” is credit policy of the firm. By “Credit policy” we mean
the policy adopted to extend credit sales which include (1) The time period
allowed to collect the debts, (2) The types of discounts allowed. (3) The
assessment of customer’s creditworthiness, (4) Collections policy etc. The credit
policy varies also with the changes in the economy.
• Business Terms: The volume of accounts receivable also depends on the terms
and conditions relating to credit sales. These conditions include
• The time period allowed to pay back the purchase price
• The types of discounts allowed.
Time Period: The time period allowed to clear the trade debt by the customers
determines the volume of accounts receivable. Longer the period allowed, higher
will be the credit sales and rise in size of the accounts receivable.
Discount: There are three categories of discounts allowed by the traders to
customers, viz..,
Trade discount,
• Cash discount, and
• Quantity discount.

• Competition: Another factor which governs the size of the accounts receivable
is competition. It a firm is having a competitive environment, it will have
liberal credit policy arid this increases the size to the accounts receivable. They
compete with the object of pushing sales and easy credit terms become

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inevitable. When the firms severely compete, the credit policy will be so liberal
that all and sundry purchase the products on credit.

• Location: Location of business unit also contributes for the size of accounts
receivable. If the business firms are located in far off places, they are forced to
adopt a credit policy which attracts the customer. If the product is exclusive,
location will not be a problem and customer development will be good.
• New Products: When the new products are introduced, the firm has to extend
the liberal credit policy till such time the product catches the market and even
afterwards the policy has to continue to maintain customers. This naturally
increases the size of accounts receivable.

COMPONENTS OF WORKING CAPITAL

The interaction between current assets and current liabilities is therefore the main
theme of the theory of working capital management. The term current assets refers to
these assets which in the ordinary course of business can be or will be turned into cash
within one year without undergoing a diminution in value and without disrupting the
operating of the firm. The major components are
• Current Assets
• Current Liabilities

Current assets Current liabilities

Cash in hand and Bank balance

Bank Overdraft

Bills Receivable Bills Payable or Account Payable

Sundry Debtors
Sundry Creditors

Short term Loans and Advances Short term Loans, Advances and Deposits

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Temporary Investments of Surplus Funds Dividends Payable

Prepaid Expenses
Provision for Taxation

Accrued Incomes Accrued or Outstanding Expenses

Inventories of Stock as:

Raw Materials
Work in Process
Stores and Spaces
Finished Goods

Operating cycle
Operating cycle is the time that elapses in conversion of raw materials into cash

Debtor
Sales

Cash

Finished
goods

Raw
Materials Work-in-
Process

Important formula and format

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Statement of working capital estimation

Particular Amount Amount

s
(Rs.) (Rs.)

A. Estimation of Current Assets: XXX

i) Raw materials XXX
ii) Work-in-process XXX
Raw materials (full cost) XX XXX
Direct labour (to the extent of completed
stage) XX XXX
Overheads (to the extent of completed
stage) XX
iii) Finished goods inventory
iv) Debtors
v). Cash balance required

Total Current
Assets XXX

B. Estimation of Current
Liabilities: XXX
i) Creditors
ii) Expenses
XXX
Overheads XX
Labour XX

Total Current Liabilities XXX

C. Working Capital (A-B) XXX

Add: Contingency (Percentage on working capital i.e. C) XXX

D. Working Capital Required XXXX

Economic order quantity (EOQ)

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EOQ: The inventory control tool that determines optimum order at which
inventory cost is minimum.
Assumptions:
• Demand for the product is constant and uniform throughout the period.
• Lead time (time from ordering to receipt) is constant.
• Price per unit of product is constant.

• Inventory holding cost is based on average inventory.

• Ordering costs are constant, and
• All demand for the product will be satisfied (no back orders are
allowed). EOQ = √2AO/CC
Where: A = Annual usage

CC = Price per unit x Carrying cost per unit in percentage

• The above simple formula will not be sufficient to determine EOQ when more
complex cost equations are involved.

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