Description
Finamcial management stuff
Financial Management
Redeemable Debentures
Redeemable debentures are those that will be repaid by the company under the term of issue at the end of a specified period or at any time within a specified period by giving them a notice of its intention to redeem them at the end of the notice period or by installments during the existence of the company. Redeemable debentures may be reissued even after they have been redeemed until they been cancelled.
Advantages of Redeemable Debentures
? Flexibility in capital Structure – By issuing such debentures the company can make its capital structure more flexible, and raise funds as and when it needs the loan money. ? Check on Over capitalization – An over capitalized company may redeem such debentures and may control the state of over capitalization. ? Best solution for Fixed Term Loan – If a company requires funds for a fixed period it may issue such debentures because these can be redeemed after a certain specified period. ? Preferred by Fixed Term Investors – These debentures are preferred by those investors who with to invest their funds for a fixed term at a fixed rate of interest and at minimum risk.
Disadvantages of Redeemable Debentures
1. Liquidation of Company – Redeemable debentures are repaid at the end of a certain specified period or at any time within the specified period by giving them notice of redemption. If the company fails to arrange the necessary amount to redeem them the debenture holders can take action for its winding up. The company’s existence is always at stake if its financial positions is not sound enough. 2. Uncertainty of Redemption – If debentures are repayable at any time within a specified period under the terms of issue, it may create a problem before the debentures holders to invest the amount immediately as soon as it is repaid by the company. There remains uncertainty in the minds of debentures holders regarding its redemption. 3. Adverse effect on liquidity of Assets – If a company has to repay a large sum at the time of redemption of debentures it may adversely affect the liquidity of assets unless it is planned wisely by creating sinking fund so that the company may get the required amount at the time of redemption of debentures at the end of the specified period.
RIGHTS DEBENTURES Under Section 81 of the Indian Companies Act 1956, there are specific provisions regarding the issue of “rights shares” by the public companies while no such specific provision has been made regarding the issue of rights debentures. Public companies are authorized to issue such debentures for raising long-term resources. The central government has formulated certain guidelines to regulate the issue of rights debentures by public companies for working capital requirements to be followed by a company, while seeking consent of the controller of capital issue
Advantages of convertible debentures to issuing company
1. Rise in Equity Capital – By such issue a company can rise equity capital indirectly without diluting the earnings of the existing shareholders. By the time debentures are converted into shares the additional investment starts earning an added return to support the additional shares. 2. Sale of Shares in Disguise – In a period of low market prices of shares the company can sell equity shares in disguise. Investors unwilling to purchase equity shares, initially, may like to convert their debentures into equity shares if they find, it to be a profitable proposition. 3. Attracts Funds from Institutions – By issuing convertible debentures, a company can attract funds from the institutions which may not otherwise purchase equity shares due to restriction imposed by their by – laws. 4. Tax Advantage – As the interest on debentures is a charge on profits, the company gets tax advantage until the bonds are converted into shares. 5. Greater appeal – Convertible debentures may have greater appeal among the investors particularly in a period of tight money. The addition of conversion right allows the company to offer comparatively a lower rate of interest in a period when prices of other bonds are falling due to rise in the interest rates. 6. Security for Other Debts – As convertible debentures are unsecured and therefore the borrowing capacity of the company remains intact by the issue of such bonds, the company can provide security against its other debts. 7. Flexibility of Capital structure – The issue of convertible debentures results in an element of flexibility to the company’s capital structure. 8. Double Benefits – Convertible debentures offer benefits of both debt financing and equity financing.
Government Guidelines for rights debentures
Govt. concerning rights debentures guidelines are as follows: 1. These may be issued by only public limited companies 2. These may be issued to augment working capital on a long-term basis. Issue of debentures for any other purpose such as financing of expansion project or addition to fixed assets will not fall under this category. 3. The amount of the issue will not exceed 20% of the gross current assets, loans and advances minus the long-term fund currently available for working capital, or 20% or the paid-up share capital, including preference capital and free reserves, whichever is lower of the two. 4. The debt-equity ratio including the proposed debenture issue, should not exceed II. 5. The debenture will carry a rate of interest 10.5% payable half-yearly where the period of maturity is up to and including 7 years and 11% where the period of maturity is from 8 to 12 years. 6. Rights debentures can be issued at a discount or additional interest of ½ % can be offered for any year, if in that year the rate of dividend on equity shares is highest in the preceding three years. 7. Rights debentures will be redeemable as follows: 1. Where the maturity period is upto 7 years, 33 1/3% of the debentures will be repaid uniformly to all debenture holders in the 5th , 6th and 7th year. 2. Where the maturity period is from 8 to 12 years, 20% of the debentures will be repaid uniformly to al the debenture holders in the 8th, 9th, 10th, 11th, and 12th year. 8. The face value of each rights debentures will be Rs. 100 9. Rights debentures will be listed with the stock exchange. 10. The issuing company should be a listed company. Its equity shares must be quoted on the stock exchanges at or above par value in six months prior to the date of application for the issue. 11. Rights debentures shall first be offered to the existing Indian Shareholders of company on a pro-rata basis and there after must be kept open for at least two months. The un-subscribed debentures, if any, will be offered on a rational basis to (a) shareholders interested in taking up additional allotment, (b) the directors of the company, and (c) the employees and business associates of the company.
12. Allotment of Rights Debentures will be made only after a minimum subscription of 75% of the amount of debentures has been secured. 13. The company should ascertain beforehand the prospects of at least 75% of the issue being take up by the shareholders of the company and other categories of investors mentioned above.
Debentures unpopular in India
High Denomination – In India, debentures are usually of high denomination, as India investors prefer securities of low denomination, the moderate investors could not go in for them. 2. Managing Agency System – Indian industries were financed primarily by the managing agents who generally discouraged the issue of debentures for fear of loosing their financial importance. 3. Heavy Stamp Duty – Debentures have been a very costly source of finance with a heavy stamp duty of Rs. 15 for Rs. 1000 for bearer debentures and Rs. 7.50 per Rs. 1000 for registered debentures. This heavy stamp duty generally discourages the investors to invest funds in debentures. 4. Adverse Attitude of Banks – Banks and other financial institutions show an adverse attitude towards companies which issue debentures. Banks did not entertain the debentures even as collateral securities. Issuing Companies lose their credit in the eyes of banks and other financial institutions. 5. Limited Marketability – For debentures there is no developed, regular and steady capital market in India. To increase the marketability of industrial securities the Government of India have recognized many new stocks exchanges in different part of the country. 6. Adverse effect of Government securities – Government of India have issued so many securities with attractive conditions which have adversely affected the popularity of debentures in India. As compared to the industrial securities government securities are considerably safer. Institutions investors have to invest their funds in government securities as per statutory provisions. 7. Unattractive terms of issue – Terms of issue of debentures in India are not as attractive as they are in some other industrially developed countries. 8. Lack of Proper Advisory Agencies – There is a total lack of advisory agencies investment in India. Stock exchange services are confined to some big cities. Investment trusts and investment banks are not developed in India. Therefore the investor cannot judge where to invest the funds. 9. Lack of Interest to Industrial Investors – Institutional investors are statutorily required to invest a large part of their funds in government securities. For example, Indian Insurance Act 1939 prohibits investment in debentures by insurance companies in India. Even to day Life corporation invests its 80% of funds in government securities. Generally Indian banks do not invest in longterm corporate securities. Investment bank and investment trust have not developed much in India. Recently, Unit Trust of India as show some interest in corporate debentures.
10. Cautious Attitude of Indian Investors – Indian investors are very cautions about the safety of their investment. They do not wish to earn more at the cost of safety. Only safety of investment attracts them to invest funds in giltedged securities. 11. Preference for Government Savings – In recent years Indian government have initiated a number of attractive saving schemes and issued securities which carry income tax rebates and other benefits like withdrawals etc. Marginal investors prefer these schemes rather to invest funds in debentures. 12. Limited Control of Holders – Debenture holders are given limited controlling power in the day to day affairs of the company unless their interests are affected. They have no vice in policy decision of the company unless they affect their interest. Hence those who desire to have a voice in the affairs of the company prefer to invest their money in equity shares.
Debt Finance Against Equity Finance
Debt Financing is recommended against equity financing due to following reasons: 1. The rate of interest payable on long terms debt is lower than the normal rate of return. 2. The cost of debt-financing is always fixed. 3. The interest payable on debt is an admissible deduction for income-tax purposes which reduces tax liability of the corporation. 4. Debt carries flexibility in the capital structure of the company because it can be redeemed at any time at the sweet will of the company.
Following are the circumstances of accepting debt capital. (1) The sales and earnings are relatively small (2) The marginal cost of debt is less than the cost of equity as it lower the average cost of capital or trading. (3) The general price level is expected to be high, resulting in higher profits in future. (4) The existing debt-ratio is relatively low. (5) Price earnings ratio on equity shares is low in relation to the level of interest rates. (6) Retention of existing control pattern because debentures carry no voting rights.
(7) Terms of debt-agreement are not burdensome on the cash position of the company. (8) Terms and conditions of debt agreement are not onerous and prejudicial to the interest of the firm and its shareholders.
Depreciation as a source of finance
Depreciation means decrease in the value of assets due to wear and tear, lapse of time, obsolescence, exhaustion and accident. There is a lot of controversy among academicians and business executives regarding treatment of depreciation as a source of funds. People who oppose treating depreciation as a source of finance argue that funds are generated by operating profits and not by making provision for depreciation. If depreciation were really a source of finance by itself any enterprise could have improved its position at will by increasing the periodical depreciation charge. They further argue that the depreciation being a non-cash item of expense does not affect the working capital of the firm and as such not at all a source of finance. Validity of the above arguments cannot be questioned, but it can also not to be denied that as a non-cash expense, depreciation does not represent any cash outlay with the result that a part of the profits adjusted for depreciation can be used by management to increase any of the current assets or pay taxes, dividend etc. Depreciation may, therefore, can be taken as a source of funds in a limited sense because of the following reasons.(i) Depreciation finds its way into current assets through charging of overheads (including depreciation). The value of closing inventory may include depreciation of fixed assets as an element of cost. (ii) Depreciation does not generate funds but it definitely saves funds. For example, if the business had taken the fixed asset on hire, it would have been required to pay rent for them. Since, it owns fixed assets, it saves outflow of funds which would have otherwise gone out in the form of rent.
(iii) Depreciation reduces taxable income and, therefore, income-tax liability for the period is reduces. This will be clear with the following example: Case I Rs. 75,000 Nil. 75,000 37,500 37,500 37,500 Case II Rs. 75,000 15,000 60,000 30,000 30,000 45,000
Income before depreciation Depreciation Income Taxable Income Income Tax say at 50% Net Income after tax (B) Net Flow of funds after tax (A) + (B)
The above example shows that in Case II, the net flow of funds is more by Rs. 7,500 as compared to Case I. This is because on account of depreciation charge being claimed as in expense, tax liability has been reduced by Rs. 7,500 in Case II. It may, therefore, by said that true funds flow from depreciation is the opportunity of saving cash outflow through taxation.
Trade Credit
Trade credit is a form of short-term financing common to almost all types of business firms. As a matter of fact, it is the largest source of short-term funds. In an advanced economy, most buyers are not required to pay for goods on delivery. They are allowed a short-term credit period before payment is due. This credit may take the form of (a) An Open Account Credit Arrangement (b) Acceptance Credit Arrangement. In case of an Open Account Credit Arrangement, the buyer does not sign a formal debt instrument as an evidence of the amount due by him to the seller. While in case of an Acceptance Credit Arrangement the buyer accepts a bill of exchange or gives a promissory note for the amount due by him to the seller. Thus, it is an arrangement by which the indebtedness of the buyer is recognized formally. Trade Credit Arrangement is generally made available to the buyer on an informal basis without creating any charge on assets. Trade Credit Arrangement usually carry stipulation of allowing a cash discount to the buyer for prompt payment. The volume of trade credit and its popularity as a means of short-term financing depends on the following factors. (i) The terms of trade credit, (ii) Reputation of the purchasing firm, (iii) Financial position of the seller, and (iv) Volume of purchase to be made by the buyer.
Merits of trade credit
(i) The major merit of trade credit as a source of finance is its ready availability. (ii) Trade Credit is available on a continuing and informal basis. There is no need to arrange financing formally. In case, the firm is not taking cash discounts, additional credit is readily available by not paying existing trade creditors till the expiry of the credit period. There is no need to negative with the supplier. The decision is entirely up to the firm. (iii) There is no need of creating any sort of charge against firm’s assets for obtaining the trade credit. (iv) Trade Credit is a flexible means of financing since the firm does not have to sing a note, pledge securities or adhere to strict payment schedule. A seller views occasional late payment with a far less critical eye than a banker or any other lender.
Demerits of Trade Credit
(i) The cost of trade credit may be very high in case all factors are considered. The seller while fixing the selling price of his products to be sold on credit takes into account the interest, the risk and inconvenience attached with
supplying goods on credit. As a matter of a fact, many firms utilize other sources of short-term financing in order to enable them to take advantage of cash discount. (ii) Availability of liberal trade credit facilities may induce a firm to over trading which may later prove to be disastrous for the firm. The firm must balance the advantages of trade credit as a discretionary source of financing without any explicit cost against the cost of losing of cash discount, the possibility of deterioration in reputation, if trade credit is stretched beyond agreed limits and the increased purchase price of the product.
Term Loans
A term loan is a business loan with a maturity of more than one year. There are exceptions to the rule, but ordinarily term loans are retained by systemic repayments over the life of the loan. The primary lenders on term credit are Commercial banks, life insurance corporation, financial institutions, general insurance companies, investment trusts and state and central government. Commercial banks and various financial institutions constitute the hard core of term financing in India. Term lending business of Commercial banks is recent innovation in India specially after 1958. It was in the year of 1958 only when a formal scheme of term loans was started. But, now-a-days these banks provide a larger share of tem finance to Indian Industries.
Special features of term loans
1. Objective – The term loans are granted for one or more of the following objectives: (a) Establishment, renovation, expansion and modernization of industrial units. (b) For meeting the requirements of the core working capital.
(c) For retiring bonds in order to reduce interest costs or to redeem preference shares so as to substitute tax deductible interest payment for non-deductible dividends. 2. Security – Terms loans are usually secured. They have either a fixed or floating charge against the assets of the company. The lender bank usually prefers a first charge, however, in appropriate cases it accepts a second charge also. 3. Time period – The term loans are granted for a period ranging from 1 to 15 years but generally from 8 to 15 years. The repayment is made in installments typically designed to fit the project capacity of the borrower to pay. The repayment starts 2 or 3 years after sanctioning of loan. The lending institution requires payment only in accordance with the specified schedule so long the borrower carries out his commitments under the loan agreement. In case of default in such commitment, the agreement provides for accelerating of the maturity of the loan. 4. Formal agreement – The term loan is granted on the basis of a formal agreement. The agreement contains the terms of granting loan and provides for certain protective clauses for the benefit of the lender, e.g. limiting the dividend rate, the power to appoint directors, conversion of loan into share capital, etc. Then terms are settled through direct negotiation between the borrower and the lending institutions. 5. Participation basis- In case of term-loan being a substantial amount, different financial institutions participate in the credit on a syndicated basis. Such participation is done either because restrictions or for sharing the risk. The larger the loan, greater is the participation. 6. Introduces financial discipline – Term loans introduce a proper financial discipline in the borrower. He has to forecast reasonable accuracy cash flows so that he can repay loan and interest as per the agreed schedule. This makes necessary for the borrower to prepare a projected cash flow statement. 7. Refinance facility – Commercial banks are granted refinance facility from Industrial Development Bank of India on the terms loans granted by them. The risk, of course, continues of the lending commercial bank. 8. Project oriented approach – Financial institution engaged in term lending do not do security-oriented lending any longer. They have detailed app of each project and asserts its own merits. The loan is sanctioned only when the project satisfies their tests. 9. Special Conditions – In order to provide safeguards against time and cost overruns the loan agreements usually require the borrower to give undertaking in respect of the following matters : (i) (ii) (iii) No further long-term loan shall be taken The debt-equity ratio will not exceed the specified limit. Current ratio will be maintained at the desired level.
(iv) Selling commission sole selling agent shall not be disbursed unless interest and installments of loans are paid.
(v) rate.
Dividend shall not be declared for a specific period or shall not exceed the agreed
(vi) Financial data and other information as required by the lending institution will be supplied as and when desired. (vii) The directors will furnish personal guarantees for repayment of the loan in addition to the financial institution’s charge on firm’s assets.
Credit Rating Information & Services of India (CRISIL)
(a) The Credit Rating Information & Services of India Limited (CRISIL) was set up by the financial institution on January 19, 1998, to facilitate the processing of proposals and giving of approvals by the SEBI for companies going to the public for raising funds through issue of securities. Share Capital : CRISIL has a capital base of Rs. 4 crores. Functions: CRISIL has proved to be a boon to both companies and investors through its following functions: (i) It provides an independent and unbiased report about the creditworthiness of company. Thus, it enables it to mobilize directly savings from individuals at reasonable cost. (ii) It provides reliable financial information and increased disclosure to investors. Thus, it enables them to buy securities with confidence.
Working: At present CRISIL is restricting its rating only to debt instruments, viz., fixed deposits, debentures, and debenture portion of equity linked debentures. There is no compulsion for any company to obtain or publicize the rating obtained from CRISIL. However, once credit rating is made compulsory by the Government. CRISIL is planning to undertake credit rating of all types of securities. CRISIL has to evaluate and monitor the performance of a company through use of qualitative as well as quantitative criteria for evaluation. The qualitative criteria include the company’s competitive position, its strengths and weakness, its management and business strategies, etc. while the quantitative criteria include the financial statements the accounting ratios, the cash flow and funds flow statements of the company concerned.
Progress of CRISIL, Since its inception till March 31, 1996, CRISIL has so far completed rating of 1,736 issues consisting of various types of debt Rs. 1,14,873 crores. Some of the companies which have used CRISIL rating are Indian Petro Chemicals Limited (IPCL), Sundaram Fiannce Limited (SFL), Mahindra Engine Steel Company Limited, Mukand Oil & Steel works Limited, Kirloskar Bros. Limited, Municipal Bonds of Ahmedabad Municipal Corporation etc. During the year 1992-94 CRISIL launched the RATINGDIGEST, which is a compilation in five volumes of CRISIL Rating Reports organized by industries categories. In 1995 – 96 it introduced CRISIL – 500 Equity Index. Credit rating analysis is relatively, new development in India. It is expected that establishment of CRISIL, will provide a strong impetus to the systematic risk evaluation of specified corporate instruments as well as the companies issuing them.
(a) ICRA Ltd. ICRA formally known as the investment Information & Credit Rating Agency of India (ICRA) was promoted by the Industrial Finance Corporation of India (IFCI). It was incorporated on Jan. 16, 1991 as public limited company and started functioning with effect from September 1, 1991. The ICRA also performs credit rating functions and finalizes its rating norms and standards in consultation with Credit Rating Information & Services of India Ltd. (CRISIL) ICR A has an authorized Capital of Rs. 10 crores. Industrial Finance Corporation of India (IFCI), Unit Trust of India, Life Insurance Corporation of India, General Insurance Corporation of India, Housing Development Finance Corporation of India, Infrastructure Leasing and Financial Services, State Bank of India, and 17 commercial banks are its shareholders.
Progress of ICRA, Since its inception till end of March, 1996 ICRA has rated 778 debt instruments involving an amount of Rs. 93,380. The Government has already announced compulsory rating for all debentures end bonds expect the following :
1. Issue of non-convertible debentures upto Rs. 5 crores on private placement basis including with mutual funds. 2. All issues of fully convertible into equity shares within 18 months from the date of issue at per determined price. 3. Public sector bonds and private placement of debentures with financial institutions – banks.
Exam Tips Formula & Proforma Sheet Sub – Financial Management Chapter 1 Working Capital Format of Working Capital Particulars Current AssetsStockRaw Material (At R.M. cost) Work in Progress Raw Material [100%] ×× Labour [50%] Amount Amount ××
×× ××
×× Overheads [50%] ×× Finished Goods (Total Cost) Debtors [At Selling Price] Cash/Bank [Given] Prepaid Expenses [Given] Total Current Assets (A) ×× ×× ×× ××
Current Liabilities Creditors [R.M. Cost] Outstanding Wages [Labour Cost] Outstanding Overheads [O/H Cost] Total Current Liabilities (B)
×× ×× ×× ×× ××
Working Capital
Tips
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For above all the common formula is Quantity × Rate × Period
• • • •
Period given in terms of months weekly or daily For monthly take 12 months weekly either 52 weeks or 50 weeks and for daily 365 or 360 days For domestic and expert type of sums the closing stock should be on total cost of goods sold Other things are one and the same.
Chapter 2 Income Statement
Income Statement Sales Less: Variable Cost Contribution Less: Fixed Cost EBIT Less: Tax EAT
×× ×× ×× ×× ×× ×× ××
•
Formulas Operating Leverage or Degree of operating leverage = Contribution/EBIT
•
Financial Leverage or Degree of financial leverage = EBIT/ EBT
•
Earning Per Share = EAT – Preference Dividend /No. of Equity Shares
• •
P/V Ratio = Contribution/Sales × 100 Debt Equity Ratio = Long Term Debt/Equity
•
Combined Leverage = Contribution / EBT = Operating Leverage × Financial Leverage
or
•
Asset Turnover = Sales/Total Assets Tips
• • •
Variable cost always in terms of % on sales If P/V ratio is 70% i.e. sales Rs. 100/- contribution Rs. 70/- and variable cost Rs. 30/-. Interest on loan means debentures & other loan funds.
•
Fixed cost always remains the same.
Chapter 3 Receivables Management Formats A. When Fixed cost is given
Particulars SalesLess:Variables CostContribution Less: Fixed Cost Profits (A) Total Cost = FC + VC Investment in Receivables Cost Opportunity CostBad Debts Other Costs Total Cost (B) Net Benefit (A – B) Incremental Benefits
Existing ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× -
OP – I ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ××
OP – II ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ××
Tips
• • • •
The incremental benefits more option is to be selected Investment in receivables is to be calculated on total cost (FC + VC) Opportunity cost is to be calculated on investment in receivables. Bad Debts is to be calculated on total sales.
B.
When Fixed Cost is not given Particulars Existing SalesLess: Variable ×× CostContribution (A) ×× ××
OP – I ×× ×× ××
OP – II ×× ×× ××
Investment in Receivables Cost ×× Opportunity CostBad DebtsOther Costs Total Cost (B) Net Benefits (A – B) Incremental Benefits ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ××
Tips
• • •
Investments in receivables is to be calculated on sales Opportunity cost is to be calculated in investment in receivables Remaining things are one and the same.
Chapter 4 Cost of Capital
Formula
Cost of Debt: Kd = I (1 – t) Tax = t Cost of Equity Ke = (D × 100) + g P
Cost = K Interest = I
Dividend = d Market Price = P Growth Rate = g
Cost of Performance always the given rate because it is always after tax. Statement of WACC Amount ×× Proportion Cost of capital ××% Ke WACC ××
Equity
Given Preference Loan ×× ×× ×× ××% ××% 100% Kd ×× ×× ××
WACC = Proportion Cost of Capital 100
Further Formula
• •
EPS = EAT – Preference Dividend/No. of Equity Shares Debt/Equity Ratio = Long Term Debt/Equity
Chapter 5 Capital Structure Planning
There are two formats
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Capital Structure EPS
The plan (option ) having highest EPS is going to be selected for the purpose of investment.
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Proforma of Capital Structure Particulars Equity Share CapitalExisting (if given) New Preference Capital Existing (if given) I ×× ×× ×× ×× II ×× ×× ×× ×× III ×× ×× ×× ××
New Debentures Existing (if given) New Retained Earnings (if given) Total No. of Equity Shares (B) ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ××
•
Proforma of E.P.S. Particulars EBITLess: Interest on Loans EBT Less: Tax EAT Less: Preference Dividend Earnings available for Equity Holders (A) I II III
EPS = A/BD.P.S. = E.P.S. × Dividend Payout
×× ×× ×× ×× ×× ×× ×× ×× ××
×× ×× ×× ×× ×× ×× ×× ×× ××
×× ×× ×× ×× ×× ×× ×× ×× ××
Tips
• • • •
If statement of capital structure is given no need to prepare. Dividend payout is given find D.P.S. only For indifference point equate two E.P.S. for two different plan. For Break even point take E.P.S. zero & apply reverse way to calculate EBIT.
Chapter 6 Cash Management Format Particulars Opening BalanceReceipts Cash Sales (working notes) Collection from Debtors (Working Notes) Deferred Receipts Total Receipts PaymentsPayments to creditors Payments of Expenses Other payment Total Payment Balance (Receipts – Payments) I II III
×× ×× ×× ×× ×× ××
×× ×× ×× ×× ×× ××
×× ×× ×× ×× ×× ××
×× ×× ×× ×× ××
×× ×× ×× ×× ××
×× ×× ×× ×× ××
Tips
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Closing balance of one month become opening of other month. Following subsequent, next and forward means one and the same. Arrears outstanding means one and the same i.e. in next month. Temporary loan is to be paid in next possible option. Existing notes to be prepare wherever required. Chapter 7 Capital Budgeting Decision Criteria Pay Back Period Net Present Value Profitability Index A.R.R. Payback Profitability
I.R.R. Discounted Payback
Formulas Payback Period Method a. If cash flows are not same = No. of years + Required Amount × 12 Next Inflow b. If cash flows are same for all years Payback Period = Cost of Project / Initial outlay 1 year’s inflow Net present value = Present value of Inflow – Initial Outlay Profitability Index or Benefit Cost Ratio = Present value of Inflow Initial Outlay A.R.R. a. Accounting Rate of Returns or A.R.R. (based on original investment) = Average Annual PAT × 100 Original Investment b. Average Rate of Returns or A.R.R. ( based on Average Investment) = Average Investment [Original Investment (if scrap is not given)] 2 OR = Original Investment – Scrap + Scrap + Working Capital (if any) 2 Payback Profitability = Average Annual Cash Inflow [ Estimated Life – Payback Period] Internal Rate of Return = L.R. + P.V. at L.R. – Initial Outlay × Difference in Rates
P.V. at L.R. – P.V. at H.R. L.R. = Lower Rate H.R. = Higher Rate P.V. = Present Value
Discounted Payback = No. of years + Required Amount × 12 Next year’s P.V.
Tips The project cost, initial outlay, investment all are one and the same PBDT = Profit Before Depreciation & Tax CFBDT = Cash Flow Before Depreciation & Tax = PBDT CFAT = Cash Flow After Tax & Depreciation = PAT Cash Flows = Cash inflows = PAT + Depreciation PAT + Depreciation also called as Profit After Tax But Before Depreciation If sales & other costs are given then PBDT is to be calculated as under PBDT = Sales – Variable Cost – Fixed Cost – Other Costs (Excluding Depreciation) To calculate Depreciation the formula is Depreciation = Original Cost – Estimated Scrap Estimated Life If estimated life is not given then depreciation rate is given and accordingly decide the estimated life.
e.g. If 10% given the life is 10 years If 25% given the life is 5 years If working capital given along with scrap or salvage value then both working capital & scrap added to last year’s inflow & last year’s P.V. factor us applied to both. For NPV calculation the working capital should be added to the initial outlay. If present value factor is not given assumed to be 10%. Mostly taxes is given, but if not given then in the question they mention about assumption & then put assumption and take tax 50% but if nothing is given then ignore taxation. Payback period in years & months or only in terms of years also be calculated.
Hey ya! Here are some tips to crack a practical subject like FM. To do anything practically, you need to understand the main concept and why is it learnt.. then only you would be able to solve the sums. Let me give a brief overview of Financial ManagementFinance is the backbone of every business. It’s management is necessary for the smooth functioning of all the activities. It is to be studied to know the basis of managing finance in real terms of the world. ¬ Working Capital ManagementWorking Capital Management refers to Current Assets – Current Liabilities. In other words, Working capital means the difference of what we are about to receive or
received in short term and what we are supposed to pay in short term. It normally comprises of sums for calculation of increase or decrease in working capital. ¬ Cash managementCash management implies management of cash flow in the business on daily basis. It represents the outflow and inflow of cash by various operations. Cash management generally involves sums where there is calculation of cash outflow and cash inflow. ¬ Cash BudgetIt refers to an estimate of cash expenses and incomes through a quarter or six months. Here all the expenses and incomes are put in the form of a budget and the closing balance of one month becomes the opening balance of another month. Cash budget is necessary in order to set the insight into the cash outflow and inflow in a particular month and accordingly preparing a budget of it so that it can be used in planning and controlling the expenditure over and above the required limits. ¬ Capital Budget – Capital Budgeting mainly aims at estimating the returns that we get on a particular investment. It involves the calculation of payback period, net present value, profitability index, internal rate of return and so on. All this ultimately refers to the returns received on a particular investment in a project or purchase of machinery which is over a period of years. ¬ Business restructuringIt normally refers to restructuring of business either internally or externally. Internally reconstructing business involves the management of liabilities and assets and accordingly bringing the business to a better position. It involves reducing the paid up value of shares, reducing the claims of outside liabilities, writing off the fictitious assets and many other entries that are done to manage the liabilities in such a way that the business is back on track. It is normally done when the business is running in severe losses and is almost in the state of getting liquidated or sells off. Question Paper Pattern-(subject to changes) Section I Q. 1) Concepts – 12 marks (4 concepts for 3 marks, explain in atleast 3/4th page) Q.2) Case studies – 18 marks (2 cases for 9 marks or 1 case for 18 marks) Section II – 30 marks (includes sums and long answers) (Long answers can be 3 pages) Be clear with the concepts, maximum practice required for practical sums and proper working note in detail should be done. First basically read the problem in detail and then go for attempting it. Every detail should be kept in mind
before solving the sum. Formula should be understood and known where to apply. Make a list of formulas and keep on reading it before the exams. Recheck the mathematical calculations again as if 1 step goes wrong, the whole sum goes wrong. Steps do contain marks. So solve the sum properly and neatly. Underline or make a box of the final answer you got. Theory questions should be precise and should contain maximum points. It can be 2-3 pages (as u wish). But more than the quantity, quality matters. So, make sure you write answers in point-form and underline the important words.
CHAPTER I INTRODUCTION TO FINANCIAL MANAGEMENT
Definitions : F.W.Paish –“In a modern money using economy finance may defined as the provision of money at the time it is wanted .”—- Procurement View . John J Hampton—“The term finance can be defined as the management of the flows of money through an organization, whether it will be a corporation , school, bank or a govt. agency.”—Custodian Function. Howard and Upton —“Finance may be defined as that administrative area or set of administrative functions in an organization which relate with the
arrangement of cash and credit so that the organization may have the means to carry out its objectives as satisfactorily as possible.” Functions of Finance — three major decisions 1) Investment Decision—Capital Budgeting. 2) Financing Decision—Procuring Owned & Borrowed Capital 3) Dividend Decision— Profits-> Dividends and Retained Earnings Scope of FM 1) Estimating requirements of funds 2) Decision regarding capital structure 3) Investment Decision 4) Dividend Decision 5) Cash Mgt. 6) Evaluation of Financial Performance 7) Negotiation for additional funds Objectives/Goals of FM Fundamental objective is WEALTH MAXIMISATION. Objectives which lead to Wealth Maximisation a) Proper Utilisation of Funds b) Maximisation of ROI c) Survival d) Achieving BEP e) Managing Cash Flows f) Minimum Profits—Peter Drucker—“Profit is a condition of survival.” g) Coordination amongst different depts.-Prodcn., Sales, Finanace etc h) Good Image of Orgn. in market & Public
Two Approaches for attaining Objectives/Goals of FM A) Profit Maximisation Approach B) Wealth Maximisation Approach Changing Role of Finance Managers Traditional role of Finance Managers was concerned only with raising funds for the organization. In the Modern times role of FM includes a) Determining the requirement of funds for the orgn.
b) Determining Capital Structure –Owned Funds and Borrowed funds c) Raising Funds at minimum cost and restrictive conditions. d) Optimum utilization of funds e) Financial solvency to be ensured at all cost. f) Allocating the funds to different departments g) Allocating funds between Fixed assets and Working Capital Types of Risks (FM has to deal with) 1) Credit /Default risk- possibility that debtor will default 2) Interest Rate risk- change in bank deposit/loan rates 3) Business risk- failure of business due to controllable/uncontrollable factors 4) Inflation risk- Decrase in purchasing of money 5) Industry risk- failure of the related industry 6) Liquidity risk- inability to convert investment into cash 7) Systematic/undiversifiable risk- arising from external uncontrollable factors like political,economic etc. 8) Unsystematic/diversifiable risk- arising from internal controllable factors like plant breakdown/labour strike etc. CHAPTER II WORKING CAPITAL MANAGEMENT Definition : Gerestenberg—“ Circulating capital means current assets of a company that are changed in the ordinary course of business from one form to another,as from cash to inventories, inventories to receivables and receivables to cash.” Components of Working Capital Current Assets = Stock of raw material , Work in process , Finished goods , spares and consumable stores , sundry debtors , bills receivable , cash balance , bank balance ,prepaid expenses , accrued income , advance payments , short term investments , marketable investments . Current Liabilities = Sundry creditors , Bank Overdraft , bills payable , outstanding expenses , proposed dividend , provision for tax , income received in advance .
Types of Working Capital A) a)Gross Working Capital = Total Current Assets b)Net Working Capital = Total Current Assets - Total Current Liabilities B) a)Positive Working Capital – when CA > CL b)Negative Working Capital — when CA < CL c)Zero Working Capital – when CA = CL C) a)Permanent Working Capital— stays continuously /permanently in business Types 1)Initial Working Capital – inception/beginning of business 2) Regular Working Capital – Minimum W Cap for normal business b)Variable Working Capital— varying WCap Types 1) Seasonal Working Capital – according to season, 2) Special Working Capital – unforeseen events like strike, large contracts & 3) Peak Working Capital – Highest WCap required during operations. D) E) Balance Sheet Working Capital – asper Balance Sheet at the year end. Cash Working Capital—operational inflows & outflows of cash
Factors determining Working Capital a) Nature of business b) Size of business c) Production period d) Stocking requirements for raw material & Finished goods e) Credit available from suppliers of goods and services f) Credit to be given to customers g) Production policies h) Inventories Turnover i) Inflation j) Technology—labour oriented/technology oriented k) Taxation Policies—High tax rates=more W Cap. l) Expanding business=more business
W. Cap.Management involves -Cash Mgt. -Receivables Mgt. -Inventory Mgt. -Creditors Mgt. Aim of W. Cap.Management=Reducing investment in W.Cap. + Reducing Operating Cycle Duration Maximum Permissible Bank Finance (MPBF) RBI appointed Tandon Committee and Chore Committee recommended that business enterprises should improve their liquidity position and strive to achieve Current Ratio of 2:1. Calculation of MPBF a) Low Risk Category of Borrowers— MPBF = 0.75 (CA-CL) b) Medium Risk Category of Borrowers—MPBF = 0.75CA - CL c) High Risk Category of Borrowers— MPBF = 0.75(CA-CCA) – CL CCA= Core Current Assets Core Current Assets mean minimum permanent level of current assets to be maintained by an enterprise so long as it is a going concern . Such core current assets assure uninterrupted production. Core current Assets should be financed from long term funds / owned funds.
Sales Less: Raw Material Wages Variable Overheads
WORKING CAPITAL CALCULATION A) Current Assets 1) Stock of Raw Material (1mth) = Annual Raw mat X 2/12mth 2) Stock of WIP (1.5 mth) R Mat–Annual Raw mat X 1.5/12mth +Labour — Annual Labour X 1.5/12mth X 1/2 +Expenses — Annual Expenses X 1.5/12mth X 1/2 3) Stock of Finished goods (2.5 mth) = Total Annual Cost of Prodn. X 2.5/12mth 4) Bills Receivable (3mth) = Credit Sales X 3/12 mth 5) Debtors ( 2mth) = Credit Sales X 2/12 mth 6) Advance for Raw Material(Adv. To creditors) (0.5mth)= Annual Raw mat X 0.5/12mth 7) Advance Fixed Overheads (1.2mth) = Annual Fixed Overheads X 1.2/12mth 8) Prepaid Expenses(1mth) = Annual Expenses X 1/12 mth 9) Cash & Bank Balance Total Current Assets (CA)
Less: Current Liabilities 1) Creditors for Materials (1mth) = Annual Raw mat X
1/12mth
2)Outstanding Wages (1mth) = = Annual Labour charges X 1/12mth 3) Bills Payable(2mth) = Credit Purchases X 2/12mth Total Current Liabilities (CL) Working Capital ( CA - CL )
Eg.—1)Cash balance is 30% of monthly Profit—then prepare cost structure. Find Annual profit (profit per unit X units produced) .Find 30% of Annual profit. 2) If inland & export Sales given calculate Debtors for inland & export Sales separately. 4) Cost W. Cap–àCalculate Debtors and Bill Receivables on Total cost instead of Credit sales. 5) Cash Cost W.Cap.-> Calculate stock of WIP & Finished goods and Debtors and Bill Receivables at Cash Cost ( Total Cost other than Depreciation)
Working Capital Cycle/Operating Cycle A continuous process starting from payment of cash for purchasing raw material , production , stocking , selling until obtaining money from debtors. It is a cycle involving—- conversion of cash into raw material > conversion of raw material into WIP > conversion of WIP into Finished goods> conversion of Finished goods into cash /debtors and > conversion of debtors into cash. OC = R+W+F+D-C Ie. Duration of Operating Cycle = Raw mat. period+WIP period +Finished goods period +Debtors collection period –Creditors payment period
CALCULATION OF W. CAP . CYCLE i) Raw Mat. Stock Holding Period = R.Mat. Stock X 365 days Annual Purchases + ii) WIP duration = WIP stock X 365 days Cost of Prodn. +
iii) Finished Goods Stock Holding Period = Finished Goods Stock X 365 days Cost of Goods Sold + iv) Debtors Collection Period = Debtors X 365 days Credit Sales LESS : i) Creditors Payment Period = Creditors X 365 days Credit Purchases
CHAPTER III RECEIVABLES MANAGEMENT
Receivables include Debtors and Bills Receivables. Increase in Receivables ( more credit period) will lead to increase in sales and profits but it will also lead to increase in risk of bad debts. Receivables Management—Definition Management of debtors and bills receivables involves determining the appropriate credit period extended to debtors in such a manner that sales are maximized and yet minimum funds are blocked in debtors and bad debts are minimized. Importance of Receivables Management Right receivables management leads to following benefits : a) Increase in sales b) Minimum funds blocked in receivables/Capital Cost c) Tight recovery system/ controlled delinquency cost d) Minimum bad debts/default cost e) Minimum Collection Cost
Costs associated with A/cs. Receivables 1) Collection Costs—exp. of admn., collecting credit info. 2) Capital Cost—Cost of Funds blocked in Receivables 3) Delinquency Cost—Legal charges addnl. Collection costs 4) Default Cost—Bad Debts
Steps in Credit Appraisal 1) Customer Evaluation—Character+Capacity+Capital+Collateral Security+Conditions (economic) 2) Financial Stmts. of Customers 3) Bank references 4) Trade References 5) Credit Bureaus 6) Bank & Third Party Guarantees 7) Field Visits Collection Methods a) Centralised Collection System b) Decentralised Collection System c) Post dated cheques d) Pay order/bank draft e) Bills of exchange f) Lock Box System g) Drop –box System h) Collection Staff i) Debt Collector j) Del Credere Agent— collection of debts + assumes risk of bad debts gets additional commission. k) Concentration Banking l) Factoring
Control of Receivables 1) Days Sales Outstanding (DSO) DSO= Debtors + Bills Receivable days Average Daily Sales:
2)
Ageing Schedule Debtors are classified into different age brackets.
3) ABC Analysis Classification of Debtors into A Category, B Category and C Category A Category—Small no. of debtors but of large values—Highest Control B Category— Moderate no. of debtors and of moderate values— - Moderate Control C Category— Large no. of debtors but of small values - Less Control Credit Analysis Involves evaluating capacity of customers requiring credit period. Criteria of measuring creditworthiness of prospective customers : 2) Character of customer 3) Capacity to repay 4) Capital / financial position of customer 5) Collateral Security provided by customer 6) Conditions (Economic, Social , competition etc.) Opportunity Cost Opportunity/profit foregone(givenup) as a result of blocking the money in Debtors instead of investing it in other manner.
Credit Policy Variables Determining Credit Policy involves determining the following variables: a) Credit evaluation and Credit Rating of customers b) Costs associated with accounts receivables- Collection cost , Capital cost , Delinquency cost and Default cost . c) Collection methods of receivables d) Control of Receivables through – Days Sales Outstanding ,Ageing Schedule and ABC Analysis
Evaluation of credit Policies Example : -Current Sales 10 lakh, shall increase by 200000 in option 1 , by 300000 in option 2 . —Variable cost are 35% of Sales. Fixed cost are Rs 200000 . -Existing credit period is 2 mth, option 1 is 2.5 mth. and option 2 is 3 mth. -Credit Sales are 80% of total Sales. -Required rate of return is 12%. -Existing Bad debt loss is 2% , option 1 is 3% and option 2 is 4%. -Collection cost is 3% of debtors .
Particulars Credit Period Sales Less:Variable Cost Contribution(S-V) Less: Fixed Cost PROFIT(BENEFIT)
Present Policy Option 1 Option 2 2 mth. 2.5 mth. 3 mth 10,00,000 12,00,000 13,00,000 3,50,000 4,20,000 4,55,000 6,50,000 7,80,000 8,45,000 2,00,000 2,00,000 2,00,000 4,50,000 5,80,000 6,45,000
TotalCost=FC+VC 5,50,000 6,20,000 6,55,000 Average Invt.in Debtors= Total Cost XCreditsales X Total Sales 6,20,000 X Debtor Period mth 5,50,000 X 80% 80% X 12 mths X 2/12mth 2.5/12mth 6,55,000 X 80% X =73333 =103333 3/12 mth. = 131000 COST a) Opportunity cost of capital= eg. 12% x 73333 X 12% 103333 X Avg.Invt.in Debtor = 8800 12% = 12400 131000 X 12% = 15720 b) Bad debt cost= 10,00,000 X 2% 12,00,000 X 13,00,000 X 4% = eg.Bad debt % x Sales =20,000 3% = 36,000 52,000 c) Collection Cost = 3% (10,00,000 X (12,00,000 (13,00,000 X
x Debtors TOTAL COST NET BENEFITS(Profit – Total Cost) RATING
X2.5 /12 mth)X 2/12mth) X 3% 3/12mth) X 3% 3% = 5000 = 7500 = 9,750 33,800 55,900 77,470 4,16,200 III 5,24,100 II 5,67,530 I
Formulae a) If P/V Ratio is given find
— Contribution = Sales X P/V ratio.
b) If Debtors Turnover ratio is given — Debtors = Credit sales Debtors Turnover ratio
c) Debtors Velocity = Debtors Turnover ratio
12 mths.
CHAPTER IV CASH MANAGEMENT Cash in a broader sense includes coins, currency notes, cheques , bank drafts and also marketable securities and time deposits with banks. Objectives of Cash Management a) To meet payment needs of trading & business activities. b) To minimize idle funds c) To avoid cash crunch d) To maintain liquidity
e) To make payments to creditors and suppliers on time.
MOTIVES for holding Cash 1) Transaction Motive – for routine business/ operating payments 2) Precautionary Motive — to provide for unexpected/ unpredictable events like strike, flood, increase in raw material cost etc. 3) Speculative Motive — to take advantage of unexpected opportunities like favourable/ reduced prices of material , discount for bulk purchases etc. 4) Compensating Motive – Minimum balance is required to be maintained with the banks for various services provided by them.
CASH MANAGEMENT MODELS 1) Baumol’s Model –Baumol (1952) Cash can be managed in the same manner as inventory using Economic Order Quantity Model (EOQ model) .
C = ?2FT I C = Optimal Transaction size F = Fixed Cost per transaction T = Expected cash payments during the period I = Interest rate on Marketable Securities
2) Miller - Orr Model (1966) ( Stochastic Model ) Specifies two control limits
Upper Control Limit- When cash touches UCL marketable securities are purchased. Lower Control Limit- When cash touches LCL marketable securities are sold.
CASH CYCLE Involves Two Cycles—Disbursement Cycle and Receipt Cycle a) Disbursement Cycle—Total time between obligation to pay supplier arises and upto when payment clears the bank. To be maximized. Three Floats should be maximized to postpone payment Mail Float- Time spent in mail Clearance Float- Time spent for clearing payment through bank Processing Float – Time required for processing payment transaction.
b) Receipt Cycle—- Total time between products or services are provided and upto when payment from customer clears the bank.
Cash Budget Definition A Statement showing expected receipts and payments (of both trading and capital nature) over a period of time , prepared with the intention of planning and controlling the use of cash. Preparation of Cash Budget
Particulars Opening Balance RECEIPTS 1) Cash Sales 2)Receipts from Debtorsafter one mth.
Jan. 2010
Feb. 2010
Mar. 2010
80000
-after 2 mths. 3) Income from4) Invt. 4) Total Receipts PAYMENTS 1) Cash Purchases 2) Payment to Creditors 3) Payment of Wages Total Payments Closing Balance
48000
72000
Eg. 1) Total Sales of Jan 2010 are 400000. 20% Cash Sales. 40% of credit sales are paid in next month and balance in second month. -à It means 80000 are cash sales received in Jan.2010 & 120000 credit sales. Of 120000, 40% ie. 48000 shall be received in Feb.2010 and balance 72000 in March 2010 2) If specifically given closing cash balance is to be maintained every month.
à Take it as closing cash balance and balancing figure should be taken as payment to debtor in that month.
doc_281549829.doc
Finamcial management stuff
Financial Management
Redeemable Debentures
Redeemable debentures are those that will be repaid by the company under the term of issue at the end of a specified period or at any time within a specified period by giving them a notice of its intention to redeem them at the end of the notice period or by installments during the existence of the company. Redeemable debentures may be reissued even after they have been redeemed until they been cancelled.
Advantages of Redeemable Debentures
? Flexibility in capital Structure – By issuing such debentures the company can make its capital structure more flexible, and raise funds as and when it needs the loan money. ? Check on Over capitalization – An over capitalized company may redeem such debentures and may control the state of over capitalization. ? Best solution for Fixed Term Loan – If a company requires funds for a fixed period it may issue such debentures because these can be redeemed after a certain specified period. ? Preferred by Fixed Term Investors – These debentures are preferred by those investors who with to invest their funds for a fixed term at a fixed rate of interest and at minimum risk.
Disadvantages of Redeemable Debentures
1. Liquidation of Company – Redeemable debentures are repaid at the end of a certain specified period or at any time within the specified period by giving them notice of redemption. If the company fails to arrange the necessary amount to redeem them the debenture holders can take action for its winding up. The company’s existence is always at stake if its financial positions is not sound enough. 2. Uncertainty of Redemption – If debentures are repayable at any time within a specified period under the terms of issue, it may create a problem before the debentures holders to invest the amount immediately as soon as it is repaid by the company. There remains uncertainty in the minds of debentures holders regarding its redemption. 3. Adverse effect on liquidity of Assets – If a company has to repay a large sum at the time of redemption of debentures it may adversely affect the liquidity of assets unless it is planned wisely by creating sinking fund so that the company may get the required amount at the time of redemption of debentures at the end of the specified period.
RIGHTS DEBENTURES Under Section 81 of the Indian Companies Act 1956, there are specific provisions regarding the issue of “rights shares” by the public companies while no such specific provision has been made regarding the issue of rights debentures. Public companies are authorized to issue such debentures for raising long-term resources. The central government has formulated certain guidelines to regulate the issue of rights debentures by public companies for working capital requirements to be followed by a company, while seeking consent of the controller of capital issue
Advantages of convertible debentures to issuing company
1. Rise in Equity Capital – By such issue a company can rise equity capital indirectly without diluting the earnings of the existing shareholders. By the time debentures are converted into shares the additional investment starts earning an added return to support the additional shares. 2. Sale of Shares in Disguise – In a period of low market prices of shares the company can sell equity shares in disguise. Investors unwilling to purchase equity shares, initially, may like to convert their debentures into equity shares if they find, it to be a profitable proposition. 3. Attracts Funds from Institutions – By issuing convertible debentures, a company can attract funds from the institutions which may not otherwise purchase equity shares due to restriction imposed by their by – laws. 4. Tax Advantage – As the interest on debentures is a charge on profits, the company gets tax advantage until the bonds are converted into shares. 5. Greater appeal – Convertible debentures may have greater appeal among the investors particularly in a period of tight money. The addition of conversion right allows the company to offer comparatively a lower rate of interest in a period when prices of other bonds are falling due to rise in the interest rates. 6. Security for Other Debts – As convertible debentures are unsecured and therefore the borrowing capacity of the company remains intact by the issue of such bonds, the company can provide security against its other debts. 7. Flexibility of Capital structure – The issue of convertible debentures results in an element of flexibility to the company’s capital structure. 8. Double Benefits – Convertible debentures offer benefits of both debt financing and equity financing.
Government Guidelines for rights debentures
Govt. concerning rights debentures guidelines are as follows: 1. These may be issued by only public limited companies 2. These may be issued to augment working capital on a long-term basis. Issue of debentures for any other purpose such as financing of expansion project or addition to fixed assets will not fall under this category. 3. The amount of the issue will not exceed 20% of the gross current assets, loans and advances minus the long-term fund currently available for working capital, or 20% or the paid-up share capital, including preference capital and free reserves, whichever is lower of the two. 4. The debt-equity ratio including the proposed debenture issue, should not exceed II. 5. The debenture will carry a rate of interest 10.5% payable half-yearly where the period of maturity is up to and including 7 years and 11% where the period of maturity is from 8 to 12 years. 6. Rights debentures can be issued at a discount or additional interest of ½ % can be offered for any year, if in that year the rate of dividend on equity shares is highest in the preceding three years. 7. Rights debentures will be redeemable as follows: 1. Where the maturity period is upto 7 years, 33 1/3% of the debentures will be repaid uniformly to all debenture holders in the 5th , 6th and 7th year. 2. Where the maturity period is from 8 to 12 years, 20% of the debentures will be repaid uniformly to al the debenture holders in the 8th, 9th, 10th, 11th, and 12th year. 8. The face value of each rights debentures will be Rs. 100 9. Rights debentures will be listed with the stock exchange. 10. The issuing company should be a listed company. Its equity shares must be quoted on the stock exchanges at or above par value in six months prior to the date of application for the issue. 11. Rights debentures shall first be offered to the existing Indian Shareholders of company on a pro-rata basis and there after must be kept open for at least two months. The un-subscribed debentures, if any, will be offered on a rational basis to (a) shareholders interested in taking up additional allotment, (b) the directors of the company, and (c) the employees and business associates of the company.
12. Allotment of Rights Debentures will be made only after a minimum subscription of 75% of the amount of debentures has been secured. 13. The company should ascertain beforehand the prospects of at least 75% of the issue being take up by the shareholders of the company and other categories of investors mentioned above.
Debentures unpopular in India
High Denomination – In India, debentures are usually of high denomination, as India investors prefer securities of low denomination, the moderate investors could not go in for them. 2. Managing Agency System – Indian industries were financed primarily by the managing agents who generally discouraged the issue of debentures for fear of loosing their financial importance. 3. Heavy Stamp Duty – Debentures have been a very costly source of finance with a heavy stamp duty of Rs. 15 for Rs. 1000 for bearer debentures and Rs. 7.50 per Rs. 1000 for registered debentures. This heavy stamp duty generally discourages the investors to invest funds in debentures. 4. Adverse Attitude of Banks – Banks and other financial institutions show an adverse attitude towards companies which issue debentures. Banks did not entertain the debentures even as collateral securities. Issuing Companies lose their credit in the eyes of banks and other financial institutions. 5. Limited Marketability – For debentures there is no developed, regular and steady capital market in India. To increase the marketability of industrial securities the Government of India have recognized many new stocks exchanges in different part of the country. 6. Adverse effect of Government securities – Government of India have issued so many securities with attractive conditions which have adversely affected the popularity of debentures in India. As compared to the industrial securities government securities are considerably safer. Institutions investors have to invest their funds in government securities as per statutory provisions. 7. Unattractive terms of issue – Terms of issue of debentures in India are not as attractive as they are in some other industrially developed countries. 8. Lack of Proper Advisory Agencies – There is a total lack of advisory agencies investment in India. Stock exchange services are confined to some big cities. Investment trusts and investment banks are not developed in India. Therefore the investor cannot judge where to invest the funds. 9. Lack of Interest to Industrial Investors – Institutional investors are statutorily required to invest a large part of their funds in government securities. For example, Indian Insurance Act 1939 prohibits investment in debentures by insurance companies in India. Even to day Life corporation invests its 80% of funds in government securities. Generally Indian banks do not invest in longterm corporate securities. Investment bank and investment trust have not developed much in India. Recently, Unit Trust of India as show some interest in corporate debentures.
10. Cautious Attitude of Indian Investors – Indian investors are very cautions about the safety of their investment. They do not wish to earn more at the cost of safety. Only safety of investment attracts them to invest funds in giltedged securities. 11. Preference for Government Savings – In recent years Indian government have initiated a number of attractive saving schemes and issued securities which carry income tax rebates and other benefits like withdrawals etc. Marginal investors prefer these schemes rather to invest funds in debentures. 12. Limited Control of Holders – Debenture holders are given limited controlling power in the day to day affairs of the company unless their interests are affected. They have no vice in policy decision of the company unless they affect their interest. Hence those who desire to have a voice in the affairs of the company prefer to invest their money in equity shares.
Debt Finance Against Equity Finance
Debt Financing is recommended against equity financing due to following reasons: 1. The rate of interest payable on long terms debt is lower than the normal rate of return. 2. The cost of debt-financing is always fixed. 3. The interest payable on debt is an admissible deduction for income-tax purposes which reduces tax liability of the corporation. 4. Debt carries flexibility in the capital structure of the company because it can be redeemed at any time at the sweet will of the company.
Following are the circumstances of accepting debt capital. (1) The sales and earnings are relatively small (2) The marginal cost of debt is less than the cost of equity as it lower the average cost of capital or trading. (3) The general price level is expected to be high, resulting in higher profits in future. (4) The existing debt-ratio is relatively low. (5) Price earnings ratio on equity shares is low in relation to the level of interest rates. (6) Retention of existing control pattern because debentures carry no voting rights.
(7) Terms of debt-agreement are not burdensome on the cash position of the company. (8) Terms and conditions of debt agreement are not onerous and prejudicial to the interest of the firm and its shareholders.
Depreciation as a source of finance
Depreciation means decrease in the value of assets due to wear and tear, lapse of time, obsolescence, exhaustion and accident. There is a lot of controversy among academicians and business executives regarding treatment of depreciation as a source of funds. People who oppose treating depreciation as a source of finance argue that funds are generated by operating profits and not by making provision for depreciation. If depreciation were really a source of finance by itself any enterprise could have improved its position at will by increasing the periodical depreciation charge. They further argue that the depreciation being a non-cash item of expense does not affect the working capital of the firm and as such not at all a source of finance. Validity of the above arguments cannot be questioned, but it can also not to be denied that as a non-cash expense, depreciation does not represent any cash outlay with the result that a part of the profits adjusted for depreciation can be used by management to increase any of the current assets or pay taxes, dividend etc. Depreciation may, therefore, can be taken as a source of funds in a limited sense because of the following reasons.(i) Depreciation finds its way into current assets through charging of overheads (including depreciation). The value of closing inventory may include depreciation of fixed assets as an element of cost. (ii) Depreciation does not generate funds but it definitely saves funds. For example, if the business had taken the fixed asset on hire, it would have been required to pay rent for them. Since, it owns fixed assets, it saves outflow of funds which would have otherwise gone out in the form of rent.
(iii) Depreciation reduces taxable income and, therefore, income-tax liability for the period is reduces. This will be clear with the following example: Case I Rs. 75,000 Nil. 75,000 37,500 37,500 37,500 Case II Rs. 75,000 15,000 60,000 30,000 30,000 45,000
Income before depreciation Depreciation Income Taxable Income Income Tax say at 50% Net Income after tax (B) Net Flow of funds after tax (A) + (B)
The above example shows that in Case II, the net flow of funds is more by Rs. 7,500 as compared to Case I. This is because on account of depreciation charge being claimed as in expense, tax liability has been reduced by Rs. 7,500 in Case II. It may, therefore, by said that true funds flow from depreciation is the opportunity of saving cash outflow through taxation.
Trade Credit
Trade credit is a form of short-term financing common to almost all types of business firms. As a matter of fact, it is the largest source of short-term funds. In an advanced economy, most buyers are not required to pay for goods on delivery. They are allowed a short-term credit period before payment is due. This credit may take the form of (a) An Open Account Credit Arrangement (b) Acceptance Credit Arrangement. In case of an Open Account Credit Arrangement, the buyer does not sign a formal debt instrument as an evidence of the amount due by him to the seller. While in case of an Acceptance Credit Arrangement the buyer accepts a bill of exchange or gives a promissory note for the amount due by him to the seller. Thus, it is an arrangement by which the indebtedness of the buyer is recognized formally. Trade Credit Arrangement is generally made available to the buyer on an informal basis without creating any charge on assets. Trade Credit Arrangement usually carry stipulation of allowing a cash discount to the buyer for prompt payment. The volume of trade credit and its popularity as a means of short-term financing depends on the following factors. (i) The terms of trade credit, (ii) Reputation of the purchasing firm, (iii) Financial position of the seller, and (iv) Volume of purchase to be made by the buyer.
Merits of trade credit
(i) The major merit of trade credit as a source of finance is its ready availability. (ii) Trade Credit is available on a continuing and informal basis. There is no need to arrange financing formally. In case, the firm is not taking cash discounts, additional credit is readily available by not paying existing trade creditors till the expiry of the credit period. There is no need to negative with the supplier. The decision is entirely up to the firm. (iii) There is no need of creating any sort of charge against firm’s assets for obtaining the trade credit. (iv) Trade Credit is a flexible means of financing since the firm does not have to sing a note, pledge securities or adhere to strict payment schedule. A seller views occasional late payment with a far less critical eye than a banker or any other lender.
Demerits of Trade Credit
(i) The cost of trade credit may be very high in case all factors are considered. The seller while fixing the selling price of his products to be sold on credit takes into account the interest, the risk and inconvenience attached with
supplying goods on credit. As a matter of a fact, many firms utilize other sources of short-term financing in order to enable them to take advantage of cash discount. (ii) Availability of liberal trade credit facilities may induce a firm to over trading which may later prove to be disastrous for the firm. The firm must balance the advantages of trade credit as a discretionary source of financing without any explicit cost against the cost of losing of cash discount, the possibility of deterioration in reputation, if trade credit is stretched beyond agreed limits and the increased purchase price of the product.
Term Loans
A term loan is a business loan with a maturity of more than one year. There are exceptions to the rule, but ordinarily term loans are retained by systemic repayments over the life of the loan. The primary lenders on term credit are Commercial banks, life insurance corporation, financial institutions, general insurance companies, investment trusts and state and central government. Commercial banks and various financial institutions constitute the hard core of term financing in India. Term lending business of Commercial banks is recent innovation in India specially after 1958. It was in the year of 1958 only when a formal scheme of term loans was started. But, now-a-days these banks provide a larger share of tem finance to Indian Industries.
Special features of term loans
1. Objective – The term loans are granted for one or more of the following objectives: (a) Establishment, renovation, expansion and modernization of industrial units. (b) For meeting the requirements of the core working capital.
(c) For retiring bonds in order to reduce interest costs or to redeem preference shares so as to substitute tax deductible interest payment for non-deductible dividends. 2. Security – Terms loans are usually secured. They have either a fixed or floating charge against the assets of the company. The lender bank usually prefers a first charge, however, in appropriate cases it accepts a second charge also. 3. Time period – The term loans are granted for a period ranging from 1 to 15 years but generally from 8 to 15 years. The repayment is made in installments typically designed to fit the project capacity of the borrower to pay. The repayment starts 2 or 3 years after sanctioning of loan. The lending institution requires payment only in accordance with the specified schedule so long the borrower carries out his commitments under the loan agreement. In case of default in such commitment, the agreement provides for accelerating of the maturity of the loan. 4. Formal agreement – The term loan is granted on the basis of a formal agreement. The agreement contains the terms of granting loan and provides for certain protective clauses for the benefit of the lender, e.g. limiting the dividend rate, the power to appoint directors, conversion of loan into share capital, etc. Then terms are settled through direct negotiation between the borrower and the lending institutions. 5. Participation basis- In case of term-loan being a substantial amount, different financial institutions participate in the credit on a syndicated basis. Such participation is done either because restrictions or for sharing the risk. The larger the loan, greater is the participation. 6. Introduces financial discipline – Term loans introduce a proper financial discipline in the borrower. He has to forecast reasonable accuracy cash flows so that he can repay loan and interest as per the agreed schedule. This makes necessary for the borrower to prepare a projected cash flow statement. 7. Refinance facility – Commercial banks are granted refinance facility from Industrial Development Bank of India on the terms loans granted by them. The risk, of course, continues of the lending commercial bank. 8. Project oriented approach – Financial institution engaged in term lending do not do security-oriented lending any longer. They have detailed app of each project and asserts its own merits. The loan is sanctioned only when the project satisfies their tests. 9. Special Conditions – In order to provide safeguards against time and cost overruns the loan agreements usually require the borrower to give undertaking in respect of the following matters : (i) (ii) (iii) No further long-term loan shall be taken The debt-equity ratio will not exceed the specified limit. Current ratio will be maintained at the desired level.
(iv) Selling commission sole selling agent shall not be disbursed unless interest and installments of loans are paid.
(v) rate.
Dividend shall not be declared for a specific period or shall not exceed the agreed
(vi) Financial data and other information as required by the lending institution will be supplied as and when desired. (vii) The directors will furnish personal guarantees for repayment of the loan in addition to the financial institution’s charge on firm’s assets.
Credit Rating Information & Services of India (CRISIL)
(a) The Credit Rating Information & Services of India Limited (CRISIL) was set up by the financial institution on January 19, 1998, to facilitate the processing of proposals and giving of approvals by the SEBI for companies going to the public for raising funds through issue of securities. Share Capital : CRISIL has a capital base of Rs. 4 crores. Functions: CRISIL has proved to be a boon to both companies and investors through its following functions: (i) It provides an independent and unbiased report about the creditworthiness of company. Thus, it enables it to mobilize directly savings from individuals at reasonable cost. (ii) It provides reliable financial information and increased disclosure to investors. Thus, it enables them to buy securities with confidence.
Working: At present CRISIL is restricting its rating only to debt instruments, viz., fixed deposits, debentures, and debenture portion of equity linked debentures. There is no compulsion for any company to obtain or publicize the rating obtained from CRISIL. However, once credit rating is made compulsory by the Government. CRISIL is planning to undertake credit rating of all types of securities. CRISIL has to evaluate and monitor the performance of a company through use of qualitative as well as quantitative criteria for evaluation. The qualitative criteria include the company’s competitive position, its strengths and weakness, its management and business strategies, etc. while the quantitative criteria include the financial statements the accounting ratios, the cash flow and funds flow statements of the company concerned.
Progress of CRISIL, Since its inception till March 31, 1996, CRISIL has so far completed rating of 1,736 issues consisting of various types of debt Rs. 1,14,873 crores. Some of the companies which have used CRISIL rating are Indian Petro Chemicals Limited (IPCL), Sundaram Fiannce Limited (SFL), Mahindra Engine Steel Company Limited, Mukand Oil & Steel works Limited, Kirloskar Bros. Limited, Municipal Bonds of Ahmedabad Municipal Corporation etc. During the year 1992-94 CRISIL launched the RATINGDIGEST, which is a compilation in five volumes of CRISIL Rating Reports organized by industries categories. In 1995 – 96 it introduced CRISIL – 500 Equity Index. Credit rating analysis is relatively, new development in India. It is expected that establishment of CRISIL, will provide a strong impetus to the systematic risk evaluation of specified corporate instruments as well as the companies issuing them.
(a) ICRA Ltd. ICRA formally known as the investment Information & Credit Rating Agency of India (ICRA) was promoted by the Industrial Finance Corporation of India (IFCI). It was incorporated on Jan. 16, 1991 as public limited company and started functioning with effect from September 1, 1991. The ICRA also performs credit rating functions and finalizes its rating norms and standards in consultation with Credit Rating Information & Services of India Ltd. (CRISIL) ICR A has an authorized Capital of Rs. 10 crores. Industrial Finance Corporation of India (IFCI), Unit Trust of India, Life Insurance Corporation of India, General Insurance Corporation of India, Housing Development Finance Corporation of India, Infrastructure Leasing and Financial Services, State Bank of India, and 17 commercial banks are its shareholders.
Progress of ICRA, Since its inception till end of March, 1996 ICRA has rated 778 debt instruments involving an amount of Rs. 93,380. The Government has already announced compulsory rating for all debentures end bonds expect the following :
1. Issue of non-convertible debentures upto Rs. 5 crores on private placement basis including with mutual funds. 2. All issues of fully convertible into equity shares within 18 months from the date of issue at per determined price. 3. Public sector bonds and private placement of debentures with financial institutions – banks.
Exam Tips Formula & Proforma Sheet Sub – Financial Management Chapter 1 Working Capital Format of Working Capital Particulars Current AssetsStockRaw Material (At R.M. cost) Work in Progress Raw Material [100%] ×× Labour [50%] Amount Amount ××
×× ××
×× Overheads [50%] ×× Finished Goods (Total Cost) Debtors [At Selling Price] Cash/Bank [Given] Prepaid Expenses [Given] Total Current Assets (A) ×× ×× ×× ××
Current Liabilities Creditors [R.M. Cost] Outstanding Wages [Labour Cost] Outstanding Overheads [O/H Cost] Total Current Liabilities (B)
×× ×× ×× ×× ××
Working Capital
Tips
•
For above all the common formula is Quantity × Rate × Period
• • • •
Period given in terms of months weekly or daily For monthly take 12 months weekly either 52 weeks or 50 weeks and for daily 365 or 360 days For domestic and expert type of sums the closing stock should be on total cost of goods sold Other things are one and the same.
Chapter 2 Income Statement
Income Statement Sales Less: Variable Cost Contribution Less: Fixed Cost EBIT Less: Tax EAT
×× ×× ×× ×× ×× ×× ××
•
Formulas Operating Leverage or Degree of operating leverage = Contribution/EBIT
•
Financial Leverage or Degree of financial leverage = EBIT/ EBT
•
Earning Per Share = EAT – Preference Dividend /No. of Equity Shares
• •
P/V Ratio = Contribution/Sales × 100 Debt Equity Ratio = Long Term Debt/Equity
•
Combined Leverage = Contribution / EBT = Operating Leverage × Financial Leverage
or
•
Asset Turnover = Sales/Total Assets Tips
• • •
Variable cost always in terms of % on sales If P/V ratio is 70% i.e. sales Rs. 100/- contribution Rs. 70/- and variable cost Rs. 30/-. Interest on loan means debentures & other loan funds.
•
Fixed cost always remains the same.
Chapter 3 Receivables Management Formats A. When Fixed cost is given
Particulars SalesLess:Variables CostContribution Less: Fixed Cost Profits (A) Total Cost = FC + VC Investment in Receivables Cost Opportunity CostBad Debts Other Costs Total Cost (B) Net Benefit (A – B) Incremental Benefits
Existing ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× -
OP – I ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ××
OP – II ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ××
Tips
• • • •
The incremental benefits more option is to be selected Investment in receivables is to be calculated on total cost (FC + VC) Opportunity cost is to be calculated on investment in receivables. Bad Debts is to be calculated on total sales.
B.
When Fixed Cost is not given Particulars Existing SalesLess: Variable ×× CostContribution (A) ×× ××
OP – I ×× ×× ××
OP – II ×× ×× ××
Investment in Receivables Cost ×× Opportunity CostBad DebtsOther Costs Total Cost (B) Net Benefits (A – B) Incremental Benefits ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ××
Tips
• • •
Investments in receivables is to be calculated on sales Opportunity cost is to be calculated in investment in receivables Remaining things are one and the same.
Chapter 4 Cost of Capital
Formula
Cost of Debt: Kd = I (1 – t) Tax = t Cost of Equity Ke = (D × 100) + g P
Cost = K Interest = I
Dividend = d Market Price = P Growth Rate = g
Cost of Performance always the given rate because it is always after tax. Statement of WACC Amount ×× Proportion Cost of capital ××% Ke WACC ××
Equity
Given Preference Loan ×× ×× ×× ××% ××% 100% Kd ×× ×× ××
WACC = Proportion Cost of Capital 100
Further Formula
• •
EPS = EAT – Preference Dividend/No. of Equity Shares Debt/Equity Ratio = Long Term Debt/Equity
Chapter 5 Capital Structure Planning
There are two formats
• •
Capital Structure EPS
The plan (option ) having highest EPS is going to be selected for the purpose of investment.
•
Proforma of Capital Structure Particulars Equity Share CapitalExisting (if given) New Preference Capital Existing (if given) I ×× ×× ×× ×× II ×× ×× ×× ×× III ×× ×× ×× ××
New Debentures Existing (if given) New Retained Earnings (if given) Total No. of Equity Shares (B) ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ×× ××
•
Proforma of E.P.S. Particulars EBITLess: Interest on Loans EBT Less: Tax EAT Less: Preference Dividend Earnings available for Equity Holders (A) I II III
EPS = A/BD.P.S. = E.P.S. × Dividend Payout
×× ×× ×× ×× ×× ×× ×× ×× ××
×× ×× ×× ×× ×× ×× ×× ×× ××
×× ×× ×× ×× ×× ×× ×× ×× ××
Tips
• • • •
If statement of capital structure is given no need to prepare. Dividend payout is given find D.P.S. only For indifference point equate two E.P.S. for two different plan. For Break even point take E.P.S. zero & apply reverse way to calculate EBIT.
Chapter 6 Cash Management Format Particulars Opening BalanceReceipts Cash Sales (working notes) Collection from Debtors (Working Notes) Deferred Receipts Total Receipts PaymentsPayments to creditors Payments of Expenses Other payment Total Payment Balance (Receipts – Payments) I II III
×× ×× ×× ×× ×× ××
×× ×× ×× ×× ×× ××
×× ×× ×× ×× ×× ××
×× ×× ×× ×× ××
×× ×× ×× ×× ××
×× ×× ×× ×× ××
Tips
• • • • •
Closing balance of one month become opening of other month. Following subsequent, next and forward means one and the same. Arrears outstanding means one and the same i.e. in next month. Temporary loan is to be paid in next possible option. Existing notes to be prepare wherever required. Chapter 7 Capital Budgeting Decision Criteria Pay Back Period Net Present Value Profitability Index A.R.R. Payback Profitability
I.R.R. Discounted Payback
Formulas Payback Period Method a. If cash flows are not same = No. of years + Required Amount × 12 Next Inflow b. If cash flows are same for all years Payback Period = Cost of Project / Initial outlay 1 year’s inflow Net present value = Present value of Inflow – Initial Outlay Profitability Index or Benefit Cost Ratio = Present value of Inflow Initial Outlay A.R.R. a. Accounting Rate of Returns or A.R.R. (based on original investment) = Average Annual PAT × 100 Original Investment b. Average Rate of Returns or A.R.R. ( based on Average Investment) = Average Investment [Original Investment (if scrap is not given)] 2 OR = Original Investment – Scrap + Scrap + Working Capital (if any) 2 Payback Profitability = Average Annual Cash Inflow [ Estimated Life – Payback Period] Internal Rate of Return = L.R. + P.V. at L.R. – Initial Outlay × Difference in Rates
P.V. at L.R. – P.V. at H.R. L.R. = Lower Rate H.R. = Higher Rate P.V. = Present Value
Discounted Payback = No. of years + Required Amount × 12 Next year’s P.V.
Tips The project cost, initial outlay, investment all are one and the same PBDT = Profit Before Depreciation & Tax CFBDT = Cash Flow Before Depreciation & Tax = PBDT CFAT = Cash Flow After Tax & Depreciation = PAT Cash Flows = Cash inflows = PAT + Depreciation PAT + Depreciation also called as Profit After Tax But Before Depreciation If sales & other costs are given then PBDT is to be calculated as under PBDT = Sales – Variable Cost – Fixed Cost – Other Costs (Excluding Depreciation) To calculate Depreciation the formula is Depreciation = Original Cost – Estimated Scrap Estimated Life If estimated life is not given then depreciation rate is given and accordingly decide the estimated life.
e.g. If 10% given the life is 10 years If 25% given the life is 5 years If working capital given along with scrap or salvage value then both working capital & scrap added to last year’s inflow & last year’s P.V. factor us applied to both. For NPV calculation the working capital should be added to the initial outlay. If present value factor is not given assumed to be 10%. Mostly taxes is given, but if not given then in the question they mention about assumption & then put assumption and take tax 50% but if nothing is given then ignore taxation. Payback period in years & months or only in terms of years also be calculated.
Hey ya! Here are some tips to crack a practical subject like FM. To do anything practically, you need to understand the main concept and why is it learnt.. then only you would be able to solve the sums. Let me give a brief overview of Financial ManagementFinance is the backbone of every business. It’s management is necessary for the smooth functioning of all the activities. It is to be studied to know the basis of managing finance in real terms of the world. ¬ Working Capital ManagementWorking Capital Management refers to Current Assets – Current Liabilities. In other words, Working capital means the difference of what we are about to receive or
received in short term and what we are supposed to pay in short term. It normally comprises of sums for calculation of increase or decrease in working capital. ¬ Cash managementCash management implies management of cash flow in the business on daily basis. It represents the outflow and inflow of cash by various operations. Cash management generally involves sums where there is calculation of cash outflow and cash inflow. ¬ Cash BudgetIt refers to an estimate of cash expenses and incomes through a quarter or six months. Here all the expenses and incomes are put in the form of a budget and the closing balance of one month becomes the opening balance of another month. Cash budget is necessary in order to set the insight into the cash outflow and inflow in a particular month and accordingly preparing a budget of it so that it can be used in planning and controlling the expenditure over and above the required limits. ¬ Capital Budget – Capital Budgeting mainly aims at estimating the returns that we get on a particular investment. It involves the calculation of payback period, net present value, profitability index, internal rate of return and so on. All this ultimately refers to the returns received on a particular investment in a project or purchase of machinery which is over a period of years. ¬ Business restructuringIt normally refers to restructuring of business either internally or externally. Internally reconstructing business involves the management of liabilities and assets and accordingly bringing the business to a better position. It involves reducing the paid up value of shares, reducing the claims of outside liabilities, writing off the fictitious assets and many other entries that are done to manage the liabilities in such a way that the business is back on track. It is normally done when the business is running in severe losses and is almost in the state of getting liquidated or sells off. Question Paper Pattern-(subject to changes) Section I Q. 1) Concepts – 12 marks (4 concepts for 3 marks, explain in atleast 3/4th page) Q.2) Case studies – 18 marks (2 cases for 9 marks or 1 case for 18 marks) Section II – 30 marks (includes sums and long answers) (Long answers can be 3 pages) Be clear with the concepts, maximum practice required for practical sums and proper working note in detail should be done. First basically read the problem in detail and then go for attempting it. Every detail should be kept in mind
before solving the sum. Formula should be understood and known where to apply. Make a list of formulas and keep on reading it before the exams. Recheck the mathematical calculations again as if 1 step goes wrong, the whole sum goes wrong. Steps do contain marks. So solve the sum properly and neatly. Underline or make a box of the final answer you got. Theory questions should be precise and should contain maximum points. It can be 2-3 pages (as u wish). But more than the quantity, quality matters. So, make sure you write answers in point-form and underline the important words.
CHAPTER I INTRODUCTION TO FINANCIAL MANAGEMENT
Definitions : F.W.Paish –“In a modern money using economy finance may defined as the provision of money at the time it is wanted .”—- Procurement View . John J Hampton—“The term finance can be defined as the management of the flows of money through an organization, whether it will be a corporation , school, bank or a govt. agency.”—Custodian Function. Howard and Upton —“Finance may be defined as that administrative area or set of administrative functions in an organization which relate with the
arrangement of cash and credit so that the organization may have the means to carry out its objectives as satisfactorily as possible.” Functions of Finance — three major decisions 1) Investment Decision—Capital Budgeting. 2) Financing Decision—Procuring Owned & Borrowed Capital 3) Dividend Decision— Profits-> Dividends and Retained Earnings Scope of FM 1) Estimating requirements of funds 2) Decision regarding capital structure 3) Investment Decision 4) Dividend Decision 5) Cash Mgt. 6) Evaluation of Financial Performance 7) Negotiation for additional funds Objectives/Goals of FM Fundamental objective is WEALTH MAXIMISATION. Objectives which lead to Wealth Maximisation a) Proper Utilisation of Funds b) Maximisation of ROI c) Survival d) Achieving BEP e) Managing Cash Flows f) Minimum Profits—Peter Drucker—“Profit is a condition of survival.” g) Coordination amongst different depts.-Prodcn., Sales, Finanace etc h) Good Image of Orgn. in market & Public
Two Approaches for attaining Objectives/Goals of FM A) Profit Maximisation Approach B) Wealth Maximisation Approach Changing Role of Finance Managers Traditional role of Finance Managers was concerned only with raising funds for the organization. In the Modern times role of FM includes a) Determining the requirement of funds for the orgn.
b) Determining Capital Structure –Owned Funds and Borrowed funds c) Raising Funds at minimum cost and restrictive conditions. d) Optimum utilization of funds e) Financial solvency to be ensured at all cost. f) Allocating the funds to different departments g) Allocating funds between Fixed assets and Working Capital Types of Risks (FM has to deal with) 1) Credit /Default risk- possibility that debtor will default 2) Interest Rate risk- change in bank deposit/loan rates 3) Business risk- failure of business due to controllable/uncontrollable factors 4) Inflation risk- Decrase in purchasing of money 5) Industry risk- failure of the related industry 6) Liquidity risk- inability to convert investment into cash 7) Systematic/undiversifiable risk- arising from external uncontrollable factors like political,economic etc. 8) Unsystematic/diversifiable risk- arising from internal controllable factors like plant breakdown/labour strike etc. CHAPTER II WORKING CAPITAL MANAGEMENT Definition : Gerestenberg—“ Circulating capital means current assets of a company that are changed in the ordinary course of business from one form to another,as from cash to inventories, inventories to receivables and receivables to cash.” Components of Working Capital Current Assets = Stock of raw material , Work in process , Finished goods , spares and consumable stores , sundry debtors , bills receivable , cash balance , bank balance ,prepaid expenses , accrued income , advance payments , short term investments , marketable investments . Current Liabilities = Sundry creditors , Bank Overdraft , bills payable , outstanding expenses , proposed dividend , provision for tax , income received in advance .
Types of Working Capital A) a)Gross Working Capital = Total Current Assets b)Net Working Capital = Total Current Assets - Total Current Liabilities B) a)Positive Working Capital – when CA > CL b)Negative Working Capital — when CA < CL c)Zero Working Capital – when CA = CL C) a)Permanent Working Capital— stays continuously /permanently in business Types 1)Initial Working Capital – inception/beginning of business 2) Regular Working Capital – Minimum W Cap for normal business b)Variable Working Capital— varying WCap Types 1) Seasonal Working Capital – according to season, 2) Special Working Capital – unforeseen events like strike, large contracts & 3) Peak Working Capital – Highest WCap required during operations. D) E) Balance Sheet Working Capital – asper Balance Sheet at the year end. Cash Working Capital—operational inflows & outflows of cash
Factors determining Working Capital a) Nature of business b) Size of business c) Production period d) Stocking requirements for raw material & Finished goods e) Credit available from suppliers of goods and services f) Credit to be given to customers g) Production policies h) Inventories Turnover i) Inflation j) Technology—labour oriented/technology oriented k) Taxation Policies—High tax rates=more W Cap. l) Expanding business=more business
W. Cap.Management involves -Cash Mgt. -Receivables Mgt. -Inventory Mgt. -Creditors Mgt. Aim of W. Cap.Management=Reducing investment in W.Cap. + Reducing Operating Cycle Duration Maximum Permissible Bank Finance (MPBF) RBI appointed Tandon Committee and Chore Committee recommended that business enterprises should improve their liquidity position and strive to achieve Current Ratio of 2:1. Calculation of MPBF a) Low Risk Category of Borrowers— MPBF = 0.75 (CA-CL) b) Medium Risk Category of Borrowers—MPBF = 0.75CA - CL c) High Risk Category of Borrowers— MPBF = 0.75(CA-CCA) – CL CCA= Core Current Assets Core Current Assets mean minimum permanent level of current assets to be maintained by an enterprise so long as it is a going concern . Such core current assets assure uninterrupted production. Core current Assets should be financed from long term funds / owned funds.
Sales Less: Raw Material Wages Variable Overheads
WORKING CAPITAL CALCULATION A) Current Assets 1) Stock of Raw Material (1mth) = Annual Raw mat X 2/12mth 2) Stock of WIP (1.5 mth) R Mat–Annual Raw mat X 1.5/12mth +Labour — Annual Labour X 1.5/12mth X 1/2 +Expenses — Annual Expenses X 1.5/12mth X 1/2 3) Stock of Finished goods (2.5 mth) = Total Annual Cost of Prodn. X 2.5/12mth 4) Bills Receivable (3mth) = Credit Sales X 3/12 mth 5) Debtors ( 2mth) = Credit Sales X 2/12 mth 6) Advance for Raw Material(Adv. To creditors) (0.5mth)= Annual Raw mat X 0.5/12mth 7) Advance Fixed Overheads (1.2mth) = Annual Fixed Overheads X 1.2/12mth 8) Prepaid Expenses(1mth) = Annual Expenses X 1/12 mth 9) Cash & Bank Balance Total Current Assets (CA)
Less: Current Liabilities 1) Creditors for Materials (1mth) = Annual Raw mat X
1/12mth
2)Outstanding Wages (1mth) = = Annual Labour charges X 1/12mth 3) Bills Payable(2mth) = Credit Purchases X 2/12mth Total Current Liabilities (CL) Working Capital ( CA - CL )
Eg.—1)Cash balance is 30% of monthly Profit—then prepare cost structure. Find Annual profit (profit per unit X units produced) .Find 30% of Annual profit. 2) If inland & export Sales given calculate Debtors for inland & export Sales separately. 4) Cost W. Cap–àCalculate Debtors and Bill Receivables on Total cost instead of Credit sales. 5) Cash Cost W.Cap.-> Calculate stock of WIP & Finished goods and Debtors and Bill Receivables at Cash Cost ( Total Cost other than Depreciation)
Working Capital Cycle/Operating Cycle A continuous process starting from payment of cash for purchasing raw material , production , stocking , selling until obtaining money from debtors. It is a cycle involving—- conversion of cash into raw material > conversion of raw material into WIP > conversion of WIP into Finished goods> conversion of Finished goods into cash /debtors and > conversion of debtors into cash. OC = R+W+F+D-C Ie. Duration of Operating Cycle = Raw mat. period+WIP period +Finished goods period +Debtors collection period –Creditors payment period
CALCULATION OF W. CAP . CYCLE i) Raw Mat. Stock Holding Period = R.Mat. Stock X 365 days Annual Purchases + ii) WIP duration = WIP stock X 365 days Cost of Prodn. +
iii) Finished Goods Stock Holding Period = Finished Goods Stock X 365 days Cost of Goods Sold + iv) Debtors Collection Period = Debtors X 365 days Credit Sales LESS : i) Creditors Payment Period = Creditors X 365 days Credit Purchases
CHAPTER III RECEIVABLES MANAGEMENT
Receivables include Debtors and Bills Receivables. Increase in Receivables ( more credit period) will lead to increase in sales and profits but it will also lead to increase in risk of bad debts. Receivables Management—Definition Management of debtors and bills receivables involves determining the appropriate credit period extended to debtors in such a manner that sales are maximized and yet minimum funds are blocked in debtors and bad debts are minimized. Importance of Receivables Management Right receivables management leads to following benefits : a) Increase in sales b) Minimum funds blocked in receivables/Capital Cost c) Tight recovery system/ controlled delinquency cost d) Minimum bad debts/default cost e) Minimum Collection Cost
Costs associated with A/cs. Receivables 1) Collection Costs—exp. of admn., collecting credit info. 2) Capital Cost—Cost of Funds blocked in Receivables 3) Delinquency Cost—Legal charges addnl. Collection costs 4) Default Cost—Bad Debts
Steps in Credit Appraisal 1) Customer Evaluation—Character+Capacity+Capital+Collateral Security+Conditions (economic) 2) Financial Stmts. of Customers 3) Bank references 4) Trade References 5) Credit Bureaus 6) Bank & Third Party Guarantees 7) Field Visits Collection Methods a) Centralised Collection System b) Decentralised Collection System c) Post dated cheques d) Pay order/bank draft e) Bills of exchange f) Lock Box System g) Drop –box System h) Collection Staff i) Debt Collector j) Del Credere Agent— collection of debts + assumes risk of bad debts gets additional commission. k) Concentration Banking l) Factoring
Control of Receivables 1) Days Sales Outstanding (DSO) DSO= Debtors + Bills Receivable days Average Daily Sales:
2)
Ageing Schedule Debtors are classified into different age brackets.
3) ABC Analysis Classification of Debtors into A Category, B Category and C Category A Category—Small no. of debtors but of large values—Highest Control B Category— Moderate no. of debtors and of moderate values— - Moderate Control C Category— Large no. of debtors but of small values - Less Control Credit Analysis Involves evaluating capacity of customers requiring credit period. Criteria of measuring creditworthiness of prospective customers : 2) Character of customer 3) Capacity to repay 4) Capital / financial position of customer 5) Collateral Security provided by customer 6) Conditions (Economic, Social , competition etc.) Opportunity Cost Opportunity/profit foregone(givenup) as a result of blocking the money in Debtors instead of investing it in other manner.
Credit Policy Variables Determining Credit Policy involves determining the following variables: a) Credit evaluation and Credit Rating of customers b) Costs associated with accounts receivables- Collection cost , Capital cost , Delinquency cost and Default cost . c) Collection methods of receivables d) Control of Receivables through – Days Sales Outstanding ,Ageing Schedule and ABC Analysis
Evaluation of credit Policies Example : -Current Sales 10 lakh, shall increase by 200000 in option 1 , by 300000 in option 2 . —Variable cost are 35% of Sales. Fixed cost are Rs 200000 . -Existing credit period is 2 mth, option 1 is 2.5 mth. and option 2 is 3 mth. -Credit Sales are 80% of total Sales. -Required rate of return is 12%. -Existing Bad debt loss is 2% , option 1 is 3% and option 2 is 4%. -Collection cost is 3% of debtors .
Particulars Credit Period Sales Less:Variable Cost Contribution(S-V) Less: Fixed Cost PROFIT(BENEFIT)
Present Policy Option 1 Option 2 2 mth. 2.5 mth. 3 mth 10,00,000 12,00,000 13,00,000 3,50,000 4,20,000 4,55,000 6,50,000 7,80,000 8,45,000 2,00,000 2,00,000 2,00,000 4,50,000 5,80,000 6,45,000
TotalCost=FC+VC 5,50,000 6,20,000 6,55,000 Average Invt.in Debtors= Total Cost XCreditsales X Total Sales 6,20,000 X Debtor Period mth 5,50,000 X 80% 80% X 12 mths X 2/12mth 2.5/12mth 6,55,000 X 80% X =73333 =103333 3/12 mth. = 131000 COST a) Opportunity cost of capital= eg. 12% x 73333 X 12% 103333 X Avg.Invt.in Debtor = 8800 12% = 12400 131000 X 12% = 15720 b) Bad debt cost= 10,00,000 X 2% 12,00,000 X 13,00,000 X 4% = eg.Bad debt % x Sales =20,000 3% = 36,000 52,000 c) Collection Cost = 3% (10,00,000 X (12,00,000 (13,00,000 X
x Debtors TOTAL COST NET BENEFITS(Profit – Total Cost) RATING
X2.5 /12 mth)X 2/12mth) X 3% 3/12mth) X 3% 3% = 5000 = 7500 = 9,750 33,800 55,900 77,470 4,16,200 III 5,24,100 II 5,67,530 I
Formulae a) If P/V Ratio is given find
— Contribution = Sales X P/V ratio.
b) If Debtors Turnover ratio is given — Debtors = Credit sales Debtors Turnover ratio
c) Debtors Velocity = Debtors Turnover ratio
12 mths.
CHAPTER IV CASH MANAGEMENT Cash in a broader sense includes coins, currency notes, cheques , bank drafts and also marketable securities and time deposits with banks. Objectives of Cash Management a) To meet payment needs of trading & business activities. b) To minimize idle funds c) To avoid cash crunch d) To maintain liquidity
e) To make payments to creditors and suppliers on time.
MOTIVES for holding Cash 1) Transaction Motive – for routine business/ operating payments 2) Precautionary Motive — to provide for unexpected/ unpredictable events like strike, flood, increase in raw material cost etc. 3) Speculative Motive — to take advantage of unexpected opportunities like favourable/ reduced prices of material , discount for bulk purchases etc. 4) Compensating Motive – Minimum balance is required to be maintained with the banks for various services provided by them.
CASH MANAGEMENT MODELS 1) Baumol’s Model –Baumol (1952) Cash can be managed in the same manner as inventory using Economic Order Quantity Model (EOQ model) .
C = ?2FT I C = Optimal Transaction size F = Fixed Cost per transaction T = Expected cash payments during the period I = Interest rate on Marketable Securities
2) Miller - Orr Model (1966) ( Stochastic Model ) Specifies two control limits
Upper Control Limit- When cash touches UCL marketable securities are purchased. Lower Control Limit- When cash touches LCL marketable securities are sold.
CASH CYCLE Involves Two Cycles—Disbursement Cycle and Receipt Cycle a) Disbursement Cycle—Total time between obligation to pay supplier arises and upto when payment clears the bank. To be maximized. Three Floats should be maximized to postpone payment Mail Float- Time spent in mail Clearance Float- Time spent for clearing payment through bank Processing Float – Time required for processing payment transaction.
b) Receipt Cycle—- Total time between products or services are provided and upto when payment from customer clears the bank.
Cash Budget Definition A Statement showing expected receipts and payments (of both trading and capital nature) over a period of time , prepared with the intention of planning and controlling the use of cash. Preparation of Cash Budget
Particulars Opening Balance RECEIPTS 1) Cash Sales 2)Receipts from Debtorsafter one mth.
Jan. 2010
Feb. 2010
Mar. 2010
80000
-after 2 mths. 3) Income from4) Invt. 4) Total Receipts PAYMENTS 1) Cash Purchases 2) Payment to Creditors 3) Payment of Wages Total Payments Closing Balance
48000
72000
Eg. 1) Total Sales of Jan 2010 are 400000. 20% Cash Sales. 40% of credit sales are paid in next month and balance in second month. -à It means 80000 are cash sales received in Jan.2010 & 120000 credit sales. Of 120000, 40% ie. 48000 shall be received in Feb.2010 and balance 72000 in March 2010 2) If specifically given closing cash balance is to be maintained every month.
à Take it as closing cash balance and balancing figure should be taken as payment to debtor in that month.
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