FINANCIAL MANAGEMENT - I

Sub Code - 736

Developed by
Prof. Abasaheb Chavan

On behalf of
Prin. L.N. Welingkar Institute of Management Development & Research
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Group Director Chancellor, D.Y. Patil University, Former Vice-Chancellor Former Director
Welingkar Institute of Navi Mumbai (Mumbai University) (YCMOU)
Management Ex Vice-Chancellor (YCMOU)

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Dean – Marketing Faculty – Travel and Tourism
Welingkar Institute of Management, Mumbai Management Consultant

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Welingkar Institute of Management, Mumbai Founder of EVALUENZ

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Dean – Management Development Programs Faculty – Rural Management
Welingkar Institute of Management, Mumbai Welingkar Institute of Management, Mumbai

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Director – Intraspect Development Faculty – Healthcare Management
Manager Medical – Air India Ltd.

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Welingkar Institute of Management, Mumbai Former Manager-Catering Services – Air India Ltd.

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Welingkar Institute of Management, Mumbai Publisher
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Welingkar Institute of Management, Mumbai Head – PGDM (HB)
Welingkar Institute of Management, Mumbai

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Dean – Banking Manager – PGDM (HB)
Welingkar Institute of Management, Mumbai Welingkar Institute of Management, Mumbai

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1st Edition, December 2021

 ABOUT THE AUTHOR

ABOUT THE AUTHOR

Mr. Abasaheb Chavan is a professional Banker. He is a postgraduate in

Science and certified Associate of Indian Institute of Banking and Finance
(CAIIB). He has more than 37 years banking work experience, out of which
23 years with one of Best performing Public Sector Bank, 12 years with
India's First Private sector Bank. Since last 2 years he is working for one of
the best performing Private sector Bank, Heading International Trade
Finance Compliance, Advisory and Regulatory Department. During all these
years he had practically handled almost all the segment of banking wherein
he was responsible for Retail credit, Corporate credit, Trade Services
operations, preparation of policies and issuance of procedural guidelines on
Bullion (Gold) Import Business – for Corporate and Retail clients. His areas
of expertise are: Import and Export (Banking Perspective) and Advisor to
corporate on Complex Matters on international trade, Expert and advisor in
formation of policies, procedures, implementation of exchange houses for
foreign inward remittance business from GCC countries, Hong Kong and
Singapore (Rupee Drawing Arrangement–RDA), Expert advisor for Money
Transfer (MTSS) Business set up and implementation, product
development for NRI Business, Expert advisors for ECB (External
Commercial Borrowing), Investment advisor for capital account transaction
viz. Foreign Direct Investment in India (FDI), Overseas Direct Investment
(ODI) in Joint Ventures (JV) and Wholly Owned Subsidiary (WOS), Advisor
for Opening and main tenance of offices abroad by Indian Entities, Advisor
for Opening and maintenance of offices in India by overseas entities such
as Liaison Office (LO), Branch Office (BO), Project Office (PO), Advisor for
Project export. He is also a professional trainer and providing training to
Bank Employees at various levels on various topics under trade finance. He
was Executive Committee Member of ICC (International Chamber of
Commerce, Paris), Delhi; He was Managing Committee Member of FEDAI
(Foreign Exchange Dealers Association of India, Mumbai); Examiner for
IIBF (Indian Institute of Banking and Finance) Foreign Exchange and Risk
Management and a Nodal Officer to Reserve Bank of India – Compliance
and Regulatory matters. Currently he is a Technical Committee Member of
FEDAI on Trade and Remittances.

3
 CONTENTS

Contents

Chapter No. Chapter Name Page No.

1 Features of Financial Management 5-27

2 Relevance and Significance of Financial 28-46
Management
3 Goals and Objectives 47-65
4 Reporting Financial Results 66-117
5 Financial Analysis for Management Decisions 118-151
6 Management of Working Capital 152-184
7 Management of Trade Receivables 185-212
8 Management of Inventory 213-256
9 Financial and Operating Leverage 257-286
10 Common and Preferred Stocks 287-316
11 Debentures 317-339
12 Capital Structure – Equity vs. Debt 340-361
13 Dividend Policy and Decisions 362-395
14 Foreign Exchange Market 396-425
15 Short Term Financial Market 426-443
16 Long Term Financial Market 444-476

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 FEATURES OF FINANCIAL MANAGEMENT

Chapter 1
Features of Financial Management

Objectives
After studying this chapter, you should be able to understand:
• The role of chief finance officer in firm’s management
• Business strategy that lays down firm’s goals and objectives
• Capital plan for long-term funds required for acquisition of assets
• Finance plan to meet requirement of funds
• Financing of day-to-day business operations
• Financial management in:
❖ Sole Proprietor Firm
❖ Partnership Firm
❖ Company

Structure:
1.1 Introduction
1.2 Discipline of Financial Management
1.3 Financial Management in Business Organizations
1.4 Requirements of Long-term Funds for the Organization
1.5 Capital Structure to Implement Business Strategy
1.6 Management of Capital for Current Operations
1.7 Financial Management in Different Forms of Organizations
1.8 Summary
1.9 Multiple Choice Questions

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 FEATURES OF FINANCIAL MANAGEMENT

1.1 INTRODUCTION
The present age is the age of industrialization. Large industries are being
established in every country. It is very necessary to arrange finance for
building, plant and working capital, etc. for the established of these
industries. How much of capital will be required, from what sources this
much of finance will be collected and how will it be invested, is the matter
of financial management.

Financial management is that managerial activity which is

concerned with the planning and controlling of the firm’s financial
resources. It was a branch of economics till 1890, and as a separate
discipline, it is of recent origin. Still, it has no unique body of knowledge of
its own, and draws heavily on economics for its theoretical concepts even
today.

In general financial management is the effective & efficient utilization of

financial resources. It means creating balance among financial planning,
procurement of funds, profit administration & sources of funds.

Following are the main characteristics of the financial management-

• Analytical Thinking: Under financial management financial problems
are analysed and considered. Study of trend of actual figures is made
and ratio analysis is done.
• Continuous Process: Previously financial management was required
rarely but now the financial manager remains busy throughout the year.
• Basis of Managerial Decisions: All managerial decisions relating to
finance are taken after considering the report prepared by the finance
manager. The financial management is the base of managerial decisions.
• Maintaining Balance between Risk and Profitability: Larger the risk
in the business larger is the expectation of profits. Financial management
maintains balance between the risk and profitability.
• Coordination between Process: There is always a coordination
between various processed of the business.
• Centralized Nature: Financial management is of a centralized nature.
Other activities can be decentralized but there is only one department for
financial management.

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 FEATURES OF FINANCIAL MANAGEMENT

1.2 DISCIPLINE OF FINANCIAL MANAGEMENT

Financial management is an integral part of overall management. It is

concerned with the duties and responsibilities of the financial managers in
the business firm.

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FINANCIAL
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Financial management “is the

operational activity of a business that
is responsible for obtaining and
effectively utilizing the funds
necessary for efficient operations.

The field of Financial Management is a branch of economics that makes

best use of accounting. Anybody engaged in this subject, therefore, has to
have command over economics as well as accounting. In olden days, the
position of Chief Finance Officer of the entity was known as Chief
Accountant. The position carried limited responsibilities mostly related to
cash transactions. As the economic environment progressed with the
industrial revolution first and then with free economy, Multinational
Corporations arrived on the scene.

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 FEATURES OF FINANCIAL MANAGEMENT

Now, the Chief Accountant is involved in each and every business decision.
He/she is expected to have deep knowledge of economics for decision-
making in areas of risk analysis, pricing based on demand-supply analysis
and risk-return analysis. Economics governs the environment in which all
business entities operate. To steer the entity towards steady growth, it was
necessary for him/her to take cognizance of several economic variables
such as inflation, gross domestic product, disposable income, employment,
interest rates, competition, government levies and many more. The role of
Chief Accountant matured into that of Chief Finance Manager.

One significant task for the Chief Finance Officer now was to conduct
decision-oriented process of allocating entity’s funds (either owned or
borrowed) for projects involving acquisition of building, plant and
equipment, etc. With rise in business competition, more care and caution
was needed for all decisions related to receivables and inventory
management, capital structures or dividend policy.

1.3 FINANCIAL MANAGEMENT IN BUSINESS

ORGANIZATIONS

Every business organization has an economic objective of maximizing

financial gains for its owner/owners. Towards this end, it has to carry a
business activity of production and/or distribution of products and services.
It has to ensure that this activity is carried systematically as per long- and
short-term plans prepared and approved by the organization’s
management. This can be efficiently achieved if the management can focus
all its attention on the main business objective without being hassled by
any problems related to availability of the needed finance and funds as and
when required. As a result, Chief Finance Manager of any business
organization has a major task of managing funds for the organization so
that funds are available at the optimum cost as and when needed and
there are no funds lying idle in the business entity.

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 FEATURES OF FINANCIAL MANAGEMENT

Financial Management

Business Capital Plan

Strategy Spells Total Spells Total Funds
Assets Required Required

Finance Plane Spells

Source For Acquisition of
Required Funds

1.4 REQUIREMENTS OF LONG-TERM FUNDS FOR THE

ORGANIZATION

Any business organization has first to be clear about the exact business
activity it wants to conduct to meet its objective of maximizing the gains
for the owners. A detailed business strategy that covers all aspects of the
business is the first step in this direction. This strategy will spell out all the
facilities the organization needs to start and conduct its business from year
to year on a continuous basis. Business (or Strategic) management is the
art, science and craft of formulating, implementing and evaluating cross-
functional decisions that will enable an organization to achieve its long-
term objectives. It is the process of specifying the organization’s mission,
vision and objectives, developing policies and plans, often in terms of
projects and programs, which are designed to achieve these objectives.
Once these objectives are finalized, the next step constitutes allocation of
both financial and non-financial resources to implement the policies, and
plans, projects and programs that are expected to meet the business
objectives. Thus, strategic management seeks to coordinate and integrate
the activities of the various functional areas of a business in order to
achieve long-term organizational objectives.

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 FEATURES OF FINANCIAL MANAGEMENT

Strategic management is the highest level of managerial activity.

Strategies are typically planned, crafted or guided by the Chief Executive
Officer, approved or authorized by the board of directors, and then
implemented under the supervision of the organization’s top management
team or senior executives. Strategic management provides overall
direction to the enterprise.

Once the strategic plan is in place, it is necessary to determine in details

financial and non-financial resources to implement the plan. Financial
resources can take the form of research and development laboratories,
factory buildings, plant and machinery, equipment, software and hardware,
distribution stores, showrooms, etc. These facilities need large amounts of
funds at pre-determined intervals. Significant managerial time, effort and
energy have to be focused on identification and evaluation of various
proposals for deployment of funds. It has to be ensured that these large
investments would generate adequate returns over a period of time to
justify initial capital cost. Chief Finance Officer prepares a Corporate Capital
Plan to take care of such capital expenditures. This essentially is a finance
function and hence the sole responsibility of the Chief Finance Officer of the
business entity.

It has to be remembered that this is not a one-time or annual exercise. As

business conditions change, this plan has to be reviewed, readjusted and
revised to address new business realities. Assumptions on which the
Capital Plan was prepared also require modifications based on the actual
experience gathered during execution of the capital plan so that they
prompt revisions to the original capital plan.

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 FEATURES OF FINANCIAL MANAGEMENT

1.5 CAPITAL STRUCTURE TO IMPLEMENT BUSINESS

STRATEGY

We are now ready with the exact amounts of funds required for various
corporate projects and time frame for their acquisition. The next task in
financial management is to determine how this requirement of funds is
going to be financed.

Here, the Chief Finance Officer has to arrange for a major decision as to
what part of the total requirements is to be financed from business entity’s
own funds. The balance portion will have to be financed by borrowing from
the capital market. This exercise is known as determining the debt-equity
ratio* in financing the capital expenditure. Here what we are trying to build
is a capital structure for the business entity.

* Reliance Industries Ltd.

March 2015 in crore rupees
Equity Share Capital 3,236.00
Share Application Money 17.00
Preference Share Capital 0.00
Reserves 212,923.00
Net Worth 216,176.00
Secured Loans 2,036.00
Unsecured Loans 87,105.00
Total Debt 89,141.00

Thus, you will observe that on March 2015, RIL has a debt-equity ratio of
89/216 or 0.41. It is claimed that lower the debt-equity ratio higher the
security enjoyed by the creditors. That is the reason why with this low
debt-equity ratio, RIL finds no difficulty in arranging finances for its
expansion projects.

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 FEATURES OF FINANCIAL MANAGEMENT

High creditworthiness

Low debt-equity ratio

The character of a company’s financing is reflected into its debt to equity

ratio. Lenders like to see a low debt-equity ratio; it means that much more
of the company’s fortunes are based on shareholders’ investment, which in
turn means that investors have a high level of confidence in the company.
If the debt-equity ratio is high, it means that the business has borrowed a
lot of money on a small base of owners’ funds. It is then said that the
business is highly leveraged—which in turn means that lenders are more
exposed to potential problems than investors.

In case of equity, the CFO has to decide which capital markets to access
and how should the issue be timed. A decision has also to be taken about
the type of specific equity instruments that are to be employed. Allied issue
is the dividend distribution policy for these capital instruments that would
make them attractive to potential investors. While determining the debt-
equity ratio, the goal is to ensure that the selected pattern would maximize
the earnings per share that would increase the market value of the entity’s
scrips traded on the stock exchanges. Similar issues have to be addressed
when the decision is to use debt funds to meet long-term capital
requirements. The aim is always to optimize the cost of financing and
increasing investor confidence in the entity. A firm always attempts to find
a minimum cost of capital through varying the mix of its sources of
financing. This cost eventually increases as more and more capital is drawn
from the capital markets.

Video Link 1

Video Link 2

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 FEATURES OF FINANCIAL MANAGEMENT

1.6 MANAGEMENT OF CAPITAL FOR CURRENT OPERATIONS

To run business activities, the entity needs working capital to finance its
current assets mainly in the form of inventories in various stages from raw
materials, work-in-progress, finished goods, inventory ready for storage,
inventory in discreet stores and warehouses awaiting delivery to retail
sales outlets or customers. The quantum of the inventory at various
locations changes drastically with raw material availability and spurts in
consumer demand during busy seasons and festivals. Financial
management has to get geared to finance this short term but substantial
requirement of what is termed working capital.

A majority of sales do not take place on cash on delivery terms. This fact
results in another current asset on the balance sheet known as sundry
debtors or accounts receivables. Many times, amount of receivables is as
large as that for inventory. In competitive markets, adequate credit needs
to be offered to customers to retain your market share. Funds have to be
arranged to finance this current asset which is a significant part of entity’s
working capital. This is the third feature of financial management that
keeps the CFO busy all throughout the year.

Net working capital consists of current assets and current liabilities and
thus includes three accounts (accounts payables, accounts receivables and
inventory) which are of special importance. These accounts represent the
areas of the business where managers have the most direct impact. An
increase in net working capital indicates that the business has either
increased current assets (that it built up inventories or is unable to collect
receivables on time) or has decreased current liabilities—for example has
paid off some short-term creditors, or a combination of both. The Working
Capital Cycle (WCC) is the amount of time it takes to turn the net current
assets and current liabilities into cash. The longer the cycle is, the larger
the amount of cash a business is tying up in its working capital without
earning a return on it. Therefore, financial management strives to reduce
the working capital cycle by collecting receivables quicker or sometimes
stretching accounts payable.

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 FEATURES OF FINANCIAL MANAGEMENT

y
or

Sa
nt

le
ve

s
In
WORKING CAPITAL
CYCLE

Accounts Receivables

Longer interval Shorter interval

Larger working capital Smaller working capital

A positive working capital cycle balances incoming and outgoing payments

to minimize net working capital and maximize free cash flow. For example,
a company that pays its suppliers in 30 days but takes 60 days to collect
its receivables has a working capital cycle of 30 days. This 30 day cycle
usually needs to be funded through a bank operating line, and the interest
on this financing is a carrying cost that reduces the company’s profitability.
Growing businesses require cash, and being able to free up cash by
shortening the working capital cycle is the most inexpensive way to grow.
Sophisticated financiers review closely a target entity’s working capital
cycle because it provides them with an idea of the management’s
effectiveness at managing their balance sheet and generating free cash
flows. Financial management actively concerns itself with supply chain
management as more efficient the supply chain less need for working
capital. Efficient supply chain is based on Just-in-time principle that
ensures that materials are needed only when they are to be used so that
they do not lie idle in inventory. It, at the same time, ensures that there is
no production idle time for want of materials. Funds required to finance
inventory are minimized. Efficient supply chain rests on building up long-
term relationship with reliable and trusted suppliers of materials required
for production.

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 FEATURES OF FINANCIAL MANAGEMENT

Some other issues the CFO has to handle at this stage include what is the
optimum levels of inventory the entity needs to hold, what are its ideal
receivables days, what are its cost-effective sources of short-term funds
and where can it place its excess cash (if any) to earn decent interest
income.

Video Link 1

Video Link 2

Self-training Exercise: 1

Asha Metal Foundry finds that it is losing many customer orders as it is

unable to deliver castings within the delivery time specified by its major
customers. To meet the customer requirements, the CEO decides to
increase sales by 50% and to increase the plant capacity by 30%.

Their balance sheet today shows:

Equity 100,000 shares of Rs.10 each 10,00,000

Reserves 25,00,000
Accounts Payables 5,00,000 40,00,000
Plant and Machinery 22,50,000
Accounts Receivables 7,50,000
Inventory 10,00,000 40,00,000

You are required to draw the balance sheet after two years from today
after implementation of CEO’s decision above.

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1.7 FINANCIAL MANAGEMENT IN DIFFERENT FORMS OF

ORGANIZATIONS

The basic financial tasks of capital budgeting, capital structure, working

capital management, or financial control are common for all forms of
organizations engaged in commerce. While the goal of profit optimization
and increasing the financial worth of the entity is common for all the
organizations, the approach to achieve this goal has to suit the typical form
of the organization like sole proprietor, partnership, cooperative society or
corporation, under which the business activity is carried out. The
discussions on Financial Management normally assume that business is
carried by a company. But huge volume of business is carried by individual
proprietors and partnerships. It is, therefore, necessary that we study how
the various forms of organizations are structured.

1.7.1 Sole Proprietor

Ashok Non-ferrous Foundry

When the business is run by a single owner, termed proprietor, the

business organization is known as Sole Proprietorship. This form is simple
and that is the main reason why a majority of business entities operate as
Sole Proprietorships. Once they grow, there is a scope to convert them into
a partnership or a company. These firms do not have a separate existence
from their owners. The tasks of determining the requirement of funds,
arranging sources of finance and executing projects by using these funds is
the responsibility of the sole proprietor or the owner. While the owner does
not have to share profits with anyone, all losses have also to be borne by
the owner alone. The owner is also personally liable for the firm’s debts
and loans. This is major obstacle for continuous growth of the business
beyond certain limits as an individual can neither raise a large capital nor
bear massive liabilities. As a result, the proprietor has ultimately to form a
joint stock company.

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 FEATURES OF FINANCIAL MANAGEMENT

If the owner is an inventor or engineer, he has to rely on an outsider to

handle financial management and in such a situation, there is a scope for
conflict of interest between the proprietor and the finance manager as well
as for a lack of accountability for financial decisions.

Video Link 1

Video Link 2

1.7.2 Partnership

Jane, John and Sons Shipping and Warehousing

When the business firm has two or more owners, it is known as a

partnership. Like in Sole Proprietorship, the financial liability of the owners
known as partners is unlimited. They bear the risks and share the profits.
‘Partnership’ is the relation between persons who have agreed to, share
the profits of a business carried on by all or any of them acting for all.
Persons who have entered into partnership with one another are called
individually “partners” and collectively ‘a firm’ and the name under which
their business is carried on is called the ‘firm name’. The Indian Partnership
Act, 1932 is an Act enacted by the Parliament of India to regulate
partnership firms in India. It received the assent of the Governor-General
on 8 April 1932 and came into force on 1 October 1932. Before the
enactment of this Act, partnerships were governed by the provisions of the
Indian Contract Act.

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 FEATURES OF FINANCIAL MANAGEMENT

Partnership, unlike Sole Proprietorship, is a unique legal entity. The net

profit of the firm is taxable. Remuneration and interest paid to partners on
their investments can be shown as an expense of the firm; however, the
same will be taxed at the hands of the receiving partners. The partnership
firm comes into existence when the owners enter into a partnership deed.
This deed is like a constitution of the business firm and it specifies the
rights, responsibilities and duties of the partners, their capital
contributions, shares in the firm’s profits, etc. Partners are bound to carry
on the business of the firm to the greatest common advantage, to be just
and faithful to each other, and to render true accounts and full information
of all things affecting the firm to any partner or his legal representative.

With more than one owner, partnership firm has greater capacity to raise
capital and can have wider talent to run operations. At the same time, key
decisions get delayed because one partner is traveling or other on family
way. Not all partners have the same appreciation for financial dynamics or
client relations or other business nuances, and only a few appear to
appreciate the “ways of the future.” Because no single partner is
accountable, lots of decisions never take place. The distinction between
ownership and management is thin. As such, this business form has
advantages as well as disadvantages more or less similar to Sole
Proprietorship.

A Limited Liability Partnership (LLP) is a partnership in which some or all

partners (depending on the jurisdiction) have limited liabilities. It,
therefore, exhibits elements of partnerships and corporations. In an LLP,
one partner is not responsible or liable for another partner’s misconduct or
negligence. This is an important difference from the traditional unlimited
partnership under the Partnership Act 1932, in which each partner has
joint and several liabilities. In an LLP, some partners have a form of limited
liability similar to that of the shareholders of a corporation. An LLP also
contains a different level of tax liability from that of a corporation.

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The Limited Liability Partnership Act 2008 was published in the Official
Gazette of India on January 9, 2009 and has been notified with effect from
31 March 2009. In Limited Liability Partnership, each member is protected
from personal liability, except to the extent of the capital contribution in
the LLP. To start a Limited Liability Partnership, at least two members are
required initially. However, there is no limit on the maximum number of
partners. The LLP Act makes a mandatory statement where one of the
partners to the LLP should be an Indian. In India, for all purposes of
taxation, an LLP is treated like any other partnership firm. LLP is a body
corporate and a legal entity separate from its partners. It has perpetual
succession. Indian Partnership Act, 1932 is not applicable to LLPs.

Like a company, LLP also has a separate Legal Entity. So, the partners in
the company and LLP are distinct from each other. This is like a company
where shareholders are different from the company. In case of companies,
there should be a minimum amount of capital that should be brought by
the members/owners who want to form it. But to start an LLP, there is no
requirement of minimum capital.

The LLP, being a firm, does not attract minimum alternative tax on its book
profits and is not subject to dividend distribution tax. Remuneration and
interest paid to partners on their investments can be shown as an expense
of the firm; however, the same will be taxed at the hands of the receiving
partners.

Fox Cam Ltd.

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 FEATURES OF FINANCIAL MANAGEMENT

1.7.3 Company

This is the most suitable form for large business undertakings. On

parameters of revenue and profits, the company is the most significant
form of organization. The Companies Act, 2013 passed by the Parliament
has consolidated the law relating to formation and regulation of companies.
The new law has been passed and is considered as trend changer in Indian
Corporate law. The new law has been rewritten extensively with several
new provisions for investor protection, better corporate governance,
corporate social responsibility, etc. It defines a number of new terms that
have come into vogue in recent times. It provides for: (a) class action suit,
which is key weapon for individual shareholders to take collective action
against errant companies, (b) better disclosure requirements in financial
statements and (c) disclosure of interests of directors, etc. It has also
streamlined procedures relating to disclosure of transactions with parties
related to directors, promoters, etc. E-voting has been recognized for the
first time in India. This new Act is one of the major achievements in Indian
economy in the recent past.

Owners of the company are its shareholders. They appoint a Board of

Directors in shareholders’ annual meetings to conduct the business. The
directors are drawn from the key management personnel of the company
or experts can be invited from outside the firm. The company is a distinct
legal entity separate from its shareholders. A company has its
memorandum of association which is its constitution. It spells out the
objectives and scope of its business activities. The rules for internal
governance of the company are enumerated in its articles of association.
Unlike in the case of sole proprietorship and partnership, the liability of
shareholders is limited to the payment of face value of the shares in full.
Company pays income tax on its profits as well as on dividends distributed
to shareholders for whom income from dividends is tax free.

Unlike sole proprietorship and partnership, formation of a company is

complex and lengthy process as companies are governed by extensive
provisions of the Indian Companies Act 2013. Companies can be private
limited or public limited. Private limited companies need to have minimum
two and can have maximum two hundred shareholders. Public limited
company must have minimum seven shareholders and there is no upper
limit for number of shareholders.

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 FEATURES OF FINANCIAL MANAGEMENT

Public limited companies invite general public to subscribe to its share

capital expressed in shares of fixed face value. Established companies issue
shares at a premium over its face value to collect larger amounts from of
shareholders.

To cite one example, Reliance Industries Ltd. shows a Share Capital of Rs.
3,236 crores from its 27,31,295 shareholders spread over the entire
country at different levels of rich and not-so-rich individuals.

For entities with substantial business volumes, a company is the best form
of organization to operate and grow. The risk to investors is limited;
potential for growth of the business is continuous as there is an access to
capital markets for sourcing funds as and when they are required for
expansion. Owners find their investments are liquid as the shares they own
can be sold/transferred on the Stock Exchanges to receive cash in a couple
of days.

It is a fact that sole proprietorship and partnerships are important business

organization forms, but in view of characteristics of a company described
above, while discussing financial management here, emphasis is obviously
on the company form of organization.

Video Link 1

Video Link 2

Self-training Exercise: 2

Deepak Shah and Harish Parekh are two partners of Bhale Padharo
Automobiles Pvt. Ltd.. Their business is steadily growing and they are
required to open new sales outlets and service centres in metro cities in
India. Deepak knows that to support this growth, partnership form of
business organization is no more viable. Write a letter on his behalf to the
partner Harish, highlighting the reasons why they should form a private
limited company to change over to Bhale Padharo Automobiles Pvt. Ltd.

21
 FEATURES OF FINANCIAL MANAGEMENT

Forms of Business Organizations – A Comparative Study

Limited Private Public

Form of Sole
Partnership Liability Limited Limited
Organization Proprietor
Partnership Company Company
Legal Entity No Yes Yes Yes Yes

Formation Simple Not difficult Not difficult Complex Complicated

and long
drawn
Number of One Minimum Minimum Minimum Minimum
Owners Two two – at two and seven
least one maximum
Indian two hundred
Liability of the Unlimited Unlimited Limited Limited Limited
Owner
Rights and NA Partnership Partnership Articles of Articles of
Duties of Deed Deed Association Association
Owners
Access to Limited Limited Limited Easy Easiest
Capital
Markets for
Funds
Tax Liability Profits Profits taxed Profits taxed Profits and Profits and
taxed as at the at the dividends dividends
owner’s specified specified taxed at the taxed at the
income rate rate specified specified
rates rates

22
 FEATURES OF FINANCIAL MANAGEMENT

1.8 SUMMARY

The field of Financial Management is a branch of economics that makes

best use of accounting. In olden days, financial management was restricted
to limited responsibilities mostly related to cash transactions. As the
economic environment progressed, with the industrial revolution first and
then with free economy, Multinational Corporations arrived on the scene
and enlarged the scope of financial management. Financial management,
these days covers entire business activities. With rise in business
competition, more care and caution was needed for all decisions related to
receivables and inventory management, capital structures or dividend
policy. CFO is being looked as a watchdog in growing business operations.

The Chief Finance Manager of any business organization has a major task
of managing funds for the organization. Business strategy spells total
assets required while capital plan spells total funds required and finance
plan spells sources for acquisition of funds. Strategies are typically
planned, crafted or guided by the Chief Executive Officer, approved or
authorized by the board of directors, and then implemented under the
supervision of the organization’s top management team of senior
executives. Strategic management provides overall direction to the
enterprise. The capital plan is then prepared and approved to specify funds
that are required for research and development laboratories, factory
buildings, plant and machinery, equipment, distribution stores, showrooms,
etc. required by the business entity and when would these funds required.

The next task in financial management is to determine how this

requirement of funds is going to be financed. The CFO decides what part of
the total requirements is to be financed from business entity’s own funds
and balance portion will then have to be financed by borrowing from the
capital market. This is termed entity’s debt-equity ratio. While determining
the debt-equity ratio, the goal is the selected pattern should maximize the
earnings per share along with market value of the entity’s shares traded on
the stock exchanges.

23
 FEATURES OF FINANCIAL MANAGEMENT

To run business activities, the entity needs working capital to finance its
current assets mainly in the form of inventories in various stages from raw
materials to finished goods at the points of sale and accounts receivables.
Control over working capital is a major concern in financial management
under intense competition.

Financial management under sole proprietary business is simple. Here, the

business has no legal entity, the owner has unlimited liability and business
income is merged with owner’s individual income and taxed. A major
business activity is carried by sole proprietors spread all over the economy
in each individual business. Partnerships have a legal entity and their
profits are taxed at specified rate. Partners’ liability is unlimited. The
present laws allow partners to form a partnership firm with limited liability.
Both these business forms have a limited access to capital markets and
when their business grows beyond certain limits, they have to grow into
private or public limited companies to attract funds from the market.

The public limited companies, because of limited liability, can have large
number of owners contributing large amounts capital at inception as well
as during expansions of their business. They need to pay tax on both their
profits and dividends they distribute to shareholders. The process of
formation of a public limited company is complex and long, however for
entities with substantial business volumes, a company is the best form of
organization to operate and grow.

24
 FEATURES OF FINANCIAL MANAGEMENT

1.9 MULTIPLE CHOICE QUESTIONS

Mark (x) against the most reasonable alternative.

1. The capital plan for the year 2016 prepared by the Chief Engineer of
Rajesh Soaps detailed each and every asset (mixer, blender, stamping
machines, wrapping machines, main store equipment, fork lift, etc.)
that was to be acquired in the next three years with total cost to acquire
it. The CFO, however, could not work on it as __________.
(a) Vendors’ names were missing
(b) Assets’ brand specs were inadequate
(c) Time schedule for acquisition was not attached
(d) Some amounts were expressed in US dollars

2. You have just joined the State Bank of India, Shahpur branch as a
Manager. There are four requests for bank finance from following
companies. Other factors remaining constant which one would you
select for lending?
(a) Company P - Net worth Rs. 49. lakhs and total assets Rs. 1.0
crore
(b) Company Q - Net worth Rs. 49 lakhs and total assets Rs. 1.5
crore
(c) Company R - Net worth Rs. 1.0 crore and total assets Rs. 2.25
crore
(d) None of the above

3. The firm Shah Brothers wanted to increase their Machine Shop capacity
substantially. The founding partner was planning to convert the firm into
a private limited company. He was not certain how many shareholders
can he have in the new company. Will you please guide him?
(a) Minimum five maximum twenty-five
(b) Minimum two maximum two hundred
(c) Maximum twenty-five
(d) Minimum seven

4. How will you describe tax liability of a partnership firm?

(a) Profits taxed with owner’s personal income
(b) Profits of the firm and owners taxed at specified rates
(c) Profits of the firm are taxed at specified rate
(d) Fifty per cent profits subject to tax

25
 FEATURES OF FINANCIAL MANAGEMENT

5. On joining Bharat Mall in Kolkata, you find that its working capital
requirements are well above the industry average. Which of the
following will be your focus point to correct the situation?
(a) Quality Control
(b) Distribution management
(c) In-process check system
(d) Supply chain management

Answers: 1. (c), 2. (a), 3. (b), 4. (c), 5. (d).

26
 FEATURES OF FINANCIAL MANAGEMENT

REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter

Summary

PPT

MCQ

Video Lecture

27
 RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT

Chapter 2
Relevance And Significance Of Financial
Management
Objectives
After studying this chapter, you should be able to understand:
• Scope of financial management
• Cash flows
• Relationships with financial bodies
• Pay package of employees/incentives
• Credit policy for suppliers and customers
• Dividend policy
• Long-term financing

Structure:
2.1 Introduction
2.2 Management of Cash Flows
2.3 Bank and Financial Institute Relationships
2.4 Handling Employee Reward Systems
2.5 Management of Purchases
2.6 Management of Finance Side of Sales
2.7 Management of Shareholder Relations
2.8 Financing Expansion and Diversification
2.9 Summary
2.10 Multiple Choice Questions

28
 RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT

2.1 INTRODUCTION

For every growing business firm, the main financial tasks include
management of cash flows, bank relationships, payroll and purchases, both
of capital items as well as raw/packaging materials and acquisition of
finances to run the show. The chief finance officer has also to find
opportunities to set aside funds to carry research and development
activities in a robust manner in order to stay ahead of ever increasing
competition. CFO also cannot afford to ignore the interest rate, exchange
rates and pulse of the capital market. All these factors are responsible in
making finance an integral part of the business activity. No business
decision can be undertaken unless the financial implications are thoroughly
analyzed to determine its impact on the entity’s income and growth.

y Cred
v entor it
In Cont
trol rol
Con

vs.
Pricing Risk
rns
Products Retu

ing
Rais
s
Fund

Finance Manager

29
 RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT

The field of finance is connected with both economics and accounting.

Economics plays a major role in financial decisions related to risk analysis,
pricing of products after study of supply and demand forces in the market,
net present value concept used to justify long-term investments or
determining true worth of an entity. Accounting is the vehicle that carries
financial data to the users in the form of income statement, balance sheet
or fund flow statement. Finance provides a bridge between economic
theory and number of accounting. CFO must use and interpret this data in
the attempts to maximize the entity’s returns and net worth. All company
executives whether in production, sales, research, marketing or general
management must familiarize themselves with the accounting data
presented to them from time to time so that they can assess for
themselves how their function is contributing to the corporate business
strategy.

2.2 MANAGEMENT OF CASH FLOWS

The all-important profit and loss account statement (and for that matter
the balance sheet) of the organization is based on the principle of accrual.
Thus, if a sale of Rs. three lakhs takes place in January 2015, it will be
reflected as income in the profit and loss statement for 2014-15 even
though actual payment for this sale may take place in April 2015. The
income from this sale is recorded in 2014-15 because all the expenses
incurred against the sale were incurred in that year. To reflect true income,
it is necessary to match revenues and expenses in the period in which they
occur.

Statement of cash
flows:The objective is to emphasise
the critical nature of clash flows to the day to
day functions of the business entity. Here the
focus is on translating the accrual based net
income into actual rupee terms

30
 RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT

The cash flow statement emphasizes the critical nature of cash flows to the
firm’s operations. Here, cash means cash as well as cash equivalents that
can easily be converted into cash within ninety days. Independent study of
cash flows is necessary and you can watch it in following situations. A firm
reports a net loss of three lakhs in a particular period where it provided
four lakhs of depreciation. The latter being a non-cash expense the firm is
still having one lakh cash on hand at the end of the period. On the other
hand, a firm reporting three lakhs of net profit can have a lakh of less cash
at the end of the period if it invests four lakhs to buy a machine, the item
that does not appear on an income statement but only on the firm’s
balance sheet.

A company's profitability, as
measured on its books, can be better
or worse than its cash generation.

Study of cash flows is necessary to maintain liquidity of the organization

which ensures that funds are available when needed.

Video Link 1

31
 RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT

Self-training Exercise: 1

Prepare a fund flow statement from following data indicating closing cash
on hand.

Jan 01 Cash on hand 1,25,000

Jan 03 Sale of goods to Shah Bros 75,000
Jan 05 Purchase materials from D’Mello 25,000
Jan 07 Wages/salaries 55,000
Jan 09 Cheque received from Shah Bros 50,000
Jan 13 Sale of goods to Ketan Bros 65,000
Jan 17 Cheque issued to D’Mello 75,000
Jan 21 Purchase materials from D’Mello 85,000
Jan 23 Cheque received from Shah Bros 25,000
Jan 25 Cheque received from Ketan Bros 45,000
Jan 30 Rent 15,000
Jan 31 Interest on bank loan 17,000

2.3 BANK AND FINANCIAL INSTITUTE RELATIONSHIPS

Banks accomplish growth by cross-selling financial products and services to

strengthen their relationships with customers and increase customer
loyalty. Relationship banking involves offering customers a broad array of
financial products and services that go beyond simple checking and savings
accounts. The Director of Finance has to rely heavily on bank and financial
institute relationships when a public limited company is being formed by
raising equity capital in the market. These institutes manage the entire
exercise of public issue of equity shares by acting as lead managers. The
success of initial public offer or rights issue is critical and the trust-based
relationship with banks is key factor.

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 RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT

Once the firm has its own equity funds, it can scout for further funds for
the business by debt financing. Debt financing, by contrast to equity, is
cash borrowed from a lender at a fixed rate of interest and with a
predetermined maturity date. The principal must be paid back in full by the
maturity date, but periodic repayments of principal may be a part of the
loan arrangement. Debt may take the form of a loan or the sale of bonds/
debentures; the form itself does not change the principle of the
transaction: the lender retains a right to the money lent and may demand
it back under conditions specified in the borrowing arrangement. While
tapping this source of finance, again firm’s bank and financial institute
relationships matter in obtaining required amounts of funds at the most
economic terms with respect to rate of interest and period for repayment
of the principal.

Once the business operations start, the Chief Finance Officer of the entity
has to rely on the firm’s standing with the banks to get fresh finance for
expansion or major capital expenditure from banks themselves or other
financing institutions like Industrial Finance Corporation of India, Industrial
Development Bank of India, State Industrial Development Corporations,
etc.

Last but not the least, firms need short-term capital to fill in the gaps in
their working capital management by borrowing short-term funds as and
when required. CFO normally arranges for long-term overdraft agreement
with one or more banks to fulfill this fund requirement.

33
 RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT

2.4 HANDLING EMPLOYEE REWARD SYSTEMS

In today’s competitive environment if you want your firm to stay ahead of

competitors, self-motivated workforce is a decisive factor. There are many
schemes that help in keeping employees motivated. Effective employee
reward system is one such important scheme that attempts to meet
employees’ financial expectations from their organization/employer.

The Chief Financial Officer has dual function in employee reward systems.
The first is ensuring that the wage packet finalized for each employee is
delivered to her/him on regular basis on the due dates and, more
importantly without any errors. With automation of payrolls, any errors in
processing the data have been eliminated but great degree of caution is to
be exercised to ensure accuracy of the periodic input data. Amounts
deducted from salaries for provident fund, income tax, etc. have to be paid
to the authorities within prescribed time frames.

The second part of the employee rewards is framing the pay package that
is attractive to all employees as well as economic to the organization. Here,
it is necessary to structure the packet that provides salaries to employees
that are commensurate with their individual performance and contribution
to the profitability and growth of the organization. It is also necessary to
consider what the firm is expecting from an individual in the next financial
year/s and required incentives have to be incorporated in the pay package
to ensure that the employees remain motivated to achieve the individual
targets set for them.

In service industries, payroll forms a major chunk of entity’s total expenses

and Chief Finance Officer has to provide more focus on monitoring and
controlling this revenue expense.

Video Link 1

Video Link 2

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 RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT

2.5 MANAGEMENT OF PURCHASES

In other than service industries, material costs form a major component of

firm’s total expenses and any variation in material cost has a direct impact
on profit margins. Primary finance function here is to make sure that
vendors are paid for their supplies based on agreed credit terms. This
eliminates vendor complaints and allows the purchasing personnel to follow
up for timely deliveries of the materials ordered. Delays, if any, in
arranging payments to suppliers are invariably used by them as a pretext
for their failures to meet agreed delivery schedules that can cause
production interruptions and costly idle time.

Finance function can assist buying personnel in arriving at payment terms

that are beneficial to both the buyer and supplier. For high value A items
ordered regularly, the Chief Finance Officer can assist Purchase Officer to
enter into annual contract for supplies. Such arrangements generate
double benefits. On one hand, such agreements can result in reduction in
prices as the supplier can better organize the production schedules and
make best use of the idle capacity. On the other hand, this arrangement
allows the CFO to organize the flow of working capital requirements in a
more efficient manner.

Significant price reductions can be obtained by your firm by agreeing to

provide funds to the vendors to increase their production capacity. Cost of
funds for your suppliers is often much higher than what it costs you to
arrange funds for your use. Savings in cost of funds that vendor enjoys on
receipt of finance from you is passed on to you in the form of loyalty and
reduced purchase prices.

Video Link 1

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 RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT

2.6 MANAGEMENT OF FINANCE SIDE OF SALES

In capital goods industries, finance must get involved when a sales

negotiation is being prepared for the project or sale of equipment. If your
firm is a leader in the industry, you are entitled for better credit terms
based on your trustworthy past performance. You need to study the credit
terms common in the industry and strive to improve them for your
organization. For example, if the common practice is twenty per cent
advance for booking the order, you have to negotiate and get twenty-five
per cent with your order. The contract for sale needs to be so framed as to
allow you to bill the customer in stages to receive say about ninety per
cent of the contract value on full delivery of materials. You should also
explore the possibility of obtaining a guarantee from customer’s bank for
payments that fall due from time to time.

Letter of Credit commonly used in international trade is now used in

domestic trade as well. Here, as per terms of credit accepted by the
customer, a letter of credit is issued by the customer’s bank in favour of
your firm. The customer’s bank agrees to make payments against drafts
drawn by your firm on the customer as per the terms of the letter of credit.
This arrangement removes the credit risk, the seller knows conditions that
need to be fulfilled to get payments from the customer and it offers safety
to the customer that payments are arranged in conformity of the
conditions specified in the letter of credit issued by him.

Any company has two major choices in determining its credit policy for its
customers. On one hand, it can adopt a strict credit policy and decide not
to grant any credit to a customer account however strong its credit rating
can be. On the other end, a firm can have a liberal credit policy and grant
say a 30 days’ credit to all customer accounts irrespective of the credit
rating. The strict credit policy has adverse effect on sales but reduces
collection costs, bad debts and the size of the receivables. Liberal credit
policy encourages sales and therefore profits, but at the same time, it does
increase collection costs, bad debts and the size of the receivables.

36
 RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT

This Arrangement is Termed 2/10, Net 30

For most industries, close scrutiny of the customers as to their past

payment record, financial stability, the amount of receivables that would be
outstanding during the year, etc. has to be carried out before proposing
credit terms in your sale offer. To minimize trade receivables in themselves
and costs incurred in follow-ups to collect them, many firms offer a cash
discount of say two per cent for payments within say ten days. If they fail
to avail of the cash discount, they need to pay full amount in stipulated
thirty days. To avail of this discount, many customers pay within the
stipulated period and allow you to control receivables in an efficient
manner.

Three tools used by Finance Managers to control receivables include

determining and reducing average collection period, monitoring and
minimizing ratio of bad debts to credit sales and ageing of receivables.

37
 RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT

Self-training Exercise: 2

Asha Metal Foundry finds that due to fierce competition, marketing team
has to grant generous credit terms to maintain its market share. This has
put pressure on collection team and accounts receivables have increased to
60 days sales. The company currently pays 15% interest on bank loans
obtained to sustain this high level of receivables.

As a CFO, draft a letter addressed to the Marketing Director to convince

her that offering two per cent cash discount on payments within a week of
delivery of castings can mitigate the problem and result in lesser cost of
funding working capital.

2.7 MANAGEMENT OF SHAREHOLDER RELATIONS

Maximizing the wealth of the firm’s shareholders through achieving the

highest possible value for the firm in the marketplace is the overriding
objective of the firm and should influence all business decisions.
Shareholders expect from the firm:
(a) An increase in the market price of the shares they hold,
(b) Regular dividends in cash and
(c) Issue of bonus shares at regular intervals.

The Chief Finance Officer’s goal of maximizing income of the entity results
in accumulation of more and more funds for the entity. These funds can
either be retained within the firm to increase its net worth or distributed to
shareholders as dividends. Dividend Payout Ratio is the percentage of
dividends to net earnings after taxes. It can be computed by dividing
dividends per share by net earnings per share.

Financial managers use the marginal principle of retained earnings in

arriving at dividend decisions. The objective before the CFO here is to
make the best use of available funds. Towards this end, the rate of return
that a firm can achieve on retained earnings has to be compared with what
shareholders would earn if these funds were distributed to them as
dividends. The CFO has to make sure that each potential project of the
corporation must provide a higher rate return than shareholder could
achieve on other investments. If that is not the case, it is imperative that
funds are distributed to shareholders as dividends. This, in other words, is

38
 RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT

the opportunity cost of using shareholders’ funds. (More in Chapter # 13 –

Dividend Policy and Decisions).

In the initial growing stage in the life of a corporation, funds are needed for
growth and expansion of the firm where they are expected to yield higher
returns. As such, ‘moderate cash dividends’ is the policy for the entity. As
the firm grows and reaches the maturity stage, more and more funds are
released for payment of dividends.

One major flaw in the use of the marginal principle of retained earnings for
declaration of dividends is that it fails to consider the shareholders’
expectations from the company in which they have invested their funds
and wish to stay invested. Many prudent corporations temper the dividends
based on reliance on the marginal principle of retained earnings by
weighing the preferences of the shareholders and release higher amounts
for dividends. This step resolves uncertainties in minds of the share
owners.

There are some more factors to consider in finalizing dividend policy. The
firm has to take a long-term view to make sure that it can maintain
stability in dividend payments. Variations in dividends paid can send wrong
signals to share markets and investors. A thorough funds flow exercise has
to be conducted before establishing dividend decisions. The firms that have
easy access to capital markets for more funds through rights issue of
equity or debentures can afford to increase dividend payout ratio in
relatively bad years to maintain stable dividends policy.

Video Link 1

39
 RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT

2.8 FINANCING EXPANSION AND DIVERSIFICATION

When substantial expansion or diversification of the business is planned, it

is necessary to arrange long-term funds to finance the activity. Funds can
be arranged either by raising the capital of the firm or by incurring long-
term debt.

Equity capital is the first source of long-term finance. It offers certain

advantages. Unlike interest on debts, payment of dividends to shareholders
who contribute to equity capital is not mandatory. If adequate cash is not
there, the firm can skip dividends. Larger the equity capital, better the
debt-equity ratio which in turn increases net worth of the company along
with its creditworthiness. This enhances firm’s ability to raise debt finance.

The equity source is one of the usually costliest sources of finance. The
rate of return expected by equity shareholders is generally higher than the
rate required by other investors. The dividends have to be paid out of
after-tax earnings while interest paid on debt reduces tax burden as the
expense is tax deductible. It has costs associated with managing the equity
issue to the potential investors which are significant compared to other
sources. In case of smaller companies, in particular, the issue of additional
equity reduces the control over the firm of the existing share owners.

Bank Loans, Bonds

Preference Shares

Internal Reserves

Equity

Financing Expansion and Diversification

40
 RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT

If the finance manager decides to meet the need for long-term finance
through issues of preference shares, she has to face with similar
advantages and disadvantages as above. However, preference shares do
not carry voting rights and hence do not dilute control of the present share
owners. The preference shares issue increases the company’s net worth
and advantages associated with it.

The financial manager must consider whether debt will contribute to or

detract from the earnings of firm’s operations. While considering the debt
option to finance major capital expenditure, it is necessary to weigh
advantages and disadvantages related to long-term debt. Major
advantages are interest paid on long-term instruments as an expense that
is tax deductible. When interest payments are arranged, the tax liability
will decrease. Thus, if you have borrowed funds at say 15%, a part of the
interest burden is offset by reduced tax that you will now be paying. Thus,
a capital project providing you with 15% net returns can be gainfully
funded by 15% long-term debt instrument. Another advantage with debt is
that the exact amounts to be paid towards interest and repayment of debt
are clearly specified and this facilitates fund flow management. In
inflationary conditions, repayments are cheaper as value of rupee
decreases. Total reliance on debt to fund major capital expenditure will
result in high debt-equity ratio frowned by firm’s creditors and investors.

Many finance companies offer hire purchase facility to acquire the asset.
Here, the asset is purchased by the finance company and offered for use to
your firm. For the duration of the hire purchase agreement, you pay
periodic (monthly or quarterly) installments consisting of interest and
return of the capital and at the end of this period, ownership of the asset is
transferred to you.

41
 RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT

2.9 SUMMARY

For every growing business firm, the main financial tasks include
management of cash flows, bank relationships, payroll, and purchases,
both of capital items as well as raw/packaging materials and acquisition of
finances to run the show. The chief finance officer has also to find
opportunities to set aside funds to carry research and development
activities in a robust manner and to get ready with required funds when
opportunity arises for expansion or diversification.

The field of finance is connected with both economics and accounting.

Economics plays a major role in economic decisions related to risk analysis,
pricing of products after study of supply and demand forces in the market,
net present value concept used to justify long-term investments or
determining true worth of an entity.

A company’s profitability, as measured on its books, may be better or

worse than its cash generation. Hence, study of cash flows is necessary to
maintain liquidity of the organization that ensures funds are available when
needed. While tapping this source of finance, again firm’s bank and
financial institute relationships matter in obtaining required amounts of
funds at the most economic terms with respect to rate of interest and
period for repayment of the principal. Firms need short-term capital to fill
in the gaps in their working capital management by borrowing short-term
funds as and when required.

The Chief Financial Officer has dual function in employee reward systems
so necessary to keep the workforce motivated and productive. The first is
ensuring that the wage packets finalized for each employee is delivered to
her/him on regular basis on the due dates and without any errors. The
second part of the employee rewards is framing the pay package that is
attractive to all employees and economic to the organization.

42
 RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT

In other than service industries, material costs form a major component of

firm’s total expenses and any variation in material cost has a direct impact
on profit margins. Primary finance function here is to make sure that
vendors are paid for their supplies based on agreed credit terms. Finance
function can assist buying personnel in arriving at payment terms that are
beneficial to both the buyer and supplier. Finance function can further
assist buying personnel in arriving at payment terms that are beneficial to
both the buyer and supplier. In capital goods industries, finance must get
involved when a sales negotiation is being prepared for the project or sale
of equipment. If your firm is a leader in the industry, you are entitled for
better credit terms based on your trustworthy past performance. You need
to study the credit terms common in the industry and strive to get better
terms.

Any company has two major choices in determining its credit policy for its
customers. On one hand, it can adopt a strict credit policy and decide not
to grant any credit to a customer account however strong its credit rating
can be. On the other end, a firm can have a liberal credit policy and grant
say a 30 days’ credit to all customer accounts irrespective of its credit
rating. To minimize trade receivables in themselves and costs incurred in
follow-ups to collect them, Finance manager has to decide whether to offer
a cash discount.

The Chief Finance Officer’s goal of maximizing income of the entity results
in accumulation of more and more funds for the entity. These funds can
either be retained within the firm to increase its net worth or distributed to
shareholders as dividends. There are quite a few factors to consider in
finalizing dividend policy for the firm.

When substantial expansion or diversification of the business is planned, it

is necessary to arrange long-term funds to finance the activity. Funds can
be arranged either by raising the capital of the firm or by incurring long-
term debt. Both have their own advantages and disadvantages.

43
 RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT

2.10 MULTIPLE CHOICE QUESTIONS

Mark (x) against the most reasonable alternative.

1. Which discipline, according to you, plays a major role in decisions

related to risk analysis, pricing of products after study of supply and
demand forces in the market, net present value concept used to justify
long-term investments or determining true worth of an entity?
(a) Accounting
(b) Philosophy
(c) Economics
(d) Finance

2. Sharayu just completed reading the chapter from Financial Management

text where she studied Trial Balance, Income Statement, Balance Sheet
and Statement of Cash Flows. When asked which document has its
focus on translating the accrual based net income into actual rupee
terms, she was confused. Can you select the document for her?
(a) Trial Balance
(b) Income Statement
(c) Balance Sheet
(d) Statement of Cash Flows

3. For __________ items ordered regularly, the Chief Finance Officer can
assist Purchase Officer to enter into annual contract with approved
vendors for supplies.
(a) Low value C
(b) High value A
(c) Average value B
(d) Spares

4. One major flaw in the use of the marginal principle of retained earnings
for declaration of dividends is that it fails to consider __________ the
company.
(a) The shareholders’ expectations from
(b) Cash available with
(c) Quantum of dividends declared in the previous year
(d) Board of directors’ expectations from

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 RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT

5. When finance manager has to arrange funds to support a major

expansion of company’s facilities, there are quite a few options there on
the table. But __________ is one of the usually costliest sources to
finance expansion.
(a) Long-term debt
(b) Loan from financial institutes
(c) Equity capital
(d) Hire purchase agreement

Answers: 1. (c), 2. (d), 3. (b), 4. (a), 5. (c).

45
 RELEVANCE AND SIGNIFICANCE OF FINANCIAL MANAGEMENT

REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter

Summary

PPT

MCQ

Video Lecture

46
 GOALS AND OBJECTIVES

Chapter 3
Goals And Objectives
Objectives
After studying this chapter, you should be able to understand:
• Profitability
• Firm’s value
• Shareholders’ wealth
• Strong and effective management
• Earnings per share – EPS
• Legal compliance
• Leadership
• Employee welfare and customer satisfaction
• Corporate Social Responsibility
Structure:
3.1 Introduction
3.2 Maximize Profits of the Business Entity
3.3 Maximize Business Entity’s Value
3.4 Maximize Shareholders’ Wealth
3.5 Strengthen Management Power
3.6 Maximize Earnings Per Share – EPS
3.7 Ensure Legal Compliance
3.8 Attain Market Leadership
3.9 Promote Employee Welfare
3.10 Ensure Customer Satisfaction
3.11 Meet Corporate Social Responsibility
3.12 Summary
3.13 Multiple Choice Questions

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 GOALS AND OBJECTIVES

3.1 INTRODUCTION

A century ago, the main goal of the finance function in India was to
prepare accounting statements like trial balance, income statement and
firm’s balance sheet. With Independence, industrial revolution, economic
growth and liberalization, the scope of finance function has grown at
accelerated speed. There is no economic field left where the finance
function has no positive role to play.

This has resulted in a variety of goals being set for finance managers in
addition to the traditional central goal of profit maximization set by owners
of the entity. In modern economic scenario, finance manager is looked
upon by the management team as an important in-house source available
to them for achieving their individual as well as corporate goals.

CEO
Marketing Manager
Materials Manager
CFO
HR Manager
Plant Engineer
Branch Managers

Chief Finance Officer is required to take care of interests of shareholders,

investors, customers, employees, revenue authorities and the society at
large. This chapter attempts to examine all these old and new goals set for
finance function and what mechanisms are employed by the finance
managers to achieve them.

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 GOALS AND OBJECTIVES

3.2 MAXIMIZE PROFITS OF THE BUSINESS ENTITY

The most obvious and pervasive goal set for finance managers who hold
the keys to the entity’s money chest, is to maximize the profits for the
organization legally and with integrity. They need to put all their physical
assets and manpower together to generate more and more net income for
the benefit of the owners and employees. Every time any business decision
has to be taken, its effect on profits will be considered and if it is positive,
then only it will be implemented.

No doubt, profits are the primary measure of the success of any business.
It is the acid test of the economic strength of the firm. Economic theory
makes fundamental assumption that maximizing profit is the basic
objective of every firm. However, this assumption does not always hold
true, as in practice, the firms may not always try to maximize profits.
There are many factors that render profit maximization objective
secondary.

The CEO of an organization can have a directive to achieve leadership in

the market it is operating. Firms often like to become top leaders in the
respective line of business. They would rather try to attain industrial
leadership at the cost of profits. In those cases, the objective of profit
maximization is subordinated to the leadership goal in the field. Leadership
may connote either maximum sales or manufacture of maximum product
lines. The firm should have the largest share in the target market.

To retain market leadership, it may be necessary to avoid potential

competition from new members in the market. Firms may restrict the profit
in order to discourage other firms from entering the field and competing
with them. If the firm is maximizing profit, it will be an alluring proposition
for the new firms to enter the field of production. The new entrants may
snatch away the market, make infringement on patent rights on the
existing firm and may also encroach on the firm’s resources of raw
materials. In order to avoid such potential competition, the firms may
adopt a policy of profit restriction, by temporarily dropping sale prices,
instead of profit maximization. This is more so in the case of firms enjoying
weak or slender monopoly.

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 GOALS AND OBJECTIVES

In regulated market environment, management may wish to prevent or

delay Governments’ intervention. Higher level of profits in business is
considered as an index of monopoly power. The government’s attitude
towards profit and the firm’s attitude towards profit will be different.
Maximum profit may create an impression that the firm is exploiting the
consumers and this may result in the public demand for nationalizing the
firm or firms. The government may also probe into the financial structure
of the firm; make regulation of prices, profits and dividends. Just to woo
the public and to restrain the zeal of nationalization, the firms may adopt a
policy of restricted profit.

For maintaining customers’ goodwill, it may be necessary to hold or reduce

sale price. In modern business, customers’ goodwill is valued more than
anything else. In order to maintain the loyalty, the firms may adopt the
policy of restricted profit and low price for the commodity. Even in times of
increased taxes and excise duties, these firms may not increase the price,
but reduce the profit margin and thereby win the admiration of the
customers.

Sometimes, restraining wage demands especially in the environment of

powerful trade unions is called for to keep costs under control. The
requirement is more important in labor-intensive industry. Higher profit is
an indication of ability to pay higher wages by the firms. Organized Trade
Unions advance their arguments on the basis of higher profits earned by
the firm for demanding increased wages, bonus and other benefits. Even
though maximum limit of twenty per cent for payment of bonus is a
statutory matter; unions demand more above this twenty per cent limit
under the pretext of ‘ex-gratia’ payments.

If you wish to achieve financial soundness and liquidity, focus cannot be

always on increasing profits. Some firms may give greater importance to
financial soundness and liquidity, rather than profit maximization.
Considerations of maximum profit may result in huge investment in fixed
assets and consequently the liquidity of the firm will be at stake.

Decisions regarding profit maximization often involve risks. Many new

projects have to be worked through uncertainties. Generally, business
managers will avoid taking those high risk new projects, failure in which
may result even in losing their jobs or losing the image of the firm.

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 GOALS AND OBJECTIVES

3.3 MAXIMIZE BUSINESS ENTITY’S VALUE

In view of the various factors listed earlier that question the propriety of
focusing on profits alone, it may be prudent to adopt a valuation approach
in determining finance management goals. This approach is based on the
premise that the ultimate measure of firm’s financial management is not
what the firm earns, but how the earnings are valued repeat valued by the
investor. In analyzing firm’s financial management, the investor in addition
to earnings will also consider the risk inherent in the firm’s operation, the
time pattern over which the firm’s earnings increase or decrease, the
quality and reliability of reported income and many such factors.

Under this ‘Business Entity’s Value’ objective, the finance manager

considers the effect of his/her decisions on the entity’s overall value. Any
financial decision that does not increase the firm’s value stands rejected.
Successful product market strategies, to cite an example, satisfy the
customers and bring in their loyalty. But beyond a certain point, customer
satisfaction and loyalty can be increased only at the cost of shareholder
value. Under this circumstance, financial management should look at the
shareholder interest and enhance the long-term viability and
competitiveness of the business entity.

3.4 MAXIMIZE SHAREHOLDERS’ WEALTH

The broad goal of the firm is often to increase the wealth of the
shareholder by financial management attempting to achieve highest
possible value for the firm. This increase in shareholders’ wealth is a
complex target as finance managers do not have any direct control on
market prices of the firm’s shares traded on exchanges. But while
arranging for any decision, the finance manager can certainly ascertain the
effect the decision can have on what is expected by its shareholders. This
is critical because share prices are governed not solely on entity’s past
earnings but on shareholders’ expectations about the entity’s future
earnings and current economic environment. Here, the focus is always on
the long-term wealth maximization rather than on day-to-day share price
fluctuations. This long-term focus is called for because of the fact, that
even best companies find their share price going south in declining stock
markets.

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 GOALS AND OBJECTIVES

The situation is, however, turning in favour of shareholders in recent times

as: (i) managements are turning more and more ‘enlightened’; (ii) any
share price fall relative to that of competitors in the industry often leads to
undesirable takeovers; (iii) management often has substantial stock option
incentives which converges the management’s interest with that of
shareholders and the last but not the least (iv) powerful institutional
investors holding key portion in shareholdings are keen to ensure that
finance manager is always focused on shareholder interests.

The CEOs of Nifty companies time and again assure the shareholders in
their annual reports that, “in everything that we do, we have only one
supreme goal, that is to maximize your wealth as members of India’s
largest investor family”; Reliance Industries Ltd.; or “all of us are
beginning to look at companies as owned by shareholders. The key is to
raise shareholder returns.” – Mahindra and Mahindra Ltd.

Video Link 1

Video Link 2

3.5 STRENGTHEN MANAGEMENT POWER

A question is often posed in discussions on the subject of the goals and

objectives of financial management of modern business corporations. The
question asked is “Do financial managers always follow the targets of
maximizing shareholders’ WEALTH?” It is often noticed that, under certain
circumstances, management is more interested in maintaining its own
tenure and protecting their individual field of influence.

However, it is a fact that when management interests are divergent from

shareholders’ interests, the objective of shareholders’ wealth management
is set aside. Finance managers prefer to protect what are known as their
private powers and assets. One particular event that can be recalled here
is the invitation from a successful competitor for merger of the two
companies. Such merger many times is in favor of shareholders’ economic
interest as after merger the shareholders’ wealth would increase
immediately and there would be potential for faster growth in future. Here,
experience indicates that management prefers to maintain ‘status quo’
rather than maximize shareholders’ wealth through merger. The main anti-

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 GOALS AND OBJECTIVES

merger reason here is that post-merger powers of the management can

get challenged.

Video Link 1

3.6 MAXIMIZE EARNINGS PER SHARE – EPS

A dividend is a payment made by a corporation to its shareholders, usually

as a distribution of profits and constitutes earnings per share. When a
corporation earns a profit or surplus, it re-invests a part of it in the
business (called retained earnings), and the balance is distributed as a
dividend to shareholders. A dividend is allocated as a fixed amount per
share, with shareholders receiving a dividend in proportion to their
shareholding. In India, as per current tax laws, dividends do not attract
income tax at the hands of the shareholder. Such dividends are normally
distributed annually but many large profitable companies with maximize
EPS objective in mind often declare additional interim dividends.

Two metrics are commonly used to examine a firm’s dividend policy.

Payout ratio is calculated by dividing the dividend paid by the company’s
earnings per share. A payout ratio greater than one, which is rare, means
the company, is paying out more in dividends for the year than its earnings
that year. This can happen when otherwise profitable company is
undergoing bad earnings phase in a particular year but wishes to maintain
its dividend track record. This step ensures that firm’s share prices remain
stable.

Dividend cover is calculated by dividing the company’s cash flow from

operations by the dividend. Lesser cover indicates firm’s emphasis on
declaring higher dividend and thus increasing EPS.

Video Link 1

Video Link 2

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 GOALS AND OBJECTIVES

3.7 ENSURE LEGAL COMPLIANCE

A Chief Finance Officer of a business entity has many legal responsibilities

for fulfillment with several tax and compliance laws applicable to the
particular business form of the entity.

A sole proprietorship calls for compliance with Shops and Establishment Act
1948 for day-to-day operations. Further, the CFO has to arrange finance
for different acts that call for payment of excise duty under Central Excise
Act 1944, customs duty under Customs Act 1962, sales tax under Central
Sales Tax Act 1956, income tax under Income Tax Act 1961, etc. In
addition to timely payments of dues per provisions of these acts, there is
additional responsibility to file stipulated returns and documents as per
prescribed schedules.

Central Excise
Companies Act 1944
Act 2013

Income Tax
Shops & Establishment Act 1961
Act 1948

Customs Indian Partnership

Act 1962 Act 1952

Audit of Accounts Companies Central Sales Tax

(Auditor’s Report) Order, 2015 Act 1956

CFO

A partnership firm has to comply with all above laws plus with provisions
related to Partnership Act 1952. Partners are individually responsible for
consequences in case there is any non-compliance.

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 GOALS AND OBJECTIVES

In case of private and public joint stock companies, the scope of

compliance is wider in view of many provisions in Companies Act 2013. The
Chief Finance Officer has to file, within 30 days of the Annual General Body
Meeting a balance sheet as at the end of the financial year, a profit and
loss account for the year along with cash flow statement for that period.
Additionally, a statement of changes of equity, where applicable and any
explanatory note annexed or forming part of the financial statement
(including consolidated statement for subsidiary companies) is required. All
companies need to get their books of accounts audited. The report has to
be prepared as per the accounting standards and according to Section 143
of the Companies Act, 2013 and Companies (Auditor’s Report) Order,
2015.
Requirements under other tax laws are both voluminous and complex and
therefore not summarized here.

3.8 ATTAIN MARKET LEADERSHIP

It is the responsibility of the finance function to provide appropriate cost

data to marketing to enable the entity to compete effectively in the
domestic and overseas markets. Marketing and finance have to jointly
decide how prices have to be set either in competitive markets and/or in
the markets where the business entity has virtual monopoly. To attain
market leadership, you need to have a good quality product/service and
effective marketing set-up. These have to be supplemented by competitive
pricing and here the goal of the finance manager is to determine how the
fixed costs of the organization are to be recovered.

In markets where the business entity has a dominant market share, prices
need to be decided in a manner that will allow better margins after
recovery of most fixed costs. On the other hand, in competitive domestic
markets, to stay ahead of the competition, it may be necessary to lower
the share of fixed costs that have to be recovered from the selling price.
This allows the firm to arrive at sale prices that competitors would find
very difficult to match.

In overseas markets, prices can be set competitive by taking into account

all financial benefits available under the government’s export promotion
drive that includes refund of levies on inputs, like excise duty and export
incentives.

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 GOALS AND OBJECTIVES

If the organization is aiming at increasing the market share, joint efforts on

the part of finance and marketing are of crucial importance at each stage
of sales negotiations.

3.9 PROMOTE EMPLOYEE WELFARE

It is the responsibility of the finance function to ensure that employees

receive their pay packets error free and on time. This step ensures there is
no cause for employee grievance on this score. Amounts deducted from
employees’ salary towards provident fund or income tax have to be paid to
the concerned authorities on or before prescribed due dates. Here, also
timely submission of mandatory returns at scheduled intervals is the CFO’s
responsibility.

Further, finance manager has a vital role in preparing pay packages for
employees based on inputs from human resource function. The object here
is to control turnover, eliminate disruption caused by resignations and
avoid large retraining costs. This task is crucial for employees who are
critical to the progress of the business entity. Care has to be exercised in
ensuring that packages so designed do offer maximum after tax income to
the employees.

Employees’ morale can be maintained at high levels if the firm has an

attractive incentive scheme in place that recognizes employees’ superior
performance on a continuous and timely basis and ensures that the
workforce at all locations and all levels stays loyal and motivated.

Video Link 1

Video Link 2

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 GOALS AND OBJECTIVES

3.10 ENSURE CUSTOMER SATISFACTION

Customer satisfaction is of prime importance for any business growth. This

is another area of operations where marketing and finance personnel have
to work as a single team. In addition to the quality of products and
services provided to customers, there pricing is also of equal importance.
Customers must perceive that price they are charged for supply of
products and services are both reasonable and match the product
performance. For maintaining customers’ goodwill, it may be necessary to
hold or reduce sale price.

Various types of discounts and other financial benefits are offered to the
potential customers on occasions of product launches in new markets and
at regular intervals thereafter to ensure customer loyalty. Finance
managers have to study legal requirements on prices and monopoly
practices if applicable to the industry in which the business entity is
operating.

3.11 MEET CORPORATE SOCIAL RESPONSIBILITY

3.11.1 Corporate Social Responsibility

In recent years, increasing attention has been provided to the concept of

Corporate Social Responsibility (CSR), defined in terms of the
responsiveness of businesses to stakeholders’ legal, ethical, social and
environmental expectations. A question arises in the minds of students
whether our earlier goal of shareholder wealth maximization is consistent
with a concern for social responsibility of the firm. In most instances, the
answer is yes. CSR initiatives do increase costs initially (e.g., purchase of
pollution prevention equipment) but in the long run, returns from these
initiatives far outweigh the costs.

Corporate Social Responsibility is a management goal whereby companies

integrate social and environmental concerns in their business operations
and interactions with their stakeholders. In this sense, it is important to
draw a distinction between CSR, which can be a strategic business
management concept, and charity, sponsorships or philanthropy. Even
though the charity can also make a valuable contribution to poverty
reduction, enhancement of the reputation of a company and strength of its
brand, the concept of CSR clearly goes beyond that.

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 GOALS AND OBJECTIVES

Corporate Social Responsibility

CSR is generally understood as being the way through which a company

achieves a balance of economic, environmental and social imperatives
(“Triple-Bottom-Line-Approach”), while at the same time addressing the
expectations of shareholders and stakeholders. CSR has generally been a
pragmatic response to consumer and civil society pressures. Accusations
by governments and civil society of environmental pollution, human rights
abuses and exploitation of labor in supply chains, have pressurized
corporations to become more environmentally and socially responsible. At
the same time, the business community has also quickly recognized the
strategic value of being socially more responsible to increase its business
worth. All large companies and especially MNCs are beginning to align
products and business relationships with CSR while finalizing the financial
decisions.

Key CSR issues include environmental management, eco-efficiency,

responsible sourcing, stakeholder engagement, labor standards and
working conditions, employee and community relations, social equity,
gender balance, human rights, good governance, and anti-corruption
measures.

A properly implemented CSR goal can bring along a variety of competitive

advantages to the business entity such as enhanced access to capital and
markets, increased sales and profits, operational cost savings, improved
productivity and quality, efficient human resource base, improved brand
image and reputation, enhanced customer loyalty, better decision-making
and risk management processes.

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 GOALS AND OBJECTIVES

Video Link 1

Video Link 2

3.11.2 Legal Compliance

The Section 135 and Schedule VII of the Companies Act, 2013, relates to
Corporate Social Responsibility (CSR) and is effective from April 01, 2014
as a part of the current Companies Act. The CSR norms will apply to
companies with: (a) net profit of Rs. 5 crore and above or (b) turnover of
Rs. 1,000 crore and above or (c) the net worth of Rs. 500 crore and above.
To decide if a company is eligible for mandatory CSR spending, its profit
from overseas branches and dividend received from other companies in
India will be excluded from the net profit criteria.

These companies will have to spend minimum two per cent of their three-
year average annual net profit on CSR activities in each financial year,
starting from FY15. “The rules have been finalized after extensive
consultations with all stakeholders and provide for the manner in which
CSR committee shall formulate and monitor the CSR policy, manner of
undertaking CSR activities, role of the board of directors therein and
format of disclosure of such activities in the board’s report” announced the
Minister of Corporate Affairs when this section was introduced.

According to the norms, the CSR activities will have to be within India, but
will apply to foreign companies registered in the country. The Ministry has
also listed out permissible activities and said companies will need to take
approval from their board for CSR activities in accordance with its CSR
policy and the decision of its CSR committee.

It has been clarified that activities such as donating funds to political

parties or spends to benefit own employees and their families will not be
counted as a company’s CSR expense. On the other hand, the activities
such as promoting preventive health care and sanitation, setting up homes
and hostels for women and orphans and livelihood enhancement projects
would qualify CSR efforts.

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 GOALS AND OBJECTIVES

Self-training Exercise: 1

You firm’s CFO has completed the following tasks. Has she completed the
task correctly and fully?

Yes No

1 All taxes were paid before the due dates.

As a part of CSR expense spent Rs. 30 lakhs on employee

2
housing loans.

As a part of CSR expense spent Rs. 30 lakhs on nearby

3
slum development.

Insisted that Marketing needs to cover relevant fixed costs

4
when it determines selling prices of each product.

In a year when net earnings were exceptionally low allowed

5
dividend payment from accumulated reserves.

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 GOALS AND OBJECTIVES

3.12 SUMMARY

A century ago, the main goal of the finance function in India was to
prepare accounting statements like trial balance, income statement and
firm’s balance sheet. But with economic growth and competition, a variety
of goals are being set for finance managers in addition to the traditional
central goal of profit maximization set by owners of the entity.

The most obvious and pervasive goal set for finance managers who hold
the keys of the entity’s money chest, is to maximize the profits for the
organization legally and with integrity. However, for maintaining
customers’ goodwill, it may be necessary to hold or reduce sale price.
Higher level of profits in business is considered as an index of monopoly
power that makes the business entity vulnerable for takeover by giants in
the industry or government intervention.

Since the propriety of focusing on profits alone has its challenges, it may
be prudent to adopt a valuation approach in determining finance
management goals. This approach is based on the premise that the
ultimate measure of firm’s financial management is not what the firm
earns, but how the earnings are valued by the investor.

Another broad goal of the firm is often to increase the wealth of the
shareholder by financial management attempting to achieve highest
possible value for the firm. This increase in shareholders’ wealth is a
complex target as finance managers do not have any direct control on
market prices of the firm’s shares traded on exchanges. It is also a fact
that when management interests are divergent from shareholders’
interests, the objective of shareholder wealth management is set aside.
The situation is, however, turning in favour of shareholders in recent times
as: (i) managements are turning more and more ‘enlightened’; (ii) any
share price fall relative to that of competitors in the industry often leads to
undesirable takeovers; (iii) management often has substantial stock option
incentives and last but not the least (iv) powerful institutional investors are
keen to ensure that finance manager is always focused on shareholder
interests.

61
 GOALS AND OBJECTIVES

A Chief Finance Officer of a business entity has many legal responsibilities

for compliance with several laws applicable to the particular business form
of the entity. This objective calls for compliance with related acts that
require payment of excise duty, sales tax, income tax, etc. In addition to
timely payments, stipulated returns and documents need to be filed as per
prescribed schedules.

It is the responsibility of the finance function to provide appropriate cost

data to marketing to enable the entity to compete effectively in the
domestic and overseas markets so that larger market share is achieved.
Marketing and finance have to jointly decide how prices have to be set in
competitive markets and in the markets where the business entity has
virtual monopoly.

Another goal for financial management is to maintain employees’ morale at

high levels. Towards this end, it is necessary to have an attractive
employee reward scheme in place that recognizes employees’ superior
performance on a continuous basis and ensures that the workforce at
locations and all levels stays loyal and motivated.

Customer satisfaction is of prime importance for any business growth. In

addition to the quality of products and services provided to customers,
their pricing is also of equal importance to keep customers loyal to the
firm’s offerings.

In recent years, increasing attention has been provided to the concept of

Corporate Social Responsibility (CSR), defined in terms of the
responsiveness of businesses to stakeholders’ legal, ethical, social and
environmental expectations. Key CSR issues include environmental
management, eco-efficiency, responsible sourcing, stakeholder
engagement, labor standards and working conditions, employee and
community relations, social equity, gender balance, human rights, good
governance and anti-corruption measures. The Section 135 and Schedule
VII of the Companies Act, 2013, relates to Corporate Social Responsibility
(CSR) and is effective from April 01, 2014 as a part of the current
Companies Act. The CSR norms will apply to companies with: (a) net profit
of Rs. 5 crore and above or (b) turnover of Rs. 1,000 crore and above or
(c) the net worth of Rs. 500 crore and above. These companies will have to
spend minimum two per cent of their three-year average annual net profit
on CSR activities in each financial year, starting from FY15.

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 GOALS AND OBJECTIVES

You will notice that goals set to finance managers are complex but if
achieved lead the business entity to profitable growth.

3.13 MULTIPLE CHOICE QUESTIONS

Mark (x) against the most reasonable alternative.

1. Shalini examined the goals set to financial management in any business

entity and had a good grasp of these objectives. But she was at a loss
to select the one that was most obvious and pervasive. Can you point it
out to her from the following four?
(a) Customer satisfaction
(b) Earnings per share
(c) Profit optimization
(d) Employee welfare

2. The increase in __________ is a complex target as finance managers do

not have any direct control on market prices of the firm’s shares traded
on exchanges.
(a) Customer satisfaction
(b) Earnings per share
(c) Profit optimization
(d) Shareholders’ wealth

3. A Chief Finance Officer of a business entity has many legal

responsibilities for compliance with several laws applicable to the
particular business form of the entity. The task is most complex for the
CFO of a __________.
(a) Partnership
(b) Hindu joint family
(c) Public limited company
(d) Private limited company

4. __________ is a management goal whereby companies integrate social

and environmental concerns in their business operations and
interactions with their stakeholders.
(a) Corporate social responsibility
(b) Earnings per share
(c) Profit optimization
(d) Shareholders’ wealth

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 GOALS AND OBJECTIVES

5. Expenditure on __________ cannot qualify for two per cent limit

specified for Corporate Social Responsibility (CSR) expenditure
stipulated under the Section 135 and Schedule VII of the Companies
Act, 2013.
(a) Donations to political party or employee incentive payments
(b) Amounts spent on employee and community relations
(c) Stakeholder engagement
(d) Expense on maintaining gender balance

Answers: 1. (c), 2. (d), 3. (c), 4. (a), 5. (a).

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 GOALS AND OBJECTIVES

REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter

Summary

PPT

MCQ

Video Lecture

65
 REPORTING FINANCIAL RESULTS

Chapter 4
Reporting Financial Results

Objectives
After studying this chapter, you should be able to understand:
• Clarity in financial reporting
• Income statement: contents, structure and drawbacks
• Income statement principles
• Balance sheet: contents, structure and drawbacks
• Balance sheet – statutory requirements
• Cash/fund flow statement
• Three sources of cash flows
• Auditor’s report
• Management discussion and analysis

Structure:
4.1 Introduction
4.2 Income Statement
4.3 Balance Sheet
4.4 Statement of Fund Flows
4.5 Other Financial Reports
4.6 Summary
4.7 Multiple Choice Questions

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 REPORTING FINANCIAL RESULTS

4.1 INTRODUCTION

Knowing how to work with the numbers in a company’s financial

statements is an essential skill expected from finance managers, financial
analysts and investors. The meaningful interpretation and analysis of
balance sheets, income statements and cash flow statements allows the
reader to understand financial position of the business entity. The diversity
of financial reporting requires that we first become familiar with all general
financial statement characteristics and understand what the financial
statements need to offer to management, analysts and investors. While
reporting financial information, finance managers need to provide adequate
clarity, so that readers do not get mixed up with profits, assets, cash flow
and return on investment, etc.

There is a general belief that all financial data is fully reported in just the
income statement along with the balance sheet. But this is no more true.
Unless you study firm’s cash flow statement that contains critically
important analytical data, you cannot have full picture of the firm’s
financial standing. It is important to note that it is futile to take a one-
size-fits-all approach. The firm’s business structure, the products and
services offered in the markets in which it operates, configuration of the
stockholders’ needs, etc.; all are to be considered with required diligence in
collecting, collating and presenting financial reports.

Preparation and publication of the balance sheet as at 31 March of the

accounting year, the statement of profit and loss and the cash flow
statement for the accounting year and a summary of significant accounting
policies and other explanatory information is the responsibility of the
Company’s Board of Directors for the matters stated in Section 134(5) of
the Companies Act, 2013 (‘the Act’). The board is responsible for the
preparation and presentation of these stand-alone financial statements that
give a true and fair view of the financial position, financial performance and
cash flows of the Company in accordance with the accounting principles
generally accepted in India, including the Accounting Standards specified
under Section 133 of the Act.

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Universally, Generally Accepted Accounting Principles (GAAP) are used to

prepare financial statements. The sum total of these accounting concepts
and assumptions is huge. For financial analysts and investors, a basic
understanding of at least two of these conventions – historical cost and
accrual accounting – is particularly important. According to GAAP, assets
are valued at their purchase price (historical cost), which may be
significantly different (normally lower) than their current market values.
Revenues are recorded when goods or services are delivered and expenses
recorded when incurred. Generally, this flow does not coincide with the
actual receipt and disbursement of cash, which is why the cash flow
becomes so important.

This reporting responsibility also includes maintenance of adequate

accounting records in accordance with the provisions of the Acts for
safeguarding the assets of the company and for preventing and detecting
frauds and other irregularities. Further, it covers selection and application
of appropriate accounting policies; making judgments and estimates that
are reasonable and prudent; and design, implementation and maintenance
of adequate internal financial controls. These have to operate effectively
for ensuring the accuracy and completeness of the accounting records.
These necessarily need to be relevant to the preparation and presentation
of the financial statements that provide a true and fair view and are free
from material misstatement, whether due to fraud or error.

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4.2 INCOME STATEMENT

4.2.1 Definition of ‘Income Statement’

Income statement is a financial statement that measures a company’s

financial performance over a specific accounting period (usually April 01 to
March 31). Financial performance is assessed by providing a summary of
how the business earns its revenues and incurs expenses through both
operating and non-operating activities. It also shows the net profit (or loss)
incurred over a specific accounting period, typically over a fiscal quarter or
year. This statement is also known as the “profit and loss statement” or
“statement of revenue and expense.”

The income statement is the one of the three major financial statements
that need to be presented each year. The other two are the balance sheet
and the statement of cash flows. The income statement is divided into two
parts: the operating and non-operating activities.

The portion of the income statement that deals with operating items is
interesting to investors and analysts alike because this section discloses
information about revenues and expenses that are a direct result of the
regular business operations. For example, if a business creates sports
equipment, then the operating items section would talk about the revenues
and expenses involved with the production of sports equipment. It
discloses margins earned on sale of equipment.

The non-operating items section discloses revenue and expense

information about activities that are not tied directly to a company’s
regular operations. For example, if the sport equipment company sold a
factory and some old plant equipment, then proceeds from the sale are to
be recorded in the non-operating items section.

Other Income items as appearing in the income statement of L&T Ltd. for
2014-15. Please refer 4.2.3(i) below.

Video Link 1

Video Link 2

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1. Interest Income:
From current investments:
(a) Subsidiary companies
(b) Others
From others:
(c) Subsidiary and associate companies
(d) Others
2. Dividend income:
(a) From long-term investments:
• Subsidiary companies
• Associate companies
• Other trade investments
(b) From current investments
3. Net gain/(loss) on sale of investment:
(a) Current investments
4. Net gain/(loss) on sale of fixed assets (net)
5. Lease rental
6. Miscellaneous income (net of expenses)

4.2.2 Structure

The income statement is a major mechanism for measuring the profitability

of the business entity. It is presented in a step by step or progressive
manner. Hence, it shows gross profit, operating profit before interest,
profit before taxes and net profit after taxes at different stages of the
income statement.

Income statement can be structured in two formats; either in the account

form with all expenses on the left debit side of the account and revenues
on right credit side of the account or in the report format where net income
is reported in step by step method. In the account format, all revenues and
expenses are listed one below other and net profit (loss) figure is arrived at
the end. The report format shows profit (loss) at various stages such as
gross profit, operating profit, etc.

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While Companies Act 2013 specifies the format in which a company’s

balance sheet is to be presented, it is silent so far as the format for the
income statement is concerned. The Act, however, specifies that the
income statement prepared by the company should contain information
that is adequate to reflect true and fair picture of the operations of the
company for the accounting period.

4.2.3 Contents

The income statement as it name suggests has to have all types of

revenues earned by the business entity. This includes net sales (after
discounts, etc.), interest earned, proceeds from sale of used assets and
any other non-operating income. On the expense side, it shows purchases,
wages and salaries, and other expenses like depreciation, manufacturing,
selling and distribution expenses as well as value (net of depreciation) of
assets disposed off.

As stated earlier in the report format, items are arranged in aggregated

manner in the account (or T) format and step by step method in the report
format where separate figures for gross profit, net profit before interest,
net profit after interest, etc. are available.
Maruti Udyog Ltd.
Income Statement for Year ended March 15
Account (or T) Format
Expense Rs. Crores Income Rs. Crores
Manufacturing expenses 35,257.20 Operating income 49,970.60
Material consumed 712.30 Other recurring income 831.60
Personnel expenses 1,606.60
Administrative expenses 5,681.60
Financial expenses 206.00
Depreciation 2,470.30
Net Profit 4,868.20
Total 50,802.20 Total 50,802.20

** Previous year’s data is omitted for this exercise

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In the account format, you will observe we have listed all expenses in the
debit column to show individual expenses for the year adding up to Rs.
45,934.20 not shown in there. On credit side, sales and other income adds
up to Rs. 50,802.20. These two numbers provide us a balancing figure of
profit of Rs. 4,868.20. We do not have any clear number for the operating
profit, profit after depreciation or effect of other income on the net profit.
These numbers are clearly shown in the income statements in report
format published by the companies. Let us, therefore, have a clear idea
about these numbers in the income statement published in the common
report format by Maruti Udyog Limited for the year ended March 2015.
Figures for the previous year again are not shown here.
Maruti Udyog Ltd.
Income Statement March 15
Report Format Rs. Crores
Income
Operating income 49,970.60
Expenses
Material consumed 35,257.20
Manufacturing expenses 712.30
Personnel expenses 1,606.60
Selling expenses –
Administrative expenses 5,681.60
Cost of sales 43,257.70
Operating Profit 6,712.90
Other recurring income 831.60
Adjusted PBDIT 7,544.50
Financial expenses 206.00
Depreciation 2,470.30
Other write-offs –
Adjusted PBT 4,868.20
Tax charges 1,157.00

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Adjusted PAT 3,711.20

Non-recurring items –
Net Profit 3,711.20

The net profit number of Rs. 3,711.20 crores is common in both the
formats but additional information about effect of depreciation, other
income and taxes is brought about only in the report format and not so in
the account format. Hence, all major companies publish the income
statement in the report format as they desire it should be more
meaningful.

Let us now see how the amounts shown in the income statement are
arrived at:

1. In respect of companies other than finance companies, revenue from

operations need to be disclosed separately as revenue from:
(a) Sale of products
(b) Sale of services and
(c) Other operating revenue.

Operating income also known as net sales is the sum of invoice price
of goods sold and services rendered during the accounting period. The
cut-off point here is the acceptance of goods sold by customers and
not the date on which they arranged payment against goods received
by them. This figure is adjusted for the value of goods returned by the
customers and excise and other taxes included in the value which is to
be paid back to the tax authorities.
2. Material consumed includes purchases of all raw materials, operating
supplies, spares, etc. that have taken place in the accounting year
adjusted for stocks on hand at the beginning and end of the accounting
period. The important factor here is the receipt of accepted materials
until the end of the period and not the date on which actual payment
was made to the suppliers.

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3. Manufacturing expenses include amounts spent on repairs to plant,

machinery and buildings, fuels and electricity, and all other expenses
incurred in the production unit.
4. Personnel expenses include wages and salaries paid to the workers and
other employees including employer’s contribution to provident fund,
employee insurance, bonus and other labor related expenses. Payments
under incentive schemes and performance bonus are also included here.
5. Selling expenses cover expenses on advertising, publicity, commission
to selling agents and other such expenses to maintain and increase
sales volumes. Expenses for product launches at various locations are
reported under this heading.
6. Administrative expenses include amounts spent on maintenance of
administrative offices, amounts paid to chief executive officer, finance
managers, directors and for management of the company organization.
Normally, expenses that are not directly associated with manufacturing,
distribution or selling and marketing are classified under administration
expenses.
7. Cost of sales also called cost of goods sold represents total cost
products and services sold during the accounting period. For a
distribution activity, cost of sales is the acquisition cost of inventories
sold and for manufacturing firm, it is total of material cost, labor cost
and overhead expenses.
8. Operating profit reflects the profit generated by the normal and
recurring business activities of the business entity but excludes non-
operating gains (or losses), interest expenses (or income) and taxes. It
is essentially a measure of how efficient management is in generating
revenue and controlling expenses related to its main business functions.
9. Other recurring income represents revenue that does not have direct
relation with the unit’s main business and can include cash discounts
earned, profit on sales of assets, etc. to cite a few examples.
10.Financial expenses cover cost incurred by way of borrowings to finance
operations or for acquisition of funds for expansion mostly in the form of
interest paid to financial institutions. In case the unit has issued
debentures, interest paid to debenture holders can form a major part of
this expense.

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11.Depreciation is a notional non-cash expense on wear and tear of the

assets held by the business entity. This reserve comes handy to a
limited extent when the asset is to be replaced. Even though Maruti
Udyog has shown this item separately after determination of operating
profit, many organizations include depreciation in total cost of goods
sold and then arrive at operating profit.
12.Other write-offs can include loss on sale of assets or one-off expenses
during the year.
13.Adjusted Profit Before Tax (PBT) reflects the profit generated by the
entity during the accounting year after taking care of all normal as well
other expenses incurred during the accounting year. Profit After Tax
(PAT) reflects amount available at the end of the year after payment of
income and other taxes for determining the change in owners’ equity
arising out of the total revenues and total expenses for the accounting
year. PAT is also known as the net profit of the entity.
14.PAT is also known as the bottom line of the business entity and when
the amount is positive, the firm is said to be running in ‘black’ but if it is
negative, the firm has incurred net loss, the firm is said to be running in
‘red’.

Video Link 1

Video Link 2

4.2.4 Principles

The income statement has to be prepared on principle of accrual and not

on cash basis. Thus, purchases are to be recorded based on the receipt of
accepted materials and supplies during the accounting period irrespective
of the fact whether the vendors were paid for the supplies during the same
period.

Similarly, sales are recorded when customers have accepted the goods and
services during the accounting period not considering the actual date of
payment. The amount paid by customer with the order in the accounting
year, therefore, would not form a part of sales if the goods against the said
order are not accepted by the customer during the period. On the other
hand, if customers accept materials and services in the accounting period,

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they form sales for the period even though customers may pay for them
any time after the close of the accounting period.

Expenses for the accounting period are accrued and included in the income
statement. Thus, rent for March 15 has to be included in the income
statement in spite of the fact that actual payment happens in the first
week of April 15, i.e., after the accounting period is over.

Video Link 1

4.2.5 Drawbacks

The income or rise in owners’ wealth that is expressed in the income

statement is the accounting income and not economic income. The
economist defines income as the change in real worth that occurs in
between the beginning and the end of accounting year. Appreciation in
value of land held for a long time by a business entity increases its real
worth. But it is not reflected in the income statement nor is it expected to
do so. Accounting values are normally determined by the transactions that
occur in the accounting period.

The finance manager uses the accrual and not the cash principle in
preparing income statement. In reality, it is the cash flow that determines
a unit’s net worth. You need cash to grow or to declare dividends for stock
owners.

Similarly, over the time, the assets lose their economic value which is
difficult to quantify for a particular accounting year. The finance manager
uses the principle of dividing the asset acquisition value over its useful life
to arrive at depreciation for the accounting year. Actual loss in value of an
asset does not follow this logic. Normally, the loss in asset value is smaller
initially and significant prior to the end of life of the asset. Depending upon
the method of straight line or diminishing value used for calculation of
depreciation, the asset value loss remains constant or goes on decreasing
in the income statement.

Expenses on research and development or advertising and publicity are

expected to provide returns to the business unit over number of years in
the future. But for income statement, the full expense is written off as it is
incurred every year.

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The last but not the least, economic inflation increases the market value of
the firm’s most assets. This increase in value is never reflected in the
income statement and to that extent, it fails to exhibit increase in net
wealth of the business entity.

4.3 BALANCE SHEET

4.3.1 Definition of Balance Sheet

We studied how the income statement aims to indicate the profitability of

the business entity. The balance sheet is prepared by the finance manager
to display the nature and value of assets owned by the firm and how are
these assets financed by the owners’ funds or firm’s borrowings appearing
as liabilities. Income statement and balance sheet together provide
answers to owners’ and financiers’ two queries:

a. How much did the firm make (or lose) in the given accounting period?

b. What is the measure of the firm’s worth on a given day?

You will notice from above that while the income statement provides
results of the accounting period; the balance provides net worth since
inception as on the last day of the same period.

For financial analysts and stock investors, the balance sheet is an

important instrument to gauge firm’s financial strength because it is a
reflection of what the company owns and owes. The strength of a
company’s balance sheet can be evaluated by three broad categories of
investment-quality measurements: (a) working capital adequacy, (b) asset
performance and

c. capitalization structure.

Working capital adequacy is reflected by comparing the sum of number of

days’ inventory plus debtors carried with the number of days’ creditors
shown in the balance sheet. There is no standard metric for working capital
adequacy that can be applied to all firms. You need to use numbers of the
nearest competitor or numbers of a few past years of the same firm.

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For judging asset performance, the Fixed Asset Turnover Ratio is quite
revealing. Property, Plant and Equipment (PP&E), or fixed assets, is
another of the “big” numbers in a company’s balance sheet. In fact, it
often represents the single largest component of a company’s total assets.
A company’s investment in fixed assets is dependent, to a large degree, on
its line of business. Some businesses are more capital-intensive than
others. Service companies and computer software producers need a
relatively small amount of fixed assets. Mainstream manufacturers
generally have around 30-40% of their assets in a fixed category;
accordingly, fixed asset turnover ratios will vary among different
industries.

The fixed asset turnover ratio is calculated as:

Average fixed assets can be calculated by adding the year-end numbers of

two fiscal periods and then dividing by two.

This fixed asset turnover ratio indicator, looked at over time and compared
to that of competitors, provides the investor an idea of how effectively a
company’s management is using its large and important assets. It is a
rough measure of the productivity of a company’s fixed assets with respect
to generating sales. The higher the ratio better the asset utilization.
Obviously, analysts/investors should look for consistency or increasing
fixed asset turnover rates as positive balance sheet investment qualities.

Return on Assets (ROA) is considered to be a profitability ratio – it shows

how much a company is earning on its total assets. Nevertheless, it is
worthwhile to view the ROA ratio as an indicator of asset performance. This
ratio is discussed in details in the next chapter.

Numerous non-physical assets are considered intangible assets, which can

essentially be categorized into three different types: intellectual property
(patents, copyrights, trademarks, brand names, etc.), deferred charges
(capitalized expenses) and purchased goodwill (the cost of an investment
in excess of book value). Unfortunately, there is little uniformity in balance
sheet presentations for intangible assets or the terminology used in the

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account captions. Often, intangibles are buried in other assets and often
disclosed in a note to the financials.

Video Link 1

Video Link 2

4.3.2 Structure

The balance sheet that shows the financial condition of a business unit at
given point of time shall be either in the account form or in the report
form. However, the current Companies Act 2013 prescribes only the report
form for preparing balance sheet for joint stock companies. Thus, the
option of account form is available to proprietary and partnership business
units alone.
Video Link 1

A typical account (or T) format balance sheet appears like:

Balance Sheet in Account Form

Liabilities Assets
I. Equity and Liabilities II. Assets
(1) Shareholders’ funds: (1) Non-current assets:
(a) Share capital (a) Fixed assets:
(b) Reserves and surplus (i) Tangible assets
(ii) Capital work-in-progress
(b) Non-current investments
(c) Deferred tax assets (net)
(d) Long-term loans
(2) Non-current liabilities: (2) Current assets:
(a) Long-term borrowings (a) Current investments
(b) Deferred tax liabilities (Net) (b) Inventories

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(c) Other Long-term liabilities (c) Trade receivables

(d) Long-term provisions (d) Cash and cash equivalents
(e) Short-term loans
(f) Other current assets
(3) Current liabilities:
(a) Short-term borrowings
(b) Trade payables
(c) Other current liabilities
(d) Short-term provisions
Total Total

And the balance sheet in the report format prescribed by the Companies
Act 2013 under Schedule III appears like this:

Figures as at Figures as at
the end of the end of the
Particulars Note No. current previous
reporting reporting
period period
1 2 3 4

Liabilities Assets
I. Equity and liabilities II. Assets
(1) Shareholders’ funds: (1) Non-current assets:
(a) Share capital (a) Fixed assets:
(b) Reserves and surplus (i) Tangible assets
(c) Money received against share
(ii) Intangible assets
warrants
(iii) Capital work-in-progress
(iv) Intangible assets under
Development

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(b) Non-current investments

(c) Deferred tax assets (net)
(d) Long-term loans
(2) Share application money pending
(2) Current assets:
allotment
(a) Current investments
(b) Inventories
(c) Trade receivables
(d) Cash and cash equivalents
(e) Short-term loans and advances
(f) Other current assets
(3) Secured Loans: (3) Less Current liabilities:
(a) Debentures (a) Trade payables
(b) Term loans (b) Short (< one year) term loans
Net current assets = Current assets –
(4) Unsecured Loans
Current liabilities
Total Total

4.3.3 Contents

We know that the balance sheet provides a snapshot of a business unit’s

net worth on a given point of time by listing its assets and liabilities. Let us
have a look at the contents of balance sheet of ITC for the year ended
March 2015. Figures for the previous years are not shown here.

in Rs. crores
Sources of Funds
Total Share Capital 801.55
Equity Share Capital 801.55
Share Application Money 0.00
Preference Share Capital 0.00

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Reserves 29,881.73
Net Worth 30,683.28
Secured Loans 0.02
Unsecured Loans 38.69
Total Debt 38.71
Total Liabilities 30,721.99
Application of Funds
Gross Block 21,392.12
Less: Revaluation Reserves 52.41
Less: Accumulated Depreciation 7,213.63
Net Block 14,126.08
Capital Work-in-progress 2,114.14
Investments 8,405.46
Inventories 7,836.76
Trade Receivables 1,722.40
Cash and Bank Balance 7,588.61
Total Current Assets 17,147.77
Loans and Advances 2,349.80
Fixed Deposits 0.00
Total Current Assets, Loans and 19,497.57
Advances
Deferred Credit 0.00
Current Liabilities 7,214.45
Provisions 6,206.81
Total Current Liabilities and Provisions 13,421.26
Net Current Assets 6,076.31
Miscellaneous Expenses 0.00
Total Assets 30,721.99

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** Please note that Previous year’s data is omitted for this exercise.

4.3.3 A Total Liabilities

Total Liabilities also termed as sources of funds by most companies shown

in the first part contain:

1. Equity and preference capital: Under liabilities, the first item is total
share capital that consists of equity capital and preference capital.
Equity capital also known as ordinary capital is a risk capital as there is
no commitment for distribution of dividends at any fixed rate. Equity
shareholders are the owners of the company. The preference capital is
not considered risky as preference shareholders are entitled to a fixed
rate of dividend. Cumulative preference shareholders are entitled to the
dividend whether company earns a profit or not. In absence of profit,
the company may not declare dividend and pay them but the amount is
carried forward (accumulated) for payment later. Unless this
accumulated amount is paid first, the company cannot declare dividends
to equity shareholders. Dividends have to be paid first to non-
cumulative preference shareholders before dividend to equity
shareholders can be declared in any year.

2. While the amount shown against share capital is paid-up capital, it is

common to indicate additionally Authorized Capital – the amount of
capital that a company can potentially issue as per its memorandum;
Issued Capital – the amount offered by the company to shareholders,
Subscribed Capital – the part of issued capital which has been
subscribed by the shareholders and Paid-up Capital – the amount
actually paid by shareholders. In the balance sheet of ITC, above all
these amounts are same as happens with most of the companies.

3. Share application money: It is the amount received by a company

from applicants who wish to purchase its shares. These are funds
received in response to an initial public offering of shares. This money
can be more, when there is a great response from investors, or less
than the actual amount anticipated in respect to the number of shares
floated. The recognition of share application money in a balance sheet
should be carefully recorded; otherwise, it will lead to misstatement of
the financial position of a company. Share application monies are

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converted to equity capital of an entity after allotment of shares to

qualifying applicants. This means that the share application money
becomes equity after the completion of the allotment process. It is,
therefore, recorded as equity share capital on the balance sheet as it
awaits issue of stock.

4. Reserves and surplus: There are two broad kinds of reserves: (i)
capital reserve and (ii) revenue reserve. The first capital reserve
includes share premium, revaluation reserve, and capital redemption
reserve. The capital reserve is not available for distribution of dividends
to shareholders. Revenue reserve is generated through accumulation of
retained earnings, i.e., profits after taxes not distributed as dividends.
You should recognize here that the paid-up capital along with reserves
constitute shareholders’ funds or net worth Rs. 30,683.28 in case of ITC
in its balance sheet above.

5. Secured loans: Secured loans are covered by a charge on the assets of

the borrowing firm by way of pledge or hypothecation – immovable
assets like buildings, plant and machinery are pledged and movable
assets like stocks of materials and sundry debtors are hypothecated.
Secured loans take form of debentures, term loans and working capital
loans.

6. Unsecured loans: These loans are provided by the banks and other
financial institutes against the general creditworthiness of the borrower.
No specific asset is pledged to get the loan. Term loans or working
capital loans are typical forms of unsecured loans. ITC being a strong
net worth company only small amount of Rs. 38.71 is reported as total
debt in its balance sheet above.

7. Thus, you will note that paid equity capital, reserves and loans together
constitute total liabilities of a business entity and it is reported as the
first part of the report from balance sheet.

Video Link 1

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4.3.3 B Total Assets

Total Assets also termed as application of funds by most companies include

fixed assets, investments, current assets, loans and advances,
miscellaneous expenses and losses:

1. Gross block: Assets included under this category provide benefits to

the business entity on a long-term basis and any case for more than
one year. Those assets with a life of less than one year are classified as
current assets. Gross assets include both tangible and intangible assets.
Tangible assets are to be classified as: (a) Land, (b) Buildings,
(c) Plant and Equipment, (d) Furniture and Fixtures, (e) Vehicles, (f)
Computers, (g) Office equipment and (h) Others (specify nature). These
fixed assets are shown in the balance sheet at their net value and not
the value at which they were acquired by the firm. To arrive at the net
value, depreciation on the assets calculated since its acquisition is
deducted from the total acquisition cost. Intangible fixed assets consist
of: (a) Goodwill, (b) Brands/trademarks, (c) Computer software, (d)
Mastheads and publishing titles, (e) Mining rights, (f) Copyrights, and
patents and other intellectual property rights, services and operating
rights, (g) Recipes, formulae, models, designs and prototypes, (h)
Licenses and franchise and (i) Others (specify nature). Goodwill,
trademarks and copyrights, etc. too are reported at their net value. The
net value of the asset is arrived at after deducting amortization on the
asset charged to income statement since its capitalization.
Tangible Assets Intangible Assets
Original Value on acquisition Original Value on capitalization
Less: Cumulative depreciation Less: Amortization to date
_________________________
_________________________
Net Value Net value

a. This net value of the tangible and intangible assets appears as Net Block
in the balance sheet at Rs. 14,126.08 in the ITC balance sheet above.

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2. Investments: These are classified into long-term and current (short-

term) investments. The former long-term investments take the form of
equity shares and debentures of the other companies most of which are
likely to be associate companies or subsidiaries, held by the firm in its
portfolio. Current investments are carried to generate income from cash
surpluses that occur during the course of the year. These investments
are carried in the balance sheet at cost or fair market value whichever is
lower. The finance manager has sole responsibility for levels of
investments held by the firm.

3. Inventories: These are valued at cost or net realizable value whichever

is lower. Inventories shall be classified as: (a) Raw materials, (b) Work-
in-progress, (c) Finished goods stored in the factory, warehouses (or
other locations until they are sold, (d) Stock-in-trade (in respect of
goods acquired for trading), (e) Stores and spares, (f) Loose tools, and
(g) Others (specify nature).

4. Goods-in-transit shall be disclosed separately: The levels of

inventory held are affected by sale, production and economic conditions.
High inventories involve more expense in the form of inventory carrying
costs and finance manager needs cooperation of marketing and
production functions to have control over inventory levels. Techniques
like Just-in-time (JIT) are often implemented to ensure continuous
availability of materials when required but with low inventory levels.

5. Sundry debtors also termed accounts receivables: The amount

shown against this head in the balance sheet represents the value of
sales and services rendered to the customers for which payment has not
been received by the firm as of the date of balance sheet. Some
companies age these debts and show separately amounts due to the
firm for more than six months. Companies are required to make
provision for debts considered uncollectible by reducing the income of
the year by creating a reserve for bad and doubtful debts. The number
of Rs. 1,722.40 indicated in the ITC balance sheet above is a net figure
after deducting the doubtful debt provision from total debtors.

6. Total Current Assets: This is a sum of inventories, sundry debtors and

cash and bank balances. This amount denotes the gross total of current
assets. An asset shall be classified as current when it satisfies any of the
following criteria:

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a. It is expected to be realized in, or is intended for sale or consumption

in, the company’s normal operating cycle;
b. It is held primarily for the purpose of being traded;
c. It is expected to be realized within twelve months after the reporting
date;
d. It is cash or cash equivalent unless it is restricted from being
exchanged or used to settle a liability for at least twelve months after
the reporting date.

All other assets shall be classified as non-current.

7. Current liabilities: Sundry creditors and provisions were earlier shown

the sources of funds on the liabilities side of the balance sheet. Now, it
is practice to show them, as reduction, in the application of funds or
assets side of the balance sheet. A liability shall be classified as current
when it satisfies any of the following criteria:
a. It is expected to be settled in the company’s normal operating cycle;
b. It is held primarily for the purpose of being traded;
c. It is due to be settled within twelve months after the reporting date;
d. The company does not have an unconditional right to defer
settlement of the liability for at least twelve months after the
reporting date.

Terms of a liability that could, at the option of the counterparty, result in

its settlement by the issue of equity instruments do not affect its
classification. All other liabilities shall be classified as non-current. Using
above logic, current liabilities include: (i) Short-term borrowings, (ii)
Trade payables or sundry creditors, (iii) Other current liabilities and (iv)
Short-term provisions.

Any loan that is repayable within one year from the date of balance
sheet has to be included in current liabilities here.

8. Current liabilities as indicated earlier are deducted from current assets

to arrive at net current assets (Rs. 6076.31) shown in the ITC balance
sheet.

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4.3.4 Principles

General instructions for preparation of balance sheet provided in the

Companies Act 2013, state that where compliance with the requirements of
the Act including Accounting Standards as applicable to the companies
require any change in treatment or disclosure including addition,
amendment, substitution or deletion in the head or sub-head or any
changes, inter se, in the financial statements or statements forming part
thereof, the same shall be made and the requirements of this schedule
shall stand modified accordingly.

The disclosure requirements specified in the prescribed format above are in

addition to and not in substitution of the disclosure requirements specified
in the Accounting Standards prescribed under the Companies Act, 2013.
Additional disclosures specified in the Accounting Standards shall be made
in the notes to accounts or by way of additional statement unless required
to be disclosed on the face of the Financial Statements. Similarly, all other
disclosures as required by the Companies Act shall be made in the notes to
accounts in addition to the requirements set out in this Schedule.

In preparing the Financial Statements including the notes to accounts, a

balance shall be maintained between providing excessive detail that may
not assist users of financial statements and not providing important
information as a result of too much aggregation.

To increase clarity of the financial data provided, depending upon the

turnover of the company, the figures appearing in the financial statements
may be rounded off to the nearest millions in case of companies with a
turnover of less than one hundred crore rupees; and up to nearest crores
in case of companies with a turnover of one hundred crore rupees or more.
Once a unit of measurement is used, it shall be uniformly used all along.

Except in the case of the first financial statements laid before the company
(after its incorporation), the corresponding amounts (comparatives) for the
immediately preceding reporting period for all items shown in the Financial
Statements including notes shall also be provided to allow better analysis.

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4.3.5 Drawbacks

Most of the values stated in the balance sheet are stated on historical or
original cost basis. These values have no relation to their market value.
This causes a major difficulty in understanding real value of plant and
machinery and inventory held by the business firm. The actual value could
be as high as three to four times the value reported. From a negative point
of view, firm may need much larger amounts than stated in the balance
sheet to replace the present plant or inventories.

It is argued that benefit from a sale is available for the business unit only
when cash against the sale is received. The balance sheet (as is the case
with the income statement) data is based on accrual principle and not on
actual cash basis.

The accountants’ cost principle and the monetary unit assumption limits
correct presentation of real value of the assets reported on the balance
sheet. Assets will be reported:

1. Only if they were acquired in a transaction, and

2. Generally at an amount that is not greater than the asset’s cost at the
time of the transaction.

This means that a company’s creative and effective management team will
not be listed as an asset. Similarly, a company’s outstanding reputation, its
unique product lines, and brand names developed within the company will
not be reported on the balance sheet. As you may surmise, these items are
often the most valuable of all the things owned by the company. However,
brand names if purchased from another company will be recorded in the
company’s accounting records at their cost.

The accountants’ matching principle will result in assets such as buildings,

equipment, furnishings, fixtures, vehicles, etc. being reported at amounts
less than cost. The reason is these assets are depreciated. Depreciation
reduces an asset’s book value each year and the amount of the reduction
is reported as Depreciation Expense on the income statement.

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While depreciation is reducing the book value of certain assets over their
useful lives, the current value (or fair market value) of these assets may
actually be increasing. (It is also possible that the current value of some
assets—such as computers—may be decreasing faster than the book
value.)

Current liabilities and current assets such as Cash, Accounts Receivable,

Inventory, Supplies, Prepaid Insurance, etc. usually have current values
that are close to the amounts reported on the balance sheet. Plus
accounting principles do not in any way affect their presentation at correct
value in the balance sheet.

Long-term liabilities such as Notes Payable (not due within one year) or
Bonds Payable (not maturing within one year) will often have current
values that differ from the amounts reported on the balance sheet due to
inflation in the economy.

Stockholders’ equity is the book value of the company. It is the difference

between the reported amount of assets and the reported amount of
liabilities. For the reasons mentioned above, the reported amount of
stockholders’ equity will therefore be different from the current or market
value of the company.

Video Link 1

4.4 STATEMENT OF FUND FLOWS

4.4.1 Definition

There is a general belief that all financial data is fully reported in just the
income statement and the balance sheet. But this is not true. Unless you
study firm’s cash flow statement that contains critically important
analytical data, you cannot have full picture of the firm’s financial standing.
Funds Flow is a statement prepared to analyze the reasons for changes in
the financial position of a company between two income statements and
balance sheets. In the statement of cash flows, these two reports are
translated into a statement that shows the inflow and outflow of funds. It
reflects sources and applications of funds for the selected period. The
statement considers cash flows in three major areas:

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1. Normal business operations,

2. Regular investing activities,
3. Normal financing activities.

The report in the form of income statement is prepared based on the

principle of accrual and, therefore, does not reflect fully the physical
movements of cash that takes place in the reporting period. When a
machine is acquired in a particular year, the business entity spends full
amount in cash. There is cash outflow of full amount, but only depreciation
part is shown as an expense in the income statement. In the following
year, there is no cash flow for that machine, but its depreciation is included
as an expense in that year’s income statement. Hence, the finance
manager has to prepare the statement of cash flow in addition to income
statement and the balance sheet.

To determine cash flows from operating activities, you have to translate

income statement from an accrual to cash basis. You can achieve this
objective in two different methods. First direct method requires you to pick
up each item from the income statement and turn it from accrual to cash
accounting. These calls for transferring all sales to cash sales or all
purchases have to be adjusted to cash purchases. This, thus, becomes a
very tedious exercise.

Hence, normally, second indirect method is popular and normally used.

Under this method, you start with net income and then adjustments are
arranged step by step to convert it into cash from operations. Both
methods provide you with the same end results.

Video Link 1

Video Link 2

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4.4.2 Indirect Method to Determine Cash Flow

Operations Activities

You need to have a six-step approach to arrive at net cash flows from
operating activities as under:
1. Record net income from the income statement.
2. You know that depreciation is a notional non-cash expense. Hence, you
need to add it back to the net income above as that would increase your
cash balance.
3. Is there an increase in the current assets? If so, it means you used cash
to acquire them and hence you need to deduct the amount from total of
cash above.
4. On the other hand, if there is a decrease in the current assets, it means
you received cash, say from liquidation of debtors, and this amount has
to be added.
5. Now, let us look at current liabilities. If you observe that there is
increase, it is a source of funds and it means your cash has been
received and you need to add the amount to total of cash accumulated
above.
6. On the other hand, if there is a decrease in the current liabilities, it
means you spent cash, say from liquidation of creditors, and this
amount has to be subtracted from the total above.

Investment Activities

Next, we have to determine the effect of investment activities on the cash

flows. Here, you need to consider long-term investments in acquiring and
disposing fixed assets (plant and machinery, software, etc.) disbursing and
collecting loans, etc. The amount you collect from sale of assets, recovery
of loans, receipt of dividends or interest – all constitute cash inflows; while
purchase of assets and disbursement of loans results into cash outflows.

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Financing Activities

Financing activities apply to the sale or retirement of bonds, preferred

stock, etc. The payment of dividends is also considered as financing
activity. The sale of firm’s securities causes increase in cash inflows and
retirement or repurchase of these instruments causes fall in cash balance
so does payment of dividends.

When you add the net cash flows from all three activities, you arrive at net
increase (decrease) in cash flows for the period under review.

Video Link 1

Video Link 2

4.4.3 Structure

Funds flow statement can be prepared in accounting (or T) format or in a

report format. In the accounting (or T) format, sources of cash flows are
listed on the left (debit) side of the fund flow statement and cash outflow
uses are listed on the right (credit) side of the statement.

Sources Uses
Fund Inflows Fund Outflows
(a) Net profit (a) Net loss
(b) Depreciation (b) Dividend paid
Funds from business operations
(a + b)
(c) Sale of assets (c) Payment of income tax
(d) Issue of shares/debentures (d) Fixed assets purchased
(e) Long-term borrowings (e) Payment of long-term loans
(f) Redemption of shares/debentures
Total Total

If total of sources/inflows is more than total of uses/outflows, there is an

increase in firm’s working capital and vice versa.

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Funds flow statement can also be prepared in the report format which is
more popular.

Sources of Funds (Fund Inflows)

Net profit
Depreciation
Sale of assets
Issue of shares/debentures
Long-term borrowings
Total Cash Inflows (A) ___________
___________
Uses of Funds (Fund Outflows)
Net Loss
Dividend paid
Income taxes paid
Purchase of assets/plant and machinery
Long-term loans repaid
Redemption of shares/debentures
Total Cash Outflows (B) ___________
___________
Net increase (A – B)/decrease (B – A) in working capital

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Illustration 4.1
East and West Air Coolers reported following financial results for the year
20XX that showed net profit of Rs. 166,525.
Other transactions in that year were as under:
1. It paid income tax of Rs. 50,965.
2. It installed new machinery of Rs. 75,456 and sold old assets worth Rs.
780.
3. Depreciation included in the P & L A/c of that year was Rs. 54,000.
4. Its opening inventory was Rs. 125,560 and closing inventory was at Rs.
124,710.
5. Sundry creditors showed a rise of Rs. 1,560 while sundry creditors of
Rs. 775.
6. In the year, additional long-term loan was arranged for Rs. 25,000.
7. Dividends on equity shares paid during the year amounted to Rs.
33,500
What would be the company’s net cash flow at the end of the year?
Now let us have a look at Funds Flow statement based on above
information:

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East and West Air Coolers

Sources of Funds (Fund Inflows)

From Operating Activities Rs. Rs.

After Tax Net Profit 1,15,560
Add Back Depreciation 54,000
Increase in Sundry Creditors 1,560
Decrease in Inventory 850
Increase in Sundry Debtors – 775
Total Operating A 1,71,195
From Investing Activities
Sale of Old Assets 780
Increase in Plant & Machinery – 75,456
Total Investing B – 74,676
From Finance Activities
Long-term Borrowings – 25,000
Dividends Paid – 33,500
Total Financing C – 58,500
Total Cash Inflows A+B+C 38,019

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Self-training Exercise: 1

What do you think is the effect of following transactions on business unit’s

fund flow?

Tick under A, B or C.

Fund Fund
Transaction Can’t Say
Inflow Outflow
A B C
1 Increase in Sales
2 Increase in Cash Purchase
3 Reduction in Sundry Creditors
4 Depreciation
5 Reduction in Purchases
6 Decrease in Sundry Debtors
7 Dividends on Preference Shares
8 Long-term Loan from the Bank
9 Increase in Inventory
10 Income Tax

Answers:

1. C, 2. A, 3. A, 4. A, 5. C, 6. B, 7. B, 8. A, 9. B, 10. B.

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4.4.4 Contents

Inflows

1. Net Profit: The amount is readily available in the income statement

and this is the starting point for calculating net fund flow by indirect
method.
2. Depreciation: This is a bit confusing amount that we add to the cash
flows. The confusion arises due to the fact that there is no cash
movement on account of use of equipment for production activity. On
acquisition of equipment, there is a cash outflow. The reason we have to
add depreciation in cash inflows is the fact that while arriving at net
profit above, we had deducted as an expense the part of the expense on
equipment that was chargeable to that year’s production. This is known
as matching the annual expense of owning a piece of plant and
machinery against the revenues produced from it. What we attempt
here is to restore non-cash deduction from income statement that was
arranged to arrive at net profit above.
3. Sale of Assets: Business units are required to sell machinery that has
outlived its productive life or to sell software that has become outdated/
unsuitable for the business unit. This transaction does not appear in the
income statement and hence has to be added as cash inflow.
4. Issue of Shares/Debentures: To finance business expansion, the firm
has to increase its production capacity or expand its operations over
larger territory. To support this expansion, firm needs to raise fresh
finance through issue of fresh equity or debentures. Cash received on
such issue is reflected here. Until profitability of a business firm is
established and it starts reporting steady income and distributing
dividends, it is not easy to collect funds through equity or debentures.
Now, it can do so and reduce its reliance on long-term loans and
interest burden.
5. Long-term Borrowings: As stated above in initial stages, a business
entity has to rely on long-term borrowings to finance its long-term
capital requirements. This source is significant source of funds in early
stage of unit’s business operations.

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Outflows
1. Net Loss: If the business unit has incurred a loss, it has a cash outflow
to that extent and it becomes the typical part of outflow from business
operations.
2. Dividends and Income Taxes Paid: These amounts do not form a
part of income statement and have to be shown separately as cash
outflows.
3. Purchase of Assets/Plant and Machinery: Expense for use of
buildings and plant and machinery appear as depreciation in income
statement and not their acquisition costs. Hence, we have to reflect this
cash outflow separately here.
4. Long-term Loans Repaid: As stated above, long-term loans are repaid
from cash received in the form of retained earnings. As business gets
established, firms find it cheaper to issue shares and debentures and
cash received therefrom is used to repay costly term loans.
5. Redemption of Shares/Debentures: As retained earnings
accumulate, firms can use cash reserves with them to repay shares and
debentures.
Video Link 1

4.4.5 Principles
The sources of cash essentially include:
(a) Increase in liabilities and owners’ equity
(b) Decrease in assets (of course, excluding cash) while cash is used to
(c) Decrease liabilities and owners’ equity
(d) Increase in assets (again, excluding cash).

Both increase and decrease in short-term liabilities provide you with cash
flows from operations. While both increase and decrease in assets provide
you with cash flows from investing activities, the third increase and
decrease in owners’ equity and long-term liabilities result into cash flows
caused by firm’s financing activities.

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4.4.6 Drawbacks

Cash flow statements, just like Income Statements and Balance Sheets,
are prepared using past information. They, therefore, do not provide
complete information to assess the future cash flows of an entity. On its
own, the statement of cash flows cannot be used to determine the financial
prospects of a company.

The balance sheet is a snapshot of a firm’s financial resources and

obligations at a single point in time, and the income statement summarizes
a firm’s financial transactions over an interval of time. These two financial
statements reflect the accrual basis accounting used by firms to match
revenues to the expenses associated with generating those revenues. The
cash flow statement includes only inflows and outflows of cash and cash
equivalents; it excludes transactions that do not directly affect cash
receipts and payments. These non-cash transactions include depreciation
or write-offs on bad debts or credit losses. As a cash flow statement is
based on the cash basis of accounting, it ignores the basic accounting
concept of accruals.

Cash flow statements are not suitable for judging the profitability of a firm,
either as of today or in future.

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4.5 OTHER FINANCIAL REPORTS

4.5.1 Auditor’s Report

The auditor’s responsibility is to express an opinion on the standalone

financial statements (the balance sheet as at 31 March 20XX, the
statement of profit and loss and the cash flow statement for the year then
ended, and a summary of significant accounting policies and other
explanatory information) based on their audit. They have to take into
account the provisions of the Companies Act, the accounting and auditing
standards and matters which are required to be included in the audit report
under the provisions of the Act and the Rules made thereunder.

Auditors conduct the audit in accordance with the Standards on Auditing

specified under Section 143(10) of the Companies Act. Those standards
require that auditors comply with ethical requirements and plan and
perform the audit to obtain reasonable assurance about whether the
financial statements are free from material misstatement.

An audit involves performing procedures to obtain audit evidence about the

amounts and the disclosures in the financial statements. The procedures
selected depend on the auditor’s judgment, including the assessment of
the risks of material misstatement of the financial statements, whether due
to fraud or error. In making those risk assessments, the auditor considers
internal financial control relevant to the company’s preparation of the
financial statements that give a true and fair view. This step is necessary in
order to design audit procedures that are appropriate in the circumstances.

An audit also includes evaluating the appropriateness of the accounting

policies used and the reasonableness of the accounting estimates made by
the Company’s Directors, as well as evaluating the overall presentation of
the financial statements. We now assume that the business unit, under
audit, has successfully complied with all legal obligations and proceed
further. The auditor then certifies that they believe that the audit evidence
they obtained is sufficient and appropriate to provide a basis for the audit
opinion on the standalone financial statements.

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Then the auditor provides an opinion that states “In our opinion and to the
best of our information and according to the explanations given to us, the
aforesaid standalone financial statements give the information required by
the Act in the manner so required and give a true and fair view in
conformity with the accounting principles generally accepted in India, of
the state of affairs of the company as at 31 March 20XX and its profit and
its cash flows for the year ended on that date.”

Thereafter, as required by Section 143(3) of the Act, auditors have to

report as under:
a. We have sought and obtained all the information and explanations
which to the best of our knowledge and belief were necessary for the
purposes of our audit.
b. In our opinion, proper books of account as required by law has been
kept by the company so far as it appears from our examination of those
books.
c. The balance sheet, the statement of profit and loss and the cash flow
statement dealt with by this report are in agreement with the books of
account.
d. In our opinion, the aforesaid standalone financial statements comply
with the Accounting Standards specified under Section 133 of the Act,
read with Rule 7 of the Companies (Accounts) Rules, 2014.
e. On the basis of the written representations received from the directors
as on 31 March 20XX taken on record by the Board of Directors, none of
the directors is disqualified as on 31 March 20XX from being appointed
as a director in terms of Section 164(2) of the Act.

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With respect to the other matters to be included in the Auditor’s Report in

accordance with Rule 11 of the Companies (Audit and Auditors) Rules,
2014, the auditors are required to certify based on their opinion and to the
best of their information and according to the explanations given to them
that:
1. The impact of pending litigations has been reflected on its financial
position in its financial statements – Refer Note XX and YY.
2. The Company has made provision, as required under the applicable law
or accounting standards, for material foreseeable losses, if any.
3. The Company has maintained proper records showing full particulars,
including quantitative details and situation of fixed assets.
4. The Company has a regular programme of physical verification of its
fixed assets by which fixed assets are verified in a phased manner over
a period of three years. In accordance with this program, certain fixed
assets were verified during the year and no material discrepancies were
noticed on such verification. In our opinion, this periodicity of physical
verification is reasonable having regard to the size of the Company and
the nature of its assets.
5. The Company has adequate system for verification inventories held by
them and for writing off identified obsolete stocks.
6. The Company has granted loans to XXX bodies corporate covered in the
register maintained under Section 189 of the Companies Act, 2013 (‘the
Act’).
7. In the case of the loans granted to the bodies corporate listed in the
register maintained under section 189 of the Act, the borrowers have
been regular in the payment of the interest as stipulated. Repayments
have been arranged per the terms of repayment schedule and there
have been no defaults.
8. There are no overdue amounts of more than rupees XXX in respect of
the loans granted to the bodies corporate listed in the register
maintained under section 189 of the Act.

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9. In our opinion and according to the information and explanations given

to us, there is an adequate internal control system commensurate with
the size of the Company and the nature of its business with regard to
purchase of fixed assets and sale of services. The activities of the
Company do not involve purchase of inventory and the sale of goods.
We have not observed any major weakness in the internal control
system during the course of the audit.
10.The Company has not accepted any deposits from the public. (If yes,
there are no defaults in repayments).
11.The Central Government has not prescribed the maintenance of cost
records under section 148(1) of the Act, for any of the services
rendered by the Company. (If yes, records maintained comply with
requirements of the Act).
12.According to the information and explanations given to us and on the
basis of our examination of the records of the Company, amounts
deducted/accrued in the books of account in respect of undisputed
statutory dues including provident fund, income tax, sales tax, wealth
tax, service tax, duty of customs value added tax, cess and other
material statutory dues have been regularly deposited during the year
by the Company with the appropriate authorities. As explained to us,
the Company did not have any dues on account of employees’ state
insurance and duty of excise.
13.According to the information and explanations given to us, no material
fraud on or by the Company has been noticed or reported during the
course of our audit.

Video Link 1

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4.5.2 Notes to Accounts

Notes to year’s financial statements start with a brief history of the

company, the fact that it is incorporated under the provisions of the
Companies Act, 2013. They further state the fact that it is engaged in the
certain type of business, etc. in India and other countries (if any).

Notes then confirm that the Financial Statements of the Company have
been prepared in accordance with Generally Accepted Accounting Principles
in India (Indian GAAP). The Company has prepared these Financial
Statements to comply in all material respects, with the Accounting
Standards notified under the Companies (Accounting Standards) Rules and
the relevant provisions of the Companies Act, 1956. The Financial
Statements have been prepared on an accrual basis and under the
historical cost convention. Further, Directors reiterate that the accounting
policies adopted in the preparation of financial statements are consistent
with those of previous year except for the change in accounting policy, if
any explained separately.

Significant accounting policies adopted by the company are listed in these

notes serially. Normally, they relate to:
1. Change in Accounting Policy: Changes, if any, are explained.
2. Uses of Estimates: Confirmation that the estimates used in financial
statements are based on the management’s best knowledge of current
events and actions. However, the uncertainty about these assumptions
and estimates could result in material or immaterial adjustments to the
carrying amounts of assets or liabilities in future periods.
3. Revenue Recognition: Explain the method for recognizing sales,
service fees, rentals, interest, etc. Tangible Fixed Assets – the fact that
Fixed Assets are stated at cost, net of accumulated depreciation and
accumulated impairment losses, if any.
4. Depreciation: Depreciation on assets is provided on (reducing balance
or) straight line method using the rates arrived at based on the useful
lives estimated by the management, or those prescribed under the
Schedule XIV.

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5. Intangible Assets: How are intangible assets acquired on initial

recognition separately measured (at cost?). Following initial recognition,
how are intangible assets carried (usually at cost less accumulated
amortization and accumulated impairment losses, if any)? Whether
internally generated intangible assets are capitalized or expensed off in
the Statement of Profit and Loss in the year in which the expenditure is
incurred? Intangible assets are amortized on a straight line (or any
other) basis over the estimated useful economic life.
6. Borrowing Cost: How some costs (if any) are capitalized and rest
expensed.
7. Foreign Exchange Transactions/Translation: Here, management
explains methods for Initial Recognition, Conversion and Exchange
Differences.
8. Taxes on Income: A statement similar to ‘Tax expense’ comprises
current and deferred tax. Current income tax is measured at the
amount expected to be paid to the tax authorities in accordance with
the Income Tax Act, 1961 enacted in India. The tax rates and tax laws
used to compute the amounts are those that are enacted, at the
reporting date. Also method of accounting and determining deferred
taxes and minimum alternate taxes.
9. Employee Benefits: How are provident fund, gratuity, leave
encashment, post-retirement medical scheme expense accounted and
whether they are based on the percentages notified by Government
Guidelines.

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10.Investment: Usually, the note states that ‘Investments, which are

readily realizable and intended to be held for not more than one year
from the date on which such investments are made, are classified as
current investments. All other investments are classified as long-term
investments. On initial recognition, all investments are measured at
cost. The cost comprises purchase price and directly attributable
acquisition charges such as brokerage, fees and duties. Current
investments are carried in the financial statements at lower of cost and
fair value determined on an individual investment basis. Long-term
investments are carried at cost. However, provision for diminution in
values is made to recognize a decline other than temporary in the value
of the investments. On disposal of an investment, the difference
between its carrying amount and net disposal proceeds is charged or
credited to the statement of profit and loss.
11.Earnings Per Share: Method of calculation adopted to be explained.
12.Impairment of Assets: Here, directors explain how in case of damage
to an asset care is taken to ensure that value shown in the statements
does not exceed its recoverable value.
13.Provisions, Contingent Liabilities and Contingent Assets:
Provisions should take care of obligations as on the date reports are
prepared. Usually, the company does not recognize a contingent liability
but discloses its existence in the financial statements,
14.Lease: Directors report what course of action the company follows
when it is either lessor or lessee.

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4.5.3 Director’s Report

This report provides additional information not included in earlier financial

statements like:
a. A summary of financial performance of the company for the period
under review.
b. Recommendation about the dividend to be distributed from the net
earnings.
c. Appointment of directors, auditors, cost auditor (if applicable).
d. Directors’ responsibility statement.
e. Company’s credit rating, status of fixed deposits and employees’ stock
option scheme.
f. Strategic acquisitions, if any.
g. Steps taken for human resource development.
h. Steps taken towards CSR – corporate social responsibility, conservation
of energy and technology absorption. Key CSR issues include –
environmental management, eco-efficiency, responsible sourcing,
stakeholder engagement, labor standards and working conditions,
employee and community relations, social equity, gender balance,
human rights, good governance, and anti-corruption measures.

Video Link 1

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4.5.4 MDA – Management Discussion and Analysis

MDA aims at familiarizing shareholders with the latest trends in the

industry, what is the business strategy of the firm, and thrust areas
emanating from it. MDA discusses threats and opportunities for the firm. It
also provides highlights on financial performance during the year. It spells
out the internal control system in place in the firm.

A typical Management Discussion and Analysis would run as under:

“Our strategic objective is to build a sustainable organization that remains

relevant to the agenda of our clients, while generating profitable growth for
our investors.

In order to do this, we will apply the priorities of our strategy relevant to

our own business and cascade it to everything we do. We plan to pursue
strategic alliances and acquisitions by developing alliances that
complement our core competencies (you can state the ones relevant to
your industry/type of business). We plan to deploy our capital in making
selective business acquisitions that augment our expertise, complement
our presence in certain market segments and accelerate the execution of
our strategies.

In order to build deep and impactful client relationships, our strategy is to

engage with clients on their large transformative programs. We are
expanding existing client relationships by providing them a broad set of
end-to-end service offerings and increasing the size, nature and number of
projects we do with them. We will acquire new clients, and increase our
presence in new geographies and market segments by investing in
targeted business development and marketing.

Our aim is to build a culture within the Company that delivers innovation to
clients. We create the required environment, structures, ecosystems and
economic models that will spur innovation across the Company. We are
using Design Thinking methods to elicit new problem statements and bring
together our deep knowledge of client industries and emerging
technologies to solve problems for our clients.

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Attract and retain a global, diverse, motivated and high performing

employee base is our another critical objective. Our employees are our
biggest assets. To meet the evolving need of our clients, our priority is to
attract and engage the best talent in the right locations with the right
skills. We are fully committed to strengthening our brand to continue to be
the ‘employer of choice’. A series of measures have been initiated to
empower our employees through trust and accountability. We have
overhauled our performance management system to bring in more
objectivity, created internal marketplace for employees to work on
challenging assignments, and increased the focus on providing a safe and
transparent working environment.

We have invested substantially in training, which is central to our

employees’ learning and career development process. We are committed to
creating a work environment that is social, fun and collaborative. We
continue to provide employees with lifelong learning opportunities in a
transparent and meritocratic culture.

To enhance our operational effectiveness for agility and cost, we

periodically assess the effectiveness of our organization structure and
processes to optimize it for alignment with our strategic objectives and
agility. We continually evaluate critical cross-functional processes and
benchmark them with best-in-class practices to optimize costs and enable
swift and effective response to our clients. We constantly monitor and
optimize various operational parameters such as the cost and utilization of
resources, distribution of employees around the world, the cost of
operating our campuses and optimally realizing the efficiencies of scale.”

The Management Discussion and Analysis is a very important section of an

annual report, especially for those analyzing the business entity’s
fundamentals, which include management and management style.
Although this section contains useful information, investors should keep in
mind that the section is unaudited.

Here is a summary of major contents in MDA.

Video Link 1

Video Link 2

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Management Discussion and Analysis 2014-15 L&T Ltd.

Overview of
Indian Economy
Business Scenario
Growth Strategies and
Thrust Areas Focus on Quality
of new orders Profitable and
efficient execution
Working Capital
Manpower.

4.5.5 Report on Corporate Governance

These days, progressive companies add this report in their annual

accounts. Corporate Governance is the system of rules, practices and
processes by which a company is directed and controlled. Corporate
governance essentially involves balancing the interests of the many
stakeholders in a company – these include its shareholders, management,
customers, suppliers, financiers, government and the community. Since
corporate governance also provides the framework for attaining a
company’s objectives, it encompasses practically every sphere of
management, from action plans and internal controls to performance
measurement and control.

Corporate governance is based on principles such as conducting the

business with all integrity and fairness, being transparent with regard to all
transactions, making all the necessary disclosures and decisions, complying
with all the laws of the land, accountability and responsibility towards the
stakeholders and commitment to conducting business in an ethical manner.
Another point which is highlighted in the SEBI Report on Corporate
Governance is the need for those in control to be able to distinguish
between what are personal and corporate funds while managing a
company.

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4.6 SUMMARY

The meaningful interpretation and analysis of balance sheets, income

statements and cash flow statements allows the reader to understand
financial position of the business entity. The diversity of financial reporting
requires that we first become familiar with all general financial statement
characteristics and understand what the financial statements need to offer
to management, analysts and investors. There is a general belief that all
financial data is fully reported in just the income statement and the
balance sheet. But this is not true. Unless you study firm’s cash flow
statement that contains critically important analytical data, you cannot
have full picture of the firm’s financial standing.

Income statement is a financial statement that measures a company’s

financial performance over a specific accounting period (usually April 01 to
March 31). Financial performance is assessed by providing a summary of
how the business earns its revenues and incurs expenses through both
operating and non-operating activities. The income statement is a major
mechanism for measuring the profitability of the business entity. It is
presented in a step by step or progressive manner. Hence, it shows gross
profit, operating profit before interest, profit before taxes and net profit
after taxes at different stages of the income statement. Income statement
can be structured in two formats; either in the account form with all
expenses on the left debit side of the account and revenues on right credit
side of the account or in the report format where net income is reported in
step by step method.

The income statement as its name suggests has to have all types of
revenues earned by the business entity. This includes net sales (after
discounts, etc.), interest earned, proceeds from sale of used assets and
any other non-operating income. On the expense side, it shows purchases,
wages and salaries, and other expenses like depreciation, manufacturing,
selling and distribution expenses as well as value (net of depreciation) of
assets disposed of. The income statement has to be prepared on principle
of accrual and not on cash basis.

The finance manager uses the accrual and not the cash principle in
preparing income statement. In reality, it is the cash flow that determines
a unit’s net worth. You need cash to grow or to declare dividends for stock
owners.

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The balance sheet is prepared to display the nature and value of assets
owned by the firm and how are these assets financed by the owners’ funds
or firm’s borrowings appearing as liabilities. Income statement and balance
sheet together provide answers to owners’ and financiers’ two queries:

a. How much did the firm make (or lose) in the given accounting period?

b. What is the measure of the firm’s worth on a given day?

The balance sheet that shows the financial condition of a business unit at
given point of time shall be in either in the account form or in the report
form. However, the current Companies Act 2013 prescribes only the report
form for preparing balance sheet for joint stock companies.

Total Liabilities also termed as sources of funds by most companies contain

equity and preference capital, share application money, reserves and
surplus as well as secured and unsecured loans. Total Assets also termed
as application of funds by most companies include fixed assets,
investments, current assets, loans and advances, and miscellaneous
expenses and losses. Most of the values stated in the balance sheet are on
historical or original cost basis. These values have no relation to their
market value.

The report in the form of income statement is prepared based on the

principle of accrual and, therefore, does not reflect fully the physical
movement of cash that takes place in the reporting period. Hence, a Funds
Flow Statement is prepared to analyze the reasons for changes in the
financial position of a company between two income statements and
balance sheets.

To determine cash flows from operating activities you have to translate

income statement from an accrual to cash basis. This objective you can
achieve in two different methods. First, direct method requires you to pick
up each item from the income statement and turn it from accrual to cash
accounting. These calls for transferring all sales to cash sales or all
purchases have to be adjusted to cash purchases. This, thus, becomes a
very tedious exercise.

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Hence, normally, second indirect method is popular and normally used.

Under this method, you start with net income and then step by step
adjustments are arranged to convert it into cash from operations. Both
methods provide you with the same end results.

The auditor’s responsibility is to express an opinion on the standalone

financial statements (the balance sheet as at 31 March 20XX, the
statement of profit and loss and the cash flow statement for the year then
ended, and a summary of significant accounting policies and other
explanatory information) in the report based on their audit. The report
takes into account the provisions of the Companies Act, the accounting and
auditing standards and matters which are required to be included in the
audit report under the provisions of the Act and the Rules made
thereunder.

Notes to accounts appearing in the published accounts provide us with the

methods adopted by the reporting firm in arriving at various numbers in
the accounts – for example, whether net asset value is based on straight
line or reducing balance depreciation basis. They also establish firm’s
standards to recognize revenue (or expense).

The Director’s report reflects financial performance of the company,

recommendation about the dividends, company’s credit rating, and status
of fixed deposits, employees’ stock option scheme, as well as steps taken
for human resource development and towards corporate social
responsibility, conservation of energy and technology absorption.

Management Discussion and Analysis aims at familiarizing shareholders

with the latest trends in the industry, what is the business strategy of the
firm, and thrust areas emanating from it. MDA report discusses threats and
opportunities for the firm. It also provides highlights on financial
performance during the year. It spells out the internal control system in
place in the firm.

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4.7 MULTIPLE CHOICE QUESTIONS

Mark (x) against the most reasonable alternative.

1. Anand and Ashok started preparing for their Chartered Accountants’

entrance examination. Anand argued that a company’s financial
statements are prepared for information and analysis by finance
executives. Ashok was of the opinion that these statement are meant
for financial analysts. Who amongst following, according to you, are
expected to study and analyze the financial statements?
(a) Investors
(b) Finance Managers
(c) Financial Analysts
(d) Each one of above

2. The increase in net wealth of the business entity is never reported in the
annual income statements and to that extent it fails to reflect economic
income. This is due to the fact that income statement __________.
(a) is based on accrual system
(b) is based on cash system
(c) fails to recognize increase in value of firms assets caused by
inflation
(d) is prepared based on the trial balance as at end of the period

3. More relevant financial information is available in the company’s balance

sheet which is prepared by the finance manager of a company
__________.
(a) in a report format
(b) on a quarterly basis
(c) in T format
(d) on an annual basis

4. If you are preparing a funds flow statement for a business entity to

accompany its Income Statement and Balance Sheet, it is necessary
that you take into consideration cash flows from the firm’s __________
activities,
(a) Operations
(b) Financial
(c) Investing
(d) All of the above

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5. You will always find that a summary of financial performance of the

company for the period under review and recommendation about the
dividend, if any, to be distributed from the net earnings is available in
firm’s __________.
(a) Management Discussion and Analysis (MDA)
(b) Director’s Report
(c) Report on Corporate Governance
(d) All of the above

Answers: 1. (d), 2. (c), 3. (a), 4. (d), 5. (b).

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REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter

Summary

PPT

MCQ

Video Lecture

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Chapter 5
Financial Analysis For Management
Decisions

Objectives
After studying this chapter, you should be able to understand:
• Ratios and Trends as tools for financial analysis and decisions
• Understanding firm’s capital structure using Leverage Ratios
• How Liquidity Ratios explain working capital management
• Measurement of returns on sales, assets, equity and debt
• How valuation ratios determine firm’s value
• Interpreting trends exhibited in financial reports

Structure:
5.1 Introduction
5.2 Ratio Analysis
5.3 Trend Analysis
5.4 Summary
5.5 Multiple Choice Questions

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5.1 INTRODUCTION

In the previous chapter 4 ‘Reporting Financial Results’, we had a look at

several documents prepared by the business entity to collect, record and
report financial data about the entity’s business operations. Based on this
fundamental financial data, we shall now leap into financial analysis that
evaluates the performance of the firm. Financial analysis is often defined
as the process of evaluating businesses, projects, budgets and other
finance-related entities to determine their suitability for investment.
Typically, financial analysis is used to analyze whether an entity is stable,
solvent, liquid, or profitable enough to be invested in. When looking at a
specific company, the financial analyst often focuses on the income
statement, balance sheet, and cash flow statement.

Ratio analysis is the process of determining and interpreting numerical

relationships based on financial statements. A ratio is a statistical yardstick
that provides a measure of the relationship between two variables or
figures. This relationship can be expressed as a per cent or as a quotient.
Ratios are simple to calculate and easy to understand. The persons
interested in the analysis of financial statements can be grouped under
three heads:
(i) Owners or investors
(ii) Creditors
(iii) Financial executives.

The absolute numbers in financial statements alone are of little value for
financial analysis, which therefore must transform these numbers into
meaningful relationships to judge a company’s financial performance and
condition. The resulting ratios and indicators must be viewed over
extended periods to reflect trends. Here again, beware of the one-size-fits-
all syndrome. Evaluative financial metrics can differ significantly by
industry, company size and stage of development.

Most of the financial analysis is undertaken using ratios like income to

sales or current assets to current liabilities. One of the most common ways
of analyzing financial data is to calculate ratios from the data to compare
against those of other companies or against the company’s own historical
performance. For example, return on assets is a common ratio used to
determine how efficient a company is at using its assets and as a measure

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of profitability. This ratio could be calculated for several similar companies

and compared as part of a larger analysis.

Video Link 1

Video Link 2

5.2 RATIO ANALYSIS

5.2.1 Classification

Ratio analysis is a commonly used tool of financial statement analysis.

Ratio is a mathematical relationship between one number to another
number. Ratio is used as an index for evaluating the financial performance
of the business concern. An accounting ratio shows the mathematical
relationship between two figures, which have meaningful relation with each
other. For exhaustive financial analysis, experts classify financial ratios into
the following five groups:
1. Structural or debt utilization ratios
2. Liquidity ratios
3. Profitability ratios
4. Turnover or asset utilization ratios
5. Valuation ratios

We shall use the following Income Statement and Balance Sheet of Larsen
and Toubro Ltd. to measure and understand various financial ratios that
are used for analysis.

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Larsen & Toubro Ltd. Profit and Loss A/c: Income Statement for
the year ended March 2015

FY 2015 FY 2014
Parameters Rs. Crores Rs. Crores
Gross Sales 57,558.07 57,163.85
Less: Excise 540.66 564.93
Net Sales 57,017.41 56,598.92
Increase/Decrease in Stock –268.18 110.20
Raw Materials Consumed 25,283.30 24,031.75
Power and Fuel Cost 685.60 656.73
Employee Cost 4,150.84 4,656.90
Other Manufacturing Expenses 16,808.97 16,762.27
Cost of Goods Sold 46,613.83 46,217.85
General and Administration Expenses 2,904.30 2,933.40
Selling and Distribution Expenses 149.63 161.80
Miscellaneous Expenses 671.06 710.39
Total Expenditure 50,385.52 50,023.44
PBIDT 6,631.89 6,575.48
Other Income 2,299.17 2,104.67
Operating Profit 8,931.06 8,680.15
Interest 1,578.85 1,208.32
PBDT 7,352.21 7,471.83
Depreciation 1,008.15 792.42
PBT and Exceptional Items 6,344.06 6,679.41
Exceptional Income/Expenses 357.16 588.50
Profit before Tax 6,701.22 7,267.91
Provision for Tax 1,645.04 1,774.78

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Profit after Tax 5,056.18 5,493.13

Appropriations 5,389.63 5,778.88
Equity Dividend) 812.50 712.50
Earnings per Share (in `) 54.39 59.26
Book Value (`) 398.78 362.95

Larsen & Toubro Ltd.: Balance Sheet as on March 31, 2015

FY 2015 FY 2014
Parameters Rs. Crores Rs. Crores
Equity and Liabilities
Share Capital 185.91 185.38
Total Reserves 36,646.11 33,152.75
Shareholder’s Funds 37,084.58 33,661.83
Secured Loans 400.00 400.00
Unsecured Loans 8,108.60 5,078.14
Deferred Tax Assets/Liabilities 362.99 409.92
Other Long-term Liabilities 119.62 93.57
Long-term Provisions 350.45 299.61
Total Non-current Liabilities 9,341.66 6,281.24
Current Liabilities
Trade Payables 18,844.77 16,345.45
Other Current Liabilities 15,340.79 16,026.50
Short-term Borrowings 3,791.08 3,876.04
Short-term Provisions 5,729.17 2,113.52
Total Current Liabilities 43,705.81 38,361.51
Total Liabilities 90,132.05 78,304.58

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Assets
Gross Block 2,290.36 11,663.21
Less: Accumulated Depreciation 4,793.00 3,978.41
Less: Impairment of Assets 6.93 6.93
Net Block 7,490.43 7,677.87
Lease Adjustment A/c –3.07 -3.07
Capital Work-in-progress 304.54 411.86
Intangible Assets under Development 189.50 150.55
Non-current Investments 17,672.82 15,168.41
Long-term Loans and Advances 2,720.83 3,721.57
Other Non-current Assets 75.43 9.54
Total Non-current Assets 28,450.48 27,136.73
Current Assets, Loans and Advances
Currents Investments 5,380.08 4,046.23
Inventories 2,207.79 1,982.53
Sundry Debtors 23,051.11 21,538.76
Cash and Bank 1,515.80 1,782.86
Other Current Assets 18,433.72 15,418.66
Short-term Loans and Advances 11,040.64 6,345.57
Total Current Assets 61,629.14 51,114.61
Net Current Assets 17,923.33 12,753.10
Total Current Assets 56,249.06 47,068.38
Miscellaneous Expenses 52.43 53.24
Total Assets 90,132.05 78,304.58
Contingent Liabilities 19,864.38 10,212.16

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We plan to study twenty-three financial ratios broken into five major

categories as under:

Turnover or
Leverage Liquidity Profitability Asset Valuation
Ratios Ratios Ratios Utilization Ratios
Ratios
Funded Debt
Gross Profit Receivables
to Current Ratio Yield
Margin Turnover
Capitalization
Operating Average
Price Earnings
Debt to Equity Quick Ratio Profit Margin Collection
Ratio
Ratio Period
Interest Market Value/
Net Profit Inventory
Coverage Book Value
Margin Ratio Turnover
Ratio Ratio
Fixed Charges
Return on Fixed Assets Price to Sales
Coverage
Assets Ratio Turnover Ratio
Ratio
Return on Total Assets Price to Book
Equity Ratio Turnover (P/B) Ratio

5.2.2 Leverage Ratios

Two types of ratios are commonly used to examine financial leverage: (a)
Structural or debt utilization ratios and (b) Coverage ratios. Structural or
debt utilization ratios allow the analyst to measure the entity’s prudence in
managing its debt. This use of debts to finance business is also known as
leveraging business. While debt capital is cheaper source of finance, it is
equally risk prone. Coverage ratios are meant to focus on the relationship
between debt servicing commitments, i.e., ability to pay interest and repay
the debt on its maturity.

Four different approaches are there to measure this prudence.

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Funded Debt to Total Capitalization

This ratio is also known as debt asset ratio. The ratio attempts to
determine the extent to which borrowed funds support the firm’s total
assets. Here, the numerator consists of long-term loans, debentures and
other forms of debts. This sum is divided by the total assets of the firm.
Generally, lower the ratio better the debt management system of the
business entity. The prudent ratio is supposed to be 0.5.

In case of L&T Ltd., the ratio for FY 2015 is Rs. 9,341.66 crores ÷ Rs.
90,132.05 crores = 0.10 and for the FY 2014, it is Rs. 6,281.24 crores ÷
Rs. 78,304.58 crores = 0.08. Thus, L&T Ltd. has one of the best debt
management as its ratio is much below 0.5 considered prudent by
analysts. The ratio for FY 2014 was better than that for FY 2015. If you
were to look at the numbers from M&M Ltd. balance sheet, you will find
total debt of Rs. 2620.38 crores versus total assets of Rs. 21875.47 for FY
2015 providing you with 0.12 another strong debt asset ratio.

Debt to Equity

This ratio indicates relative contribution of creditors and owners to operate

the business activities of the firm. Debt/Equity Ratio is used to measure a
company’s financial leverage. It is calculated by dividing company’s total
liabilities by its stockholders’ equity. The D/E ratio indicates how much debt
a company is using to finance its assets relative to the amount of value
represented in shareholders’ equity. The formula for calculating D/E ratios
is represented in the following way:

Debt to Equity Ratio = Long-term Debt/Shareholders’ Equity

In case of L&T Ltd., the ratio for FY 2015 is Rs. 9,341.66 crores ÷ Rs.
37,084.58 crores = 0.25 and for FY 2014 Rs. 6,281.24 crores ÷ Rs.
33,661.83 crores = 0.19 thereby establishing once again that this company
has built-up reserves to raise its equity to four times the amount it needs
to pay back its lenders. For FY 2015, M&M Ltd. – another financially sound
corporation – has built-up capital and reserves of Rs. 19255.09 crores to
service debt of only Rs. 2620.38 crores – thus providing strong debt/equity
ratio of 0.14. From the study of published accounts of about of 3114
companies in 2007-08, it was observed that the average debt/equity ratio
for all industries was 0.44.

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Given that the debt/equity ratio measures a company’s debt relative to the
total value of its stock, it is most often used to gauge the extent to which a
company is taking on debts as a means of leveraging (attempting to
increase its value by using borrowed money to fund various projects). A
high debt/equity ratio generally means that a company has been
aggressive in financing its growth with debt. Aggressive leveraging
practices are often associated with high levels of risk. This may result in
volatile earnings as a result of the additional interest expense.

If a lot of debt is used to finance increased operations (high debt to

equity), the company could potentially generate more earnings than it
would have without this outside financing. If this were to increase earnings
by a greater amount than the debt cost (interest), then the shareholders
benefit as more earnings are being spread among the same amount of
shareholders. However, if the cost of this debt financing ends up
outweighing the returns that the company generates on the debt through
investment and business activities, stakeholders’ share values may take a
hit. If the cost of debt becomes too much for the company to handle, it can
even lead to bankruptcy, which would leave shareholders with nothing.

Like with most ratios, when using the debt/equity ratio, it is very important
to consider the industry in which the company operates. Because different
industries rely on different amounts of capital to operate and use that
capital in different ways, a relatively high D/E ratio may be common in one
industry while a relatively low D/E may be common in another.

Another important point to consider when assessing D/E ratios is that the
“Total Long-term Liabilities” portion of the formula may often be
determined in a variety of ways by different companies, some of which are
not actually the sum of all of the company’s liabilities. In some cases,
companies will only incorporate debts (like loans and debt securities) into
the liabilities portion of the formula, while omitting other kinds of liabilities
(unearned revenue, etc.). In other cases, companies may calculate D/E in
an even more specific way, including only long-term debts and excluding
short-term debts and other liabilities. Yet, “long-term debt” here is not
necessarily a term with a consistent meaning. It may include all long-term
debts, but it may also exclude long-term debts nearing maturity, which are
then categorized as “short-term” debts. Because of these differentiations,
when considering a company’s D/E ratio, one should try to determine how

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the ratio was calculated and should be sure to consider other ratios and
performance metrics as well.

Interest Coverage Ratio

This ratio is determined by dividing the sum of profit before interest and
taxes by the total interest burden arising from the debts. The taxes are
added to the profit as the ability of the firm to pay interest does not get
affected by taxes as interest happens to be a tax deductible expense.
Higher the ratio, greater the firm’s ability to pay interest even if there is a
partial drop in it profits. The high ratio attracts investors to the business
entity.

For L&T Ltd., the ratio for FY 2015 is Rs. 8,280.07 crores ÷ Rs. 1,578.85 =
5.24 showing that the company has robust earnings to cover the interest
burden. The ratio for FY 2014 works to 7.01 much stronger because of high
figure of interest plus profits of Rs. 8,476 crores earned that year.

In case of M&M Ltd. for FY 2015, it has Rs. 8,904 crores to support interest
burden of Rs. 3050 crores providing a ratio of 2.92 which is sound but not
as sound as that of L&T Ltd.

Low interest coverage ratio is a warning for investors because if there is a

fall in profits before interest, it can embarrass the firm in complying with
its interest payment schedules.

Fixed Charges Coverage Ratio

This ratio is determined by dividing the sum of profit before interest and
taxes by the total burden arising from the fixed charges. This ratio takes a
wider look at debt management than the one taken to use interest
coverage ratio. By measuring this ratio, the analyst judges the firm’s
sustained ability to meet its, not only interest but, all fixed financial
obligations based on the assumption that failure to meet any financial (not
interest alone) burden would endanger the credit rating of the business
entity.
Video Link 1

Video Link 2

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5.2.3 Liquidity Ratios

After reviewing the firm’s prudence in managing its debt that take care of
long-term obligations, next area for analysis is how does the management
handle its short-term day-to-day financial obligations like disbursing wages
and salaries, paying its suppliers of goods and services and meeting
operating expenditure. As a consequence, these ratios focus on firm’s
current debts and liabilities. We examine two ratios now.

Current Ratio

Current assets like inventory and debtors get converted repeatedly into
cash. This cash is used to meet short-term liabilities of the firm and pay off
its creditors. Therefore, current ratio is calculated by dividing firm’s current
assets by its current liabilities. In the numerator, you will find a total of
cash, current investments (maturity < one year) debtors, inventory, loans
and advances and prepaid expenses. While current liabilities include loans
both secured/unsecured, creditors and provisions for expenses.

From the balance sheet of L&T above, you can derive current ratio of 1.41
for the FY 2015 by dividing current assets valued at Rs. 61,629.14 by
current liabilities of Rs. 43,705.81. In case of M&M, the current assets in
2015 were Rs. 11698.49 crores and current liabilities of Rs. 2,620.38
providing a still better current ratio of 4.46. The study of 3114 companies
mentioned earlier provides 1.30 as the average current ratio for all
industries. Accounts of M&M Ltd. for FY 2015 reveal that it held Rs. 11,698
crores of current assets to support 2,620 crores of current liabilities to
provide a very strong current ratio of 4.46.

Higher the current ratio, better liquidity available to the firm to meet its
financial obligations in the near term. It must be noted here that you must
look closely at the type of assets included in the numerator. Two firms can
have the same liquidity ratio. But one with a high proportion of cash and
debtors in the numerator is much more liquid than the firm with high
proportion of inventories.

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Quick Ratio

This ratio is also known as Acid Test Ratio and is used to measure firm’s
liquidity in a much stricter manner than the current ratio above. Its
numerator consists of really liquid assets. To measure this numerator, you
need to deduct value of inventories from total current assets to arrive at a
sum of cash and bank balances, sundry debtors and short-term current
investments. We do not consider inventories for this stringent ratio
because inventories are considered less liquid among all current assets.

For denominator, we use total current liabilities as used in above ‘Current

ratio’. Some analysts remove even debtors from the numerator to arrive at
what they term Cash Ratio. Use of cash ratio to judge liquidity is too harsh
a measure as firms can always either delay payments and if that is not
possible borrow short-term funds at a short notice.

In case of L&T, the ‘Quick Ratio’ for 2015 works out to Rs. 59,420 ÷ Rs.
43,705 = 1.36 versus current ratio of 1.41 calculated above. The all
industry average quick ratio was 0.54 (against 1.30 current ratio)
indicating major part of current assets consists of inventories.

Video Link 1

Video Link 2

5.2.4 Profitability Ratios

The main objective of any business unit is to earn profits for the owners.
Its efficiency in achieving this goal is measured through use of profitability
ratios. It is a class of financial metrics that is used to assess a business’s
ability to generate earnings as compared to its expenses and other
relevant costs incurred during a specific period of time. For most of these
ratios, having a higher value relative to a competitor’s ratio or the same
ratio from a previous period is indicative that the company is doing well.

This ability is reflected in two different manners, one deals with efficiency
with which profits are earned while carrying the business activity (i.e.,
sales) and the other is how profitably the owners’ funds have been
deployed.

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In the first category, we have earnings or profit margin ratios which are
further broken into gross margin, operating margin and net margin ratios.
In the second category fall return on assets and return on equity ratios.

Gross Profit Margin Ratio

This ratio is calculated by dividing gross profit by net sales where gross
profit = net sales minus cost of goods sold. The ratio indicates how much
money is available per hundred rupees of sales for meeting selling and
administration expenses and taxable profits for the owners. Some analysts
include depreciation in cost of goods sold while others exclude it and add it
to the sales and administration expenses.

This ratio for L&T Ltd. for 2015 is gross margin of Rs. 8,931.06 divided by
net sales of Rs. 57,017.41 resulting in 15.6%. While in the previous year,
it was (Rs. 8,931.06 ÷ Rs. 56,598.92) a little lower at 15.3%. Compared to
this for Mahindra’s, the ratio in the year 2015 was (Rs. 10,381 ÷
Rs. 715,539) 10.04%. This lower rate could be contributed to the
competitive auto market in which it is operating.

The ratio measures both how effectively production costs are controlled
and how remunerative is the firm’s pricing policy. Further analysis can be
conducted to observe how each element of production cost (material, labor
and overheads) is affecting the gross margin.

Operating Profit Margin Ratio

This ratio is calculated by dividing operating profit by net sales where

operating profit = net sales minus cost of goods sold (that includes
depreciation) plus selling and general administration expenses. This ratio is
indicator of overall efficiency of the organization in contributing to the
firm’s profit objective.
This ratio for L&T
For FY 2015 (Rs. 6,631.89 ÷ Rs. 57,017.41) appears to be 11.6% and
For FY 2014 (Rs. 6,575.48 ÷ Rs. 56,598.92) same 11.6% indicating
steady profitability of operations.

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Difference between 15.6% gross profit margin ratio and 11.6% operating
profit margin ratio equal to 4.0% indicates that selling and administration
expenses of the company for FY 2015 were 4% of its net sales.

Net Profit Margin Ratio

This ratio is calculated by dividing net profit by net sales where net profit =
operating profit minus interest and other financing costs as well as taxes
paid. Net profit, in other words, is the amount available for distribution to
both ordinary and preference shareholders. The ratio indicates firm’s
efficiency in overall as well as finance and tax management.
This ratio for L&T
For FY 2015 (Rs. 6,344.06 ÷ Rs. 57,017.41) appears to be 11.1% and
For FY 2014 (Rs. 6,679.41 ÷ Rs. 56,598.92) same 11.8%.

There is a clear indication that tax and finance management was better in
FY 2014. It can also be seen from the interest burden of Rs. 1,208.32
crores in the year 2014 versus higher burden of Rs. 1,578.85 in the
following year.

Return on Assets Ratio

Return on Assets (ROA) is a financial ratio that shows the percentage of

profit that a company earns in relation to its overall resources (total
assets). Return on assets is a key profitability ratio which measures the
amount of profit made by a company by use of its assets. The ratio is an
indicator of how assets of the firm are being turned around profitably. It is
calculated by dividing net profits by average total assets. ROA provides an
idea as to how efficient management is at using its assets to generate
earnings. Sometimes, this ratio is referred to as “return on investment”.

Using the above formula for L&T Ltd. for the year ending March 2015, the
ROA is Rs. 5,056 ÷ Rs. 90,132 = 5.6%; indicating profitable utilization of
the assets. The same ratio for the previous year was Rs. 78,304 ÷ Rs.
5,493 = 7.0%. This clearly indicates that the assets were more profitably
turned around by the company in FY 2014.

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Return on assets indicates the rupees earned on each hundred rupees of

assets. Thus, higher values of return on assets show that business is more
profitable. This ratio should be only used to compare companies in the
same industry. The reason for this is that companies in some industries are
most asset-intensive, i.e., they need expensive plant and equipment to
generate income, compared to others. Their ROA will naturally be lower
than the ROA of companies which are low asset-intensive. An increasing
trend of ROA indicates that the profitability of the company is improving.
Conversely, a decreasing trend means that profitability is deteriorating.

Return on assets gives an indication of the capital intensity of the

company, which will depend on the industry. Capital-intensive industries
(such as railroads and thermal power plant) will yield a low return on
assets, since they must possess very high value assets to do business.
Shoestring operations (such as software companies and personal services
firms) will have a high ROA; their required assets are minimal. The number
will vary widely across different industries. This is why, when using ROA as
a comparative measure, it is best to compare it against a company’s
previous ROA figures or the ROA of a similar company.

Though this ratio is widely used by the financial analysts, it certainly is an

odd measure. The numerator here measures return to shareholders but
denominator measures the contribution from both share owners and
creditors that generates the total assets.

Further, assets are stated at their depreciated book value and therefore, in
inflationary economy, the ratio provides much higher numbers that could
not be reflecting the real profitability of the assets.

Return on Equity Ratio

Return on Equity (ROE) is the amount of net income returned as a

percentage of shareholders’ equity. Return on equity measures a
corporation’s profitability by revealing how much profit a company
generates with the money shareholders have invested. ROE is expressed
as a percentage and calculated as Return on Equity = Net Income divided
by Shareholders’ Equity. Net income is for the full fiscal year (before
dividends paid to common stockholders but after dividends to preferred
stock). Shareholders’ equity does not include preferred shares but includes
paid-up capital, reserves, and surplus or retained earnings. For FY 2015,

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L&T Ltd. reported net income of Rs. 5056 crores on equity of Rs. 186
crores thereby indicating a strong ROE of 27%.

Video Link 1

Video Link 2

5.2.5 Turnover or Asset Utilization Ratios

This category of turnover ratios as the name suggests, speaks about a

firm’s asset management performance. They show you how efficiently
firm’s total assets or inventories or debtors are employed and turned
around in a productive manner. These ratios establish a relationship
between items on the income statement with those on the balance sheet.

This category of ratios include: (i) Receivables Turnover, (ii) Average

Collection Period, (iii) Inventory Turnover, (iv) Fixed Assets Turnover and
(v) Total Assets Turnover. Let us examine all of them at this stage.

Receivables Turnover

The ratio is determined by dividing the net credit sales (and if this data is
not there in published accounts then net sales) by average debtors/
receivables per day in the year. Higher ratio, therefore, indicates efficient
formulation and implementation of credit policy and business entity’s credit
terms for its customers.

In case of L&T Ltd. for 2015, the receivables turnover would be Rs. 57,017
÷ Rs. 23,051 = 2.47 and for the previous year 2014, it would be Rs.
56,598 ÷ Rs. 21.538 = 2.63. This leads us to conclude that receivables
turnover dropped from 2.63 to 2.47 in 2015 almost a 6% drop in efficiency
in management of trade debtors. Or to put in other words, management’s
inability to retain debtors at Rs. 21,679 (Rs. 57,017 ÷ 2.63) and allowing
them to climb to Rs. 23,051 in the year 2015. The ratio for all industries in
2007-08 was 15. L&T, being a construction company, the ratio is very less.
The ratio for M&M Ltd. for the year 2015 was 28.

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Average Collection Period

This ratio looks at efficiency of receivables management from other angle.

It finds the number of a day’s net sales are locked in receivables. First you
find out the year’s total net sales and divide them by 365 to determine
daily sales. Next step is to divide receivables by daily sales.

For L&T for the year 2015, the ratio is as per calculations below:
• Rs. 57,017 ÷ 365 days = Rs. 156.2 sales per day.
• Rs. 23,051 debtors ÷ Rs. 156.2 sales per day = 147 days is the
collection period.

The collection period for a year can also be determined by the formula 365
÷ receivables turnover. The all industries average is 24. For M&M Ltd. for
the year 2015, it would be 365 ÷ 28 = 13 days much better than all
industries average mainly because it sells vehicles to selling agencies on a
wholesale basis.

The efforts for improving the collection period start when the business
entity determines terms of sale at the time of seeking a sales order from
its customers. If the terms of payments are correctly defined, understood
and agreed upon by the customer, the job of collecting debts gets simple
and effortless. But if this step is not properly handled, a lot of efforts are
required to keep receivables under control.

Inventory Turnover Ratio

Inventory is a critical component of current assets of all manufacturing and

processing business units. A proper planning of purchasing of raw material,
handling, storing and recording is to be considered as a part of inventory
management. Inventory management means management of raw
materials and related items. Inventory management considers what to
purchase, how to purchase, how much to purchase, from where to
purchase, where to store, when to use for production, etc.

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Inventories can be classified into five major categories:

a. Raw Material: It is basic and important part of inventories. These are
goods which have not yet been committed to production in a
manufacturing business concern.
b. Work-in-progress: These include those materials which have been
committed to production process but have not yet been completed.
c. Consumables: These are the materials like oils, cotton waste, cleaning
agents, etc. which are needed for smooth running of the manufacturing
process.
d. Finished Goods: These are the final output of the production process
of the business concern. These materials are ready for shipment to
consumers and lastly.
e. Spares: These spare parts are required for upkeep of equipment and
form a part of inventories.

If the inventories are not turned over from raw materials to finished goods
regularly, there is vast scope for it to get obsolete. Continuous movement
of materials is a key to better inventory turnover ratio. On one hand, we
do not want to lock up our funds in idle stocks and on the other, we do not
wish to cause an interruption in production for want of a single component.

Many corporations adopt a “Just-in-time (JIT)” philosophy to ensure that

there is no over-stocking or idle stocks in the factories or warehouses of
the business entity.

This ratio is determined by dividing the cost of goods sold by value of

stocks on hand at the end of the year. In case of L&T Ltd. for the year
2015, cost of goods sold was Rs. 46,613 and inventory on hand at year
end Rs. 2,207 providing a good turnover ratio of 21:1. For the previous
year, the numbers were Rs. 46,218 and inventory on hand at year end Rs.
1,982 providing a still better ratio of 23:1.

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Another technique used to keep inventories at lower levels to increase the

turnover in adoption of ABC analysis. It is observed that 20% of the items
in the inventory; termed important A class items, constitute 80% of the
value of total inventory consumed in the year. If you watch just these A
class 20% items closely, you can maintain high turnover ratio. These A
class items can be procured on a monthly, or even weekly, basis. Balance
80% items are again broken into B class items causing higher consumption
value and balance C class items with lesser consumption value. B class
items can be procured quarterly and C class low consumption value items
can be procured annually. ABC system minimizes cost of procurement but
increases turnover.

Fixed Assets Turnover Ratio

This ratio is used to determine how efficiently the investment in fixed

assets is being put to profitable use by the business entity. The business
unit that creates maximum sale from say one crore of investment in fixed
assets is naturally putting the assets to the best use.

For L&T Ltd., the ratio for FY 2015 will work to Rs. 57,017.41 net sales ÷
Rs. 7,490.43 fixed assets = 7.61. For the previous year, it is a little less at
7.37 (Rs. 56,598 net sales ÷ Rs. 7,677 fixed assets = 7.37).

Care must be exercised in analyzing this ratio, as with the age of the fixed
assets, their book value goes down through accounting for depreciation
with no corresponding loss in efficiency of the equipment. Just because of
this decrease in value, your ratio may indicate better asset utilization!

Total Assets Turnover Ratio

A little variation from above is the total asset turnover ratio. This ratio is
used to determine how efficiently investment in the total assets of the firm
is being put to profitable use. The business unit that creates maximum sale
from say one crore of total assets is naturally putting the total assets to
better use. Here, net sales of the organization are divided by the total
assets at the end of the year.

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For L&T Ltd., the fixed assets turnover rate in 2015 works out to Net sales
of Rs. 57,017.41 ÷ Total assets of Rs. 90,132.05 = 0.63. While for the
previous year it is Net sales of Rs. 56,598.92 ÷ Total assets of Rs.
78,304.58 = 0.72. The fall in the rate could be attributed to increase of
over ten thousand worth of current assets.

Video Link 1

Video Link 2

5.2.6 Valuation Ratios

These ratios are popular with investors to find which company is returning
more value to shareholders both in the form of dividends and increase
(decrease) in its share prices in the stock market. With valuation ratios, a
company’s stock price enters your investment analysis. Valuation ratios
include the ever-popular yield, Price to Earnings (P/E) ratio, along with
Price to Sales (P/S) and Price to Book. (P/B). Valuation ratio measures
what the firm has earned for its equity holders through its own earnings
and increase (decrease) in market price of its share. This category of ratio
is considered to be most comprehensive.

Yield

A typical criterion used to measure total return to equity holders. Yield in a

particular year is in the form of dividend and increase in share market price
over the year. The formula used is [dividend declared per share + (the
current share price less share price at the start of the year)] ÷ the market
price at the start of the year. If the yield is more than that required by the
investor, she has inclination to invest in that company. It is expressed as a
percentage and any yield above 15% is usually considered attractive. This
is just an indicative ratio and has to be used along with other financial data
for any conclusion to be arrived by the analyst for investment.

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Price to Earnings

This is the most common ratio with all investment analysts world over. It is
arrived at by simply dividing the market price of the share by the earnings
per share. Here, earnings mean after tax profit for the year less dividends
to preference shareholders (if any) divided by total number of equity
shares outstanding at the year end. With the P/E ratio, investors can
evaluate the difference between what they are paying for the stock and its
earning power. A company with a P/E of 40 is trading at a level 40 times
higher than its earnings, while a company with a P/E of 20 is trading at a
level 20 times its earnings.

P/E = {(Profit after Tax – Preference Share Dividend for the year) ÷
Number of Equity Shares Outstanding.}

L&T Ltd. normally is traded at around 30 P/E. A high P/E ratio may signify
that the company is overvalued, which means that eventually market
forces will drive the price down. On the other hand, a high P/E could
indicate great earning power and the possibility that profitability will
increase over time, justifying the higher price. The price earnings ratio is
influenced by the earnings and sales growth of the firm, the risk (or
volatility in performance), the debt/equity structure of the firm, the
dividend policy, quality of management and many such factors.

A low P/E may indicate the potential for strong future performance.
Companies with low P/Es may be undervalued or trading at a price lower
than the company’s fundamentals merit. In that case, earnings may
increase dramatically in future weeks and years. Or, a low P/E could just as
easily denote a faltering company that would be an inadvisable investment.
The bottom line is that while P/E is a valuable tool, it does not provide all
the information you need to make an informed decision.

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Price to Sales Ratio

In some cases, a company that you are seeking to value does not have any
current earnings. In other cases, the company is very young or might be
experiencing a cyclical low in their earnings cycle. Additionally, a variety of
accounting rules can make a profitable company appear to have no
earnings due to special write-offs specific to that industry. For all of the
above-mentioned reasons, some prefer to use a ratio of current price to
sales of the company. The ratio is calculated as:

P/S Ratio = (Current Price Per Share × Shares Outstanding)/Revenue, i.e.,

Net Sales.

As with most ratios, the lower the ratio, the better the expected value of
those companies’ shares. However, much like the P/E ratio, it fails to
account for future growth and therefore can give you misleading results if
used alone.

Market Value to Book Value

This is also known as the price-to-book ratio, or P/B ratio and the price-to-
equity ratio (which should not be confused with the price-to-earnings
ratio). It is a financial ratio used to compare a company’s current market
price to its book value. The calculation can be performed in two ways, but
the result should be the same each way. In the first way, the company’s
market capitalization can be divided by the company’s total book value
from its balance sheet. The second way, using per-share values, is to
divide the company’s current share price by the book value per share (i.e.,
its book value divided by the number of outstanding shares).

As with most ratios, it varies by a fair amount per industry. Industries that
require more infrastructure capital (for each dollar of profit) will usually
trade at P/B ratios much lower than, for example, consulting firms. P/B
ratios are commonly used to compare banks, because most assets and
liabilities of banks are constantly valued at market values. A higher P/B
ratio implies that investors expect management to create more value from
a given set of assets, all else being equal (and/or that the market value of
the firm’s assets is significantly higher than their accounting value). P/B
ratios do not, however, directly provide any information on the ability of

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the firm to generate profits or cash for shareholders. This ratio also gives
some idea of whether an investor is paying too much for what would be left
if the company went bankrupt immediately.

Unfortunately, because of the way accounting rules work, the assets

reported on the balance sheet might be held at cost or some other value
that would not accurately reflect what the firm could get for them today.
Additionally, the balance sheet is not always able to accurately represent
the true earning power of those assets. Therefore, the ratio itself might be
misleading without some form of additional analysis and modifications to
balance sheet accounts.

Book Value literally means the value of the business according to its
“books” or financial statements. In this case, book value is calculated from
the balance sheet, and it is the difference between a company’s total
assets (Rs. 90,132.05 crores in case of L&T Ltd. in 2015) and total
liabilities (Rs. 53,047.47 crores in case of L&T Ltd. in 2015). Note that this
is also the term for shareholders’ equity (37,084.58 for L&T Ltd.). L&T’s
market capitalization in that year was around Rs. 1,43,700 crores providing
a P/B of 2.7.

The difference between market value and book value can depend on
various factors such as the company’s industry, the nature of a company’s
assets and liabilities, and the company’s specific attributes. There are three
basic generalizations about the relationships between book value and
market value:

a. If Book Value Greater than Market Value: The financial market

values the company for less than its stated value or net worth. When
this is the case, it’s usually because the market has lost confidence in
the ability of the company’s assets to generate future profits and cash
flows. In other words, the market doesn’t believe that the company is
worth the value on its books. Value investors often like to seek out
companies in this category in hopes that the market perception turns
out to be incorrect. After all, the market is giving you the opportunity to
buy a business for less than its stated net worth.

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b. If Market Value Greater than Book Value: The market assigns a

higher value to the company due to the earnings power of the
company’s assets. Nearly, all consistently profitable companies (like L&T
Ltd.) will have market values greater than book values.

Another way to understand why the market may assign a higher value than
stated book is to understand that book value is not necessarily an accurate
value of a company’s net worth. Book value is an accounting value, which
is subject to many rules like depreciation that require companies to write
down the value of certain assets. But if those assets are consistently
generating greater profit, then the market understands that those assets
are really worth more than what the accounting rules dictate.

Video Link 1

Video Link 2

5.2.7 Limitations to Ratio Analysis

When computing financial ratios and when doing other financial statement
analysis, always keep in mind that the financial statements reflect the
accounting principles. This means assets are generally not reported at their
current value. It is also likely that many brand names and unique product
lines will not be included among the assets reported on the balance sheet,
even though they may be the most valuable of all the items owned by a
company. Same is the situation of the skills with which the business of the
firm is managed by managers. They are just beyond quantification.

It is always a challenging job to find an adequate standard against which

the financial performance of a business unit can be measured. The
conclusions drawn from the ratios can be no better than the standards
against which they are measured. That leaves analysts with alternative of
comparing the ratios with those available of other business units in the,
preferably, same industry. When the two companies are of substantially
different size, age and diversified products, comparison between them will
be more unrealistic.

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A change in price level can seriously affect the validity of comparisons of

ratios computed for different time periods and particularly in case of ratios
whose numerator and denominator are expressed in different kinds of
rupees. Comparisons are also losing their relevance due to differences of
the terms like gross profit, operating profit, net profit, etc. If the reporting
companies follow guidelines issued by statutory accounting bodies, this
problem can be brought under control.

Many times, a lot of measures are resorted to by finance managers in

collusion with the chief operating executives, to overstate earnings. If
companies resort to such ‘window dressing’, analysts and investors cannot
search for the facts and this factor affects the validity of comparison. Here
again, use of several ratios together can bring in realism into numbers.

Financial statements are based upon past performance and past events
which can only be guides to the extent they can reasonably be considered
as meaningful indicators for the future. Great amount of care and caution,
therefore, has to be exercised, in arriving at any conclusions based on
study of above-mentioned financial ratios of any business entity.

All firms publishing their accounts under Companies’ Act 1956 have to
attach Notes to Accounts as prescribed by this Act. These need to be
carefully studied. Otherwise you will arrive at incorrect conclusion after
examining financial ratios. Mumbai Machinery Ltd. and Kolkata Machinery
Ltd. started their operations in fiscal 2010 with Rs. 40 crores of Fixed
Assets. In fiscal 2015, both the companies reported net profit of Rs. 23.5
crores over net sales of Rs. 100 crores. In other words, both firms were
equally efficient in running their operations as they achieved same
quantum of sales and returns after putting to use the initial investment of
Rs. 100 crores.

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As on 31.03.15, fixed assets of Mumbai Machinery Ltd. were at Rs. 20.0

crores and those of Kolkata Machinery Ltd. at Rs. 23.63 crores. To
summarize:
Figures for the year 2014-15
Mumbai Machinery Ltd. Kolkata Machinery Ltd.
In Rs. crores In Rs. crores
Net sales 100 100
Net Profit 23.6 23.6
Fixed Assets 20.00 23.63
Assets Turnover 5.0 4.23
Return on Assets 11.75 9.94

When you study the assets turnover ratio and return on asset ratio, you
are certain to conclude that Mumbai Machinery Ltd. is more efficient in
utilizing its fixed assets and that to more profitably as both its Asset
Turnover and ROA is more than its competitor. But when you read the
notes to the accounts, you will observe that Mumbai Machinery Ltd.
depreciates its assets at 10% on straight line basis while its competitors
adopt reducing balance method to calculate depreciation. And this
difference in depreciation calculating methods misguided you in comparing
the firms’ asset utilization efficiency.

Video Link 1

Video Link 2

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Self-training Exercise: 1

Ratio Classification

Ratio Classification

Profitability Valuation Leverage Liquidity Asset

Utilization
Debt to Equity Y

Interest coverage

Return on Assets

Return on Equity

Price Earnings Ratio

Price to Sales Ratio

Debt to Equity

Current

Inventory Turnover

Quick

Put Y as appropriate for ratios # 2 to # 10 in the above table.

5.3 TRENDS ANALYSIS

The financial ratios we studied so far provide us with a snapshot of

business unit’s financial performance as of a certain date (usually end of
quarters when the data is released). The absolute numbers in financial
statements are of little value for investment analysis, which must
transform these numbers into meaningful relationships to judge a
company’s financial performance and condition. The resulting ratios and
indicators must be viewed over extended periods to reflect trends. Here
again, beware of the one-size-fits-all syndrome. Evaluative financial
metrics can differ significantly by industry, company size and stage of
development.

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Under trend analysis, our objective is always too review financial

performance of the business entity over a period of a few years to identify
a trend. Then to arrange for a decision, we assume that this identified
trend would continue.

Let us study sales revenue, cost of goods sold and gross profit of ABC Ltd.
for four years.
ABC Ltd.
In Rs. crores
2012 2013 2014 2015
Total Revenues 5,87,731 6,79,632 6,94,436 7,15,539 Sales
increasing
Increase over 2012 1.16 1.18 1.22
Cost of Goods 3,82,105 4,49,427 4,39,624 4,49,053
Increase over 2012 1.18 1.15 1.18 Costs
steady
Gross Profit 2,05,626 2,30,205 2,54,812 2,66,486
Increase over 2012 1.12 1.24 1.30

As a result pro ts up
by 10% p.a.

The sales revenue trend indicates that in four years under review there is
an increase of 22%. When the company started exports in 2013, there was
a significant increase of 16%. Thereafter, the sales are showing healthy
growth.

The company is successful in holding its costs for the last three years even
though volumes have increased, may be by gradually filling its capacity.
This has resulted in profit percentage going up by 10% each year. The
trend is likely to continue till the business unit fills up its capacity fully.

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Let us review progress in receivables management of Surya Fertilizers Ltd.

located in Gujarat.
In Rs. crores

2012 2013 2014 2015

Total Revenues 5,87,731 6,79,632 6,94,436 7,15,539 Sales
increasing
Increase 1.16 1.18 1.22
Sundry Debtors 96,555 1,08,252 1,03,354 1,04,365
Increase Collection 1.12 1.07 1.08 Costs
steady
Period 60 58 54 53
Decrease 0.97 0.91 0.89

Collection period
reduced by seven
days.

From fiscal 2012 to fiscal 2015, sales have grown by 22%, but debtors only
by 8% from Rs. 96,555 to Rs. 104,365 only thereby reflecting efficient
receivables management.

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5.4 SUMMARY

Financial performance of a business entity can be measured by analyzing

the data contained in its published accounts. The objective is to analyze
whether the entity under analysis is stable, solvent, liquid, and profitable.
Such analysis is carried by management, shareholders, bankers and other
lenders as well as investors. Meaningful relationships have to be
established for effective analysis. Most of the financial analysis is
undertaken using ratios that are classified as:
1. Structural or debt utilization;
2. Liquidity;
3. Profitability;
4. Turnover or asset utilization and
5. Valuation ratios.

Two types of ratios are commonly used to examine financial leverage: (i)
Structural or debt utilization ratios and (ii) Coverage ratios. Structural or
debt utilization ratios allow the analyst to measure the entity’s prudence in
managing its debt. Coverage ratios are meant to focus on the relationship
between debt servicing commitments, i.e., ability to pay interest and repay
the debt on its maturity.

Funded Debt to Total Capitalization attempts to determine the extent to

which borrowed funds support the firm’s total assets. Debt to Equity
indicates relative contribution of creditors and owners to operate the
business activities of the firm.

Interest Coverage Ratio is very popular with bankers and lenders as

indicates how many times the interest burden of a firm covered by its
profits. This ratio takes a wider look at debt management than the one
taken to use interest coverage ratio. By measuring this ratio, the analyst
judges the firm’s sustained ability to meet its, not only interest but, all
fixed financial obligations.

There are two major liquidity ratios; current ratio and quick ratio or acid
test ratio both measure firm’s liquidity by dividing the current assets by
current liabilities. The second stricter ratio excludes inventories while
determining the ratio.

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Profitability Ratios include Gross Profit Margin Ratio, Operating Profit

Margin Ratio, Net Profit Margin Ratio, Return on Assets Ratio and Return on
Equity Ratio. They all measure firm’s earnings in terms of its sales
revenue, assets and equity.

Turnover or Asset Utilization Ratios are calculated to measure how

efficiently business unit’s assets in various forms like receivables,
inventory, fixed assets and total assets are utilized. Higher turnover
indicates faster utilization. Average Collection Period reflects how long the
firm takes to collect its trade debts.

Yield ratio, Price to Earnings (PE), market value to book value, price to
sales ratio, market value to book value and Price to Book (P/B) ratios
together are known as Valuation Ratios. They in their own way assist
determination of the firm’s value in financial terms.

While using these financial ratios, you must bear in mind that the numbers
under scrutiny are arrived at after following stipulated accounting
principles. Assets, for example, are stated at their historical value that
bears no relation to their value on the day of analysis. Valuable but
intangible assets find no place in ratio analysis. Analysts do not have any
standard metrics against which the ratio can be gainfully compared. While
making decisions based on ratio analysis, you need to assume past trend
would continue in future, which you know has doubtful element of truth.

Under trend analysis, our objective is always too review financial

performance of the business entity over a period of a few years to identify
a trend. Then to arrange for a decision, we are compelled to assume that
this identified trend would continue.

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5.5 MULTIPLE CHOICE QUESTIONS

Mark (x) against the most reasonable alternative.

1. __________ ratios are meant to focus on the relationship between debt

servicing commitments, i.e., ability to pay interest and repay the debt
on its maturity.
(a) Coverage
(b) Utilization
(c) Profitability
(d) Liquidity

2. Amala and Kamala, management trainees in Ghotala Abrasives Ltd.,

were studying their company’s published accounts. They calculated a
few financial ratios among the interest coverage ratio which they
observed was 1.15. Kamala was unable to interpret its significance, so
she looked at Amala for the conclusion. Amala’s response ‘I think
__________ was the correct one.
(a) The coverage is above 1.0 as such there is no need to worry
(b) From now on, it will increase by 0.15 each year
(c) A marginal drop in profits and company will have repayment
problems
(d) Lenders’ interests are well protected

3. Interpretation of __________ ratio needs to be carried with a lot of care

and study, as the numerator reflects book value that does not reflect
the true market value.
(a) Debt Equity
(b) Return on Assets
(c) PBT
(d) Price Earnings

4. The scrutiny of Income Statement and Balance Sheet of United

Machinery Ltd. indicated that the company’s receivables turnover ratio
was 3.6. Can you indicate its collection period?
(a) No, data is incomplete
(b) 25 days
(c) 65 days
(d) 100 days

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5. Financial ratio analysis has a few limitations like __________.

(a) Assets are not shown at their market values
(b) There is no standard metric for comparison
(c) Precise definitions of terms used in the financial statements
(d) All of the above

Answers: 1. (a), 2. (c), 3. (b), 4. (d), 5. (d).

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REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter

Summary

PPT

MCQ

Video Lecture

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Chapter 6
Management Of Working Capital

Objectives
After studying this chapter, you should be able to understand:
• Short-term and long-term impact of working capital
• Components of working capital
• Determining working capital required for a business entity
• Optimum level of working capital
• Impact of industry and economy on working capital
• Funds used to finance working capital

Structure:
6.1 Introduction
6.2 Gross and Net Working Capital
6.3 Cash Management
6.4 Why Do Current Assets Grow?
6.5 Forecasting Working Capital Requirements
6.6 Ideal Level of Gross Working Capital
6.7 Working Capital – Operating and Other Cycles
6.8 Factors Influencing Working Capital
6.9 Financing Working Capital
6.10 Cash Requirement for Working Capital
6.11 Summary
6.12 Multiple Choice Questions

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6.1 INTRODUCTION

Working capital management is critical because of its two characteristics:

(i) investment in current assets represents a substantial portion of funds
blocked in total assets and (ii) there is little time available to analyze data
and arrange correct financial decisions when the amount has to be
increased to meet business needs. Levels of current assets and current
liabilities have to be quickly geared to support growing and changing
business activity. Here, you do not have the time interval otherwise
available for other financial decisions related to say make or buy or to
long-term capital investment in machinery/equipment.

Management of working capital involves finance manager’s decisions in

respect of short-term credit and controlling cash, trade receivables and
inventories. This is the area where the finance manager has to spend most
of her time and efforts. With rapid growth of business firms in the current
economic scenario, there is always an intense pressure for inventory and
trade receivables which drain cash resources. These current assets change
their volume daily, and in many cases hourly.

Working capital is often defined as:

The finance manager must decide how much inventory is to be maintained

and how does she gets funds to pay for it. And, unlike long-term decisions,
here decisions have to be arranged on the spot and cannot be deferred any
longer. Or else there will be immediate losses in the form of delayed
deliveries and lost customers.

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It is true that long-term decisions involving plant and machinery, opening a

new branch or a product line determine the eventual growth and success of
any business entity, but correct short-term decisions on working capital
determine whether the firm gets to the long-term.

6.2 GROSS AND NET WORKING CAPITAL

Gross working capital consists of all current assets that normally self-
liquidate in a period of a year or less than a year. Current assets include:
1. Inventory consisting of raw materials, in-process materials, sub-
assemblies, finished goods in the factory as well as at firm’s various
warehouses, spare parts for sale or maintenance and supplies.
2. Trade receivables that increase and decrease with volume of sales and
are defined by the prevailing terms of payments as agreed with sole
selling agents, wholesalers and direct retailers.
3. Fixed deposits, loans and advances arranged during business activities.
4. Cash and bank balances on hand which if expected to lie idle need to be
invested on a short-term basis.

Net working capital consists of all the current assets as above less current
liabilities consisting of:
1. Trade payables that increase and decrease with volume of purchases
and are defined by the prevailing terms of payments as agreed with
vendors of materials and services.
2. Trade advances, short-term borrowings both from commercial banks
and other lenders.

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Illustration 6.1

Management of Bokhara Mills Limited has requested you to prepare a

statement showing the working capital requirements for a level of activity
of 30,000 units of output for the year.

The cost structure for the company’s product for the above activity level is
as under:
Cost per Unit
Raw materials Rs. 20
Direct labor Rs. 5
Overheads Rs. 15
Total Rs. 40
Profit Rs. 10
Selling price Rs. 50

a. Past experience indicates that raw materials are held in stock, on an

average for two months.
b. Work-in-progress (100% complete in regard to materials and 50% for
labor and overheads) will be half a month’s production.
c. Finished goods are in stock on an average for one month.
d. Credit allowed to suppliers: one month.
e. Credit allowed to debtors: two months.
f. The minimum cash balance to be maintained Rs. 25,000.

Prepare a statement of working capital requirements.

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Solution:

Output per annum = 30,000 units and hence per month 2,500 units

Raw materials cost p.m. (Rs. 20 × 2,500) Rs. 50,000

Labor cost p.m (Rs. 5 × 2,500) Rs. 12,500
Overheads p.m. (Rs. 15 × 2,500) Rs. 37,500
Total Rs. 1,00,000
Current assets
Stock of raw materials (2 months) (50,000 × 2) Rs. 1,00,000
Work-in-progress (½ months)
Raw materials (50,000 × ½ ) Rs. 25,000
Labor (12,500 × ½ × 50/100) Rs. 3,125
Overheads (37,500 × ½ × 50/100) Rs. 9,375
Total Rs. 37,500
Stock of finished goods (1 month) (1,00,000 × 1) Rs. 1,00,000
Debtors (2 month) (1,00,000 × 2) Rs. 2,00,000
Cash balance required Rs. 25,000
Total Rs. 4,62,500
Less: Current liability
Creditors (1 month) (50,000 × 1) Rs. 50,000
Net Working Capital required Rs. 4,12,500

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6.3 CASH MANAGEMENT

Managing of this most liquid and non-earning asset has become both an art
and science in current global electronic age. Since childhood, you have
been learning about the virtues of cash. But today’s Chief Finance Officer is
busy in maintaining this idle asset to its minimum. The less cash you have,
generally speaking, better off you are. But at the same time, you do not
ever wish to be caught without cash when you need it to liquidate
payments on their due dates.

You need cash on the balance sheet to:

a. Operate cash transactions each day of the year. These transactions

include payments for inputs, payroll and other operating expenses.

b. Satisfy requirements for compensating balances as stipulated by your

bankers to compensate for services rendered to you. With such
balances, you are not required to pay for bank activities like issue of
cheque books, drafts, electronic money transfers, supply of daily
transaction reports, etc.

c. Meet precautionary needs. The needs arise when cash inflows are less
than expectations. These needs are critical for business units operating
in seasonal/cyclical industries where cash inflows are more uncertain

6.3.1 Cash Flow Cycle

A simplified cash flow can be depicted in a four-step diagram as indicated

in Figure 6.1 below. The cycle starts with placement of orders by
customers. Inventory is used to execute these orders, and this execution in
turn creates trade receivables. The receivables on liquidation generate cash
that is used to buy inventory. This is the simplest basic form of cash flow.
Here, you need to notice that cash generating process is continuous though
actual cash receipts are both uneven and uncertain. Synchronization of
receipts and payments plays a major role in management of cash
flows.These cash flows are planned through cash budgets that consider:

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a. Payment patterns of customers over past few years.

b. The time interval suppliers and creditors need to deposit cheques.
c. Efficiency with which receipts and payments are processed by your
banker.

Figure 6.1

In reality, the above diagram is complex.

Sales income has its own pattern depending on the geographic locations of
customers, types of products they buy and their individual volume of
transactions. Trade receivables will generate cash based on credit terms
granted which could 0-15 days, 16-30 days, 31-60 days, 61 days and
above. Then there are cash outflows on account of interest and dividends
as well as local, state and central taxes payable by the business unit. Cash
goes out not only for inventory inputs but also for wages, purchase of
spares, supplies and other sales and administrative expenses. The diagram
plans to emphasize main drivers alone.

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6.3.2 Managing Receipts and Disbursements

The efficient method to handle receipts is to collect cheques and other

instruments (either hard or soft copies) at the customers’ locations.
Amounts collected through this network of collection centers are
electronically transferred. This assures cash inflow in your main treasury
account in hours instead of days (and weeks in case of remote locations).
The business unit needs to establish a network of collection centers all over
the market. Slowing of disbursements is a technique quite common among
established business units and provides a much needed float to the finance
manager. To achieve this objective, avoid the early payment of cash; the
firm should pay its trade payables only on the last day of the payment. If
the firm avoids early payment of cash, the firm can retain the cash with it
and that can be used for other purpose. Next, centralize the disbursement
system. Just as decentralized collection system ensures speedy cash
collections, centralized disbursement of cash system takes time for
debiting our accounts. Next, you can prioritize payments and maintain
stipulated dates.

This efficient cash management system has its costs. Your banker either
will levy specific charges per type of transactions or demand maintenance
of an amount of cash balance in the bank large enough to justify waiving of
the bank fees. As we noticed, M&M Ltd. indicated trade receivables of Rs.
2,558 crores as on 31.03.15. If their CFO arranges to reduce time interval
between deposit of cheques by customers to receipt into corporate’s
treasury account by a day, it will have (2,558 ÷ 365) seven crores of cash
to use elsewhere. This benefit has to be compared with incremental bank
charges to arrange a decision.

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6.4 WHY DO CURRENT ASSETS GROW?

By very definition, current assets are expected to be self-liquidating.

Inventory of inputs held by your firm is turned into a saleable output,
bought by your customers and thus turns into trade receivables.
Depending upon the agreed terms of payments, these trade receivables
get liquidated into cash. When your volume of operations is small, this is a
fact.

But as the volume grows, your firm has to hold inventory of higher
amounts, and before it gets converted into saleable outputs, you have
fresh inputs into the inventory to cater to orders being accepted on a day-
to-day basis. Initially, the firm was holding inventory for your first product,
but with business growth and changing customer behavior, you now need
inventory for more and more products. This growth in inventories built is
further accelerated when you expand and start producing and/or selling
from more than one location. You hold inventory for each product at each
location. To maintain and accelerate business activities, a variety of
products and additional business locations are essential.

This phenomenon is also applicable to trade receivables. Unless you carry a

cash-and-carry business all throughout the year, you will always have a
trade receivable for each of your customer waiting for self-liquidation on
expiry of the payment period stipulated in the credit terms. As you expand,
you have more customers and consequent more trade receivables.

Business managers often do not consider the fact that in current assets in
addition to a large quantum of self-liquidating inventory and trade
receivables, you also carry the anomaly of significant quantum of
permanent current assets.

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Figure 6.2: Number of Days

But as business, products, locations increase at the start of business.

Figure 6.3: As Business Grows

*These along with your fixed assets are firm’s total assets that appear on
the balance sheet.

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The increase in permanent current assets over a period of time as shown

by A B is directly related to increase in sales, products, locations or
customers and their preferences. Efficiency in working capital management
directly depends on finance manager’s ability in quantifying A B with a
high degree of accuracy.

Here, we have to recognize the fact that a part of your inventories does not
self-liquidate in a period of a year because of miscalculations, the changing
patterns of manufacture, types of machines used and variations in
customer demands. This part then stays either in a dormant condition or
gets obsolete.

Similar situation is there with trade receivables where a certain portion

does not get liquidated in time and in spite of rigorous follow-up over a
period gets doubtful and then bad.

6.5 FORECASTING WORKING CAPITAL REQUIREMENTS

Let us look at the rising permanent current assets of leading auto

manufacturer M&M Ltd. for the five periods FY 2011 to 2015.

Figure 6.4: Total Current Assets 2011 to 2015

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If working capital is to be correctly managed, the financial management of

this successful firm has to anticipate its growing but changing
requirements. Growth from 2011 to 2012 is 27.3% while that from 2012 to
2013 is only 14.9%, while the total current assets in the year 2015 were
less than that of the previous year. In case of L&T Ltd., sales and current
assets for the years 2014 and 2015 were as under:

2015 2014
in Rs. crores
Total Current Assets 61,629.14 51,114.61
Gross Sales 57,558.07 57,163.85

For almost the same volume of sales turnover, there is a rise of Rs. 10,515
crores in one year.

To forecast working capital requirements with a high degree of accuracy, it

is necessary for the finance manager to collaborate with marketing
manager and materials managers so that integrated plans are prepared for
Sales, Purchases and Working Capital for the next three or five years.
These plans have to be revised every quarter or more often based on
actual experience gained.

Within the year also, these requirements change significantly. For auto
industry, the activity is intense during festive seasons – when larger
working capital is needed to support it; while prior to rainy days when the
demand is slack, it is not necessary to build inventory and working capital
requirements fall for a couple of months. As stated earlier, integrated
approach from all business functions is a must for successful working
capital forecasts.

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6.6 IDEAL LEVEL OF GROSS WORKING CAPITAL

Another decision that finance manager has to deal with concerns the
working capital policy of the business entity. Here, two choices are
available. The first conservative policy is fancied by both productions as
well as marketing functions. Under this flexible policy, the investment in
current assets is high as by policy adequate stocks of inventories are
maintained all through the year so that there is hardly any interruption in
production or deliveries to customers. The policy calls for high level of
trade receivables as the marketing objective is to offer adequate credit to
customers to retain and attract more sales.

The Flexible or Conservative Working Capital Management Policy**

Zero stock-outs Liberal credit terms High inventory carrying costs

No production stoppages More sales volume More non-moving stocks
Nil idle time costs Higher obsolete stocks
Larger bad/doubtful debts
**Maintain higher levels of current assets.

The second aggressive policy aims at maintaining lesser inventory through

inventory optimization that minimizes interruptions in production and
avoids any inventory buildup by following just in time inventory.

Under this policy, marketing personnel involve:

a. Finance representatives at each major sales negotiation so that credit

terms agreed with customers restrict the volume of trade receivables;

b. Manufacturing personnel at each stage of completion of sales orders.

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The Aggressive or Restrictive Working Capital Management

Policy***

Less funds in inventory Few bad debts Lost production due to

stock-outs
Less funds in debtors Least obsolescence Lost sales as delayed
delivery
Lost sales as customer
denied credit

***Maintain lower levels of current assets.

As a result, the finance manager has to arrange for a trade-off between

costs that rise with current assets and costs that fall with current assets to
arrive at an optimum level of current assets. The costs that rise with
increase in current asset levels are termed carrying costs (interest burden,
storage and obsolescence, bad debts, etc.) while those that fall with
increase in current asset levels are termed shortage costs (loss of
production/sales due to non-availability of required inventory or credit
terms). Their relationships are shown in the Figure 6.5 below. The
optimum level of current assets is where the total of carrying costs and
shortage costs is the minimum. The optimum current asset level for XYZ
Ltd. is indicated by OCA* in this figure.

Figure 6.5

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6.07 WORKING CAPITAL – OPERATING AND OTHER

CYCLES
The major phases in working capital cycle can be reckoned in a simplified
manner as under:
(a) Receipt of Sale Order
(b) Issue Purchase Order for materials for above
(c) Receive materials against above PO
(d) Receive Invoice from vendor
(e) Process materials into finished goods
(f) Pay cash to vendor
(g) Deliver finished goods to customer
(h) Issue Invoice to customer
(i) Receive cash from customer.

Operating Cycle: This cycle covers the period from (c) receipt of raw
materials to (i) receipt of cash from the customer.
Trade payables cycle: Starts from (d) receipt of invoice for materials to (f)
payment of cash to vendor.

Trade receivables cycle: Starts from (h) issue of invoice to customer to

receipt of cash against it (i).

Cash cycle: Starts from (f) payment of cash to vendors to (i) receipt of
cash from customer.

Inventory cycle: Starts from (c) receipt of materials from vendors to (g)
delivery of finished goods to customer.

You will observe from above that operating cycle is the sum of inventory
period and trade receivables cycle [(c) to (i)] and that cash cycle is
operating cycle minus trade payables cycle [(f) to (i)].

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These various phases of overall working capital cycle can also be measured
in days. Here are the formulae that can be used by you in your analysis of
working capital.

Video Link 1

Video Link 2

Let us measure these parameters for L&T Ltd. for the year 2015.
Income Statement Balance Sheet
2015 2015 2014
Net Sales Rs. 57,558 Inventory Rs. 2,207 Rs. 1,982
Cost of Goods Rs. 46,618 Trade Rs. 23,051 Rs. 23,051
Sold Receivables
Trade Rs. 18,845 Rs. 16,345
Payables
Amounts in crores.

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How does Automobile giant Mahindra’s control their working

capital?
Amount in Rs. crores
2015 2014
Net sales 71553.9 73433.3
Sales per day 196 201
Inventories 2437.57 2803.63
Number of days’ sales 12.43 13.94
Sundry Debtors 2558.03 2509.84
Number of days’ sales 13.05 12.48

Both inventories and receivables are under tight control.

6.8 FACTORS INFLUENCING WORKING CAPITAL

Working capital requirements of a business firm depend upon so many

factors that we cannot formulate a policy that can be adopted universally.
For trading and service industries, the requirements are much simple as
they do not have to carry inventories. On the other hand, capital goods
industries need large inventories to operate business activities. The
requirements also depend on credit terms offered by the firms, liberal the
terms larger the trade payables and therefore, working capital. Let us
study all these factors on individual basis:

1. Type of business: As a rule firms engaged in heavy, capital intensive

industries require large amounts of working capital to finance
inventories which take long time for conversion into finished products.
Stocks are to be held at various stages throughout the production cycle.
Construction, chemicals and metals are some such industries where
firms need to hold a large volume of inventories. On the other hand,
need for inventories for service, a small-scale or consumer product
industry is minimal. It is observed that Hotels have around 10% of their
total assets in current category and rest in fixed assets.

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2. Organization Structure: Some business firms are organized to handle

all business activities from procurement and processing of inputs,
storage of finished goods and their delivery to the final consumers all
over their market. They need to manage factories, warehouses,
transport, and sales outlets. Such firms need substantial working
capital. On the other hand, others manage just one part of the total
business operations sub-contracting the rest. An automobile
manufacturer can focus only on producing cars and then sell them to
another wholesaler firm who takes responsibility for their sales,
distribution and delivery to customers. Under these arrangements,
managing both inventory as well as trade receivables (related to two-
three distributors) is not a very complex process and can be carried with
working capital within a few known parameters.

3. Production cycle: Amount of working capital has direct relationship

with the length of the production cycle. If the production cycle length is
short, a firm needs to maintain lesser amount of working capital. In all
probability, inputs move through the short cycle till the end with no
need for any in-process storage of materials. At the end of the shift, the
work-in-process is nil. Longer production cycles usually call for change
in equipment, addition of different inputs or in process inspection at
various stages. This results in accumulation of inventories all through
the production cycle. Inventory period is longer and working capital
requirements are larger.

4. Business cycle: Business fluctuations lead to cyclical and seasonal

changes in the business volumes thus affecting the requirements of the
working capital during different parts of the year. In the case of
consumer and luxury products, there are boom conditions in the
markets prior to all major festivals. Similarly, prior to opening of schools
and colleges, the demand for stationary, uniforms, shoes, etc. witnesses
a surge that lasts for a month or so. Industries using agricultural inputs
also have to plan for additional working capital after harvest each year.

Need for working capital increases whenever there is a boom in the

industry caused by positive economic growth or good monsoons that call
for high working capital and conversely when there is recession firms
have to limit their production activities and are not required to maintain
their earlier working capital levels.

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5. Capacity utilization: Normally, business entities match supply of

finished products to demand for its products in the markets. Here, our
earlier rule to vary working capital levels with sales volume is
applicable. But others, especially with heavy investments in fixed
assets, focus on capacity utilization and prefer to maintain a steady
level of production all throughout the year. These business units require
more working capital during the period when this policy results in build-
up stocks for a brief period of low sales levels. In these lean periods,
first there is inventory build-up and funds shortage as cash is not
forthcoming from liquidation of normal trade receivables.

6. Credit policy: Credit terms policy followed by sales and purchase

functions of the business unit also affects the working capital levels to
be maintained by the business entity. If the firm is a major customer for
its suppliers, it can ask and get longer period to arrange payments for
its purchases. It can enjoy longer trade payable period which we noted
reduces working capital cycle and requirements. But if you are buying
from a monopolist, you may not get such liberal credit terms and in
worst cases may have to pay on (or in advance of) delivery of inputs
needing larger working capital to finance purchase.

This logic applies conversely to credit terms that the business entity
offers to its customers. If you are a major supplier to your customer,
you can get payments faster and enjoy a short trade receivables period.
But if you are facing a tough competition in the market, it will be
necessary to offer liberal credit to clients to maintain your competitive
advantage in the market. Trade receivables period will be longer and
working capital requirements higher.

7. Growth and expansion: Steady growth in sales of the regular

products and/or sale of new products in the established markets
necessitates provision of additional working capital. Similarly, more
working capital is necessary when the firm plans to seek entry into new
domestic or overseas markets as a part of business development.

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8. Availability of raw materials: If the supply of raw materials, spares

and stores is steady, the business firm can procure inputs as and when
required per its Materials Requirement Planning (MRP). But if the supply
is inadequate or not prompt, to avoid shortages, the firm needs to hold
higher levels of stocks that demand more working capital to finance
them. In case where major inputs are imported from overseas markets,
you need to maintain higher safety stocks on hand thereby locking more
working capital in imported inventory.

9. Earning capacity: Firms with higher earnings capacity normally follow

conservative working capital policy and maintain higher levels of on-
hand inventory of raw materials and spares to avoid any possibility of
unplanned interruption in production due lack of inputs or spares. They
normally offer better terms of credit to customers to ensure no sale is
lost on account of restrictive credit period. Small-scale business entities
and entities with leading edge managements go for aggressive working
capital policy that ensures that working capital requirements are at the
very minimum.

Before planning for working capital requirements for the firm, the finance
manager has to review all above factors carefully to determine their impact
on working capital volumes.

Video Link 1

Video Link 2

6.9 FINANCING WORKING CAPITAL

The definition of working capital requires us to subtract current liabilities

(trade payables, bank loans, etc.) from total current assets thereby
suggesting that the firm needs outside funding only for the excess of
current assets over the current liabilities – shown in Figure 6.6 below. But
the permanent build-up of current assets we reviewed above, challenges
this assumption. Selection of outside sources of funds to support firm’s
working capital requirements thus becomes a major financial decision.

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Figure 6.6: As Business Grows over Years

This decision-making process gets more complex as there is no precise

demarcation between total current assets and permanent current assets.
Further, one can never be certain as to how much short-term and long-
term funds are available at any given time. To strictly adhere to financing
pattern as indicated in Figure 6.6 above where only self-liquidating current
assets are financed by short-term funds, the finance manager would
require real ingenuity.

To summarize:
Asset Classification Funds required for finance Means of finance
Fixed Assets Long-term Funds Equity
Debentures
Long-term loans
Current Assets:
Permanent portion Long-term Funds Long-term loans
Variable portion Short-term funds Short-term loans
Bank arrangements

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In practice, therefore, to protect against the possibility of not being able to

provide short-term financing in tight money periods, it is quite common to
rely on long-term finance to support short-term needs. Please see Figure
6.7 below.

A case where temporary current assets are financed through long-

term funds

Figure 6.7

By adopting this measure of utilizing long-term funds for all permanent and
a part of temporary current assets, this business entity is ensuring that
adequate funds are available all throughout. To illustrate further, the
business unit prefers to arrange a long-term loan of a crore rupees for a
ten-year period rather than borrowing a crore at the start of each year.

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A case where permanent current assets are financed through

short-term funds

On the other hand, and which is the case with smaller businesses, a
business entity can finance even a part of permanent current assets
through short-term finance as shown in the Figure 6.8.

This arrangement recognizes the fact that if short funds are available with
lower costs, then the finance manager has an option available to use the
funds for temporary self-liquidating funds as well as for a part of
permanent current assets. Thus funding of working capital requirements
can be quite innovative.

Video Link 1

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Self-training Exercise: 1

Cause and Effect – Working Capital Requirements

Cause Effect on Working Capital

Requirements
Increase (A) Decrease (B)
1 Monopoly vendor increases lead time Y
2 Vendor increases minimum order quantity
3 New raw material has short shelf life
4 Increase in sales with COD* terms
5 One product manufactured now purchased
6 Change in wage payments – monthly to
weekly
7 New vendors approved for main raw
material A
8 Cash discount on sales increased by 1%

*Cash on Delivery.

Mark Y – Yes as appropriate either in column A or B for items # 2 to # 8.

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6.10 CASH REQUIREMENT FOR WORKING CAPITAL

After determining overall levels of working capital, the next step for finance
manager is to determine cash part of the working capital. Towards this
end, it is necessary, first, to review value of current assets as shown in the
projected balance sheet and reduce profit element and non-cash expense
of depreciation from it to arrive at cash cost of current assets. The second
step is to reduce total of: (a) trade payables and (b) unpaid expenses to
arrive at cash requirement. First, let us see how to calculate cash cost of
trade receivables.

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Illustration 6.2:

Assume one unit of product X was sold at a selling price of Rs. 5,000 to a
customer on credit.
Your Trade Receivable as a current asset is Rs. 5,000.
This includes say Rs. 500 as profit which has no cash cost.
In cost of sales of Rs. 4,500, there is an element of depreciation say Rs. 50
which again has no cash cost.
So, cash cost of the Trade Receivable = Rs. 5,000 less (Rs. 500 and Rs.
50) is equal to Rs. 4,450.
Let us make this concept clearer. Arun Industries holds Rs. 2,00,00,000 as
Trade Receivables in the balance sheet for 2015. Their profit margin is
15%, if depreciation was excluded, it would have been 18%. Calculate cash
cost of Trade Receivables.

(i) Value per balance sheet Rs. 2,00,00,000

(ii) Profit margin 15% Rs. 30,00,000
(iii) Cost of sales Rs. 1,70,00,000
(iv) Less: pro rata depreciation Rs. 6,00,000
(v) Cash cost of receivables Rs. 1,64,00,000
Problem:

Now, we shall look at calculation of cash requirement of working capital for

Ashok Industries from following data.

Particulars Rs. crores

(a) Annual sales 600
(b) Total raw material cost 180
(c) Total wages 120
(d) Unpaid manufacturing expenses (one month) 10
(e) Total sales/administration overheads paid in cash 90

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Notes:
1. Customers are offered a month’s credit.
2. Gross profit percentage is 25% after considering depreciation in cost of
sales.
3. Vendors are paid after 90 days.
4. Wages are paid one month in arrears.
5. Ashok Industries hold two months’ stock of raw materials and a month’s
stock of finished output.
6. It wants to hold two crores as cash.

Solution:
Amount in Rs.
Short Notes
crores
(a) Annual sales 600
Less: Gross Profit (25%) 150
Total cost to make 450
Less: Materials 180
Wages 120
Manufacturing expenses 300
(b) Cash manufacturing expenses (10 × 12) 150
(c) Depreciation (a) less (b) 120
(d) Total cash cost 30
Total manufacturing cost 450
Less: Depreciation 30
Cash Manufacturing cost 420
Add: Sales/administration overheads 90
Total cash cost 510

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Amount in Rs.
Particulars Formula
crores
A. Current Assets
Trade Receivables 510 ÷ 12 42.5
Raw materials stock 180 ÷ 12 × 2 30.0
Finished output 510 ÷ 12 42.5
Cash on hand Predetermined 2.0
Total Current Assets 117.0
B. Current Liabilities
Trade Payables 180 ÷ 12 × 3 45.0
Unpaid expenses 10.0
Unpaid wages 120 ÷ 12 10.0
Total Current Liabilities 65.0
Working Capital Requirement (A – B) 117 - 65 52.0

To sum up, cash requirement for working capital can be determined by:
a. Estimating the cash cost of various current assets to be maintained,
b. Deducting the amount of spontaneous current liabilities from the cost
arrived above.

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6.11 SUMMARY

“Working capital management is concerned with the problems which arise

in attempting to manage the current assets, current liabilities and the
interrelationship that exists between them.” Working capital management
is critical because of its two characteristics: (i) investment in current assets
represents a substantial portion of funds blocked in total assets and (ii)
there is little time available to analyze data and arrange correct financial
decisions to vary the amount.

Gross working capital consists of all current assets that normally self-
liquidate in a period of a year or less than a year and include inventories,
trade receivables, loans, advances and cash and bank balances of a firm.
To arrive at net working capital, you subtract current liabilities like trade
payables, trade advances, short-term borrowings both from commercial
banks and other lenders.

By very definition, current assets are expected to be self-liquidating.

Inventory of inputs held by a firm is turned into a saleable output, bought
by customers and thus turns into trade receivables. Depending upon the
agreed terms of payments, these trade receivables get liquidated into
cash. In view of this fact, basic self-liquidating working capital levels
should remain the same. But as business grows, you add to items held in
inventory, add to locations where inventory is held and thus increase
inventory levels forever. Here, we have to recognize the fact that a part of
your inventories does not self-liquidate in a period of a year because of the
changing patterns of manufacture, types of machines used and variations
in customer demands. Similarly, when new customers are added, each one
has a certain trade receivable all through the year. This incremental level is
termed permanent current assets.

To forecast working capital requirements with a high degree of accuracy, it

is necessary for the finance manager to collaborate with marketing
manager and materials managers so that integrated plans are prepared for
Sales, Purchases and Working Capital for the next three or five years and
updated every quarter. The flexible or conservative working capital
management policy attempts to maintain higher levels of current assets so
that there are zero stock-outs, no production stoppages, and nil idle time
costs. The firm offers liberal credit terms to attract high sales volume. The

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policy, however, results in high inventory carrying costs, higher non-

moving obsolete stocks and larger bad/doubtful debts.

The aggressive or restrictive working capital management policy calls for

lower levels of current assets. This policy results in less funds being locked
in inventory, least obsolescence, few funds locked in debtors and low bad
debts. On downside, it can cause lost production due to stock-outs, lost
sales because of delayed delivery or the fact that customer is denied credit.
Finance manager has to determine an optimum working capital levels
where both carrying costs and shortage costs are minimum.

Overall, volume of working capital is determined by factors like type of

business, organization structure, production cycle, business cycle, capacity
utilization, credit policy, growth and expansion, availability of raw materials
and earning capacity.

Normally, fixed and permanent working capital is financed through long-

term debt or equity and self-liquidating working capital by short-term
finance like bank loans. But there are cases where firms finance a part of
self-liquidating working capital by long-term debts and conversely a part of
permanent working capital by short-term funds.

After determining overall levels of working capital, the next step for finance
manager is to determine cash part of the working capital. For this purpose,
it is necessary to remove profit margin and non-cash expenses like
depreciation included in the balance value of current assets.

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6.12 MULTIPLE CHOICE QUESTIONS

Mark (x) against the most reasonable alternative.

1. Non-moving or obsolete inputs and old doubtful trade receivables on the

balance sheet in reality are to be classified as __________.
(a) Current assets
(b) Spontaneous current liabilities
(c) Permanent current assets
(d) Fixed assets

2. Shalini insisted that by their very nature are self-liquidating and have to
be classified as current assets. Malini explained with details how a part
of trade receivables and inventory always fails to self-liquidate and
hence has to be considered as permanent current assets. But when
Shalini asked “What happens to the volume of permanent current assets
as business grows?” Malini was confused. How will you answer the
question?
(a) The volume grows steadily
(b) Permanent current assets become self-liquidating current assets
(c) The volume goes down each year
(d) Size of business volume has no effect on permanent current assets

3. CFO of Fox India Ltd. wishes to determine working capital requirements

for his firm for the years 20XX to 20YY. Whom should she request to
join for this particular exercise?
(a) Plant Engineer and Purchase Manager
(b) Materials Manager and Marketing Manager
(c) Marketing Manager and Company Secretary
(d) Materials Manager and Internal Auditor

4. Ideal level of working capital for any business entity is arrived at by

determining the point where carrying costs and shortage costs are
__________.
(a) Equal
(b) Maximum
(c) Falling
(d) Minimum

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5. To arrive at cash requirement of working capital, finance managers

reduce __________ from the current assets’ value as shown in the
business entity’s balance sheet.
(a) Interest and depreciation
(b) Profit and depreciation
(c) Interest and profit
(d) Only depreciation

Answers: 1. (c), 2. (a), 3. (b), 4. (d), 5. (b).

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REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter

Summary

PPT

MCQ

Video Lecture

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Chapter 7
Management Of Trade Receivables

Objectives
After studying this chapter, you should be able to understand:
• Credit policy of business units
• Credit terms for incorporation in sales quotations
• Cash discounts – how do they reduce receivables?
• Multi-functional approach to control receivables – Asset Management
Committee
• Corrective measures to retain receivables within set limits
• Debt collection process in India

Structure:
7.1 Introduction
7.2 Trade Credit Terms
7.3 Cash Discount
7.4 Customer Credit Index (CCI)
7.5 Asset Management Committee
7.6 Control of Receivable Levels
7.7 Indian Scenario
7.8 Summary
7.9 Multiple Choice Questions

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7.1 INTRODUCTION

Trade receivables occupy prominent compartment in the current assets of

most of the larger corporations who enjoy growth in sales volume and
breadth of their customer base. Inflationary conditions in the economy are
further adding to the pressure on this part of current assets. In case of L&T
Ltd., as of 31.03.15 out of total current assets of Rs. 61,629.14 crores,
trade receivables accounted for Rs. 23,051.11 crores (more than 30% of
the total and much more than its inventory of Rs. 2,207.49 crores.)

The volume of this current asset should not be judged on the basis of
business unit’s historical data or the industry norm. Trade receivables is an
investment, hence the test should be to examine the level of returns the
firm is obtaining from this asset vis-à-vis potential gains from other
investments. If we increase receivables days by, say five, the firm’s
investment in trade receivables will increase causing a drain in marketable
securities or bring down the inventory beneath established norms.

The past records of private local companies indicate that the number of
day’s sales locked in trade receivables are on rise partly in view
changeover from seller’s market to competitive buyer’s market. But main
reason for this increase is often laxity exercised by management in its
focus on working capital in general and trade receivables in particular.

Days of easy availability of credit may already be past. Firms now have to
compete for funds in the financial market which itself is under pressure
with all-round economic growth. Financial management has, therefore, to
focus internally and gear up its machinery for working capital management
with special attention to trade receivables where its funds get locked.

Further, just like receivables are unavoidable for any business entity
operating in competitive markets, they also result in certain costs that
reduce firm’s income. First, there is the cost of capital that gets locked in
this current asset. Next, there is cost of collection. Many follow-up visits
have to be arranged with the customers before and after the due date of
payment followed by phone calls and reminders. On many occasions, the
focus on new sales and new customers is shifted when more time has to be
spent by sales workforce in collecting overdue receivables. Collection
efforts are supported by administrative costs in preparing and updating
statement of customer accounts, analysis of debts and preparation of

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appropriate periodic reports for guidance of the collection staff. Last, but
not the least, when these collection efforts do not yield results, the
business unit has to provide for doubtful debts and write off bad ones
generating income loss.

Trade Receivables Management

Preventive Measures Curative Measures

Trade Credit Terms Ratio Analysis/Collection Period
Cash Discount Aging Receivables
Customer Credit Index (CCI) ABC Analysis
Asset Management Committee Trend Analysis
Bad Debt Analysis
Preventive measures are policy matters to be arranged prior to actual sale
and at the time of submitting sales quotations. On the other hand, curative
measures are undertaken after sales happen and when actual trade
receivables are generated. The objective here is of retaining receivables
within acceptable limits set in the credit policy for the customer.

7.2 TRADE CREDIT TERMS

Trade receivables management starts before they are generated through

actual sale. With this objective in mind, managements determine the credit
terms to be offered to customers in quotations that are submitted to them.
Trade credit is probably the easiest and most important source of short-
term finance available to businesses. Trade credit is a helpful tool for
growing business, as when suitable terms are agreed with the customer,
chances of securing that order increase.

One must note here that, any liberal terms agreed with your customers or
clients reduce the benefit you have obtained through trade credit
negotiations with your vendors and suppliers. Credit terms will differ from
business to business and industry to industry. Businesses that receive
payments on delivery, for example online shopping sites, may have a
shorter credit term than an industrial manufacturer or those working on
contractual jobs.

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Firms grant credit to customers to attract sales. It is considered valuable

by customers because they find this credit simple and less expensive than
short-term credit from their bankers for which they need to undergo
several formalities. The terms usually vary between two weeks to three
months. When goods are sold on credit, the firm’s inventory gets converted
into trade receivables. Liquidation of these receivables into cash is
essentially determined by the credit terms granted to customers. Thus,
volume of trade receivables is reflection of trade credit policy adopted by
the business entity. And a decision to grant credit to a customer forms a
part of either the marketing strategy or financial strategy; but in most
cases, it is a trade-off among these two functions. Finance would prefer
cash on delivery while marketing would like to offer credit even beyond
120 days in order to secure the sale, especially when it is of major value.

Marketing personnel promote liberal credit terms which please the

customers and thereby ease the marketing efforts to do business. For
many customers, availability of liberal credit terms is a great attraction to
shortlist their source of supply. On the other hand, finance personnel
oppose them as liberal terms result into larger volume of receivables,
greater efforts for collection and generation of possible bad and doubtful
debts. Both positive and negative factors need to be considered in
determining standard credit terms.

When granting credit to a particular customer account, the nature of risk

has to be measured based on customer’s prior record of payment, financial
stability, current net worth and other such factors. Financiers usually talk
about five C’s while granting credit to any account – character, capital,
capacity, conditions and collaterals. These five C’s decide whether payment
after delivery of goods is going to be arranged on agreed dates or on dates
thereafter or never.

Video Link 1

Video Link 2

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Customer Character, Capacity and Capital Credit Decisions

• Character: While considering character, reliance is placed on the ethical

standards of persons managing the business. A person of principle is
considered a sound business risk. Character is often a subjective
judgment to decide if the client is trustworthy with regard to payments
and here client’s business performance and experience count.
• Capital: Capital represents the profits, investments, and other assets of
the client that can assure on-time payments after sale. An analysis of
debt to equity ratio and capital structure of the client has to be
undertaken to decide upon the offer of credit terms.
• Capacity: Is availability and sustainability of cash flows at a level that
matches payments against purchases per schedule determined by
accepted credit terms.

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• Conditions: Is the clients business susceptible to business cycles? Are

cash flows sensitive to state of economy? These questions pop up when
conditions are used to decide credit. During a recession or periods of
tight credit, it is obviously more difficult for a small business to pay their
dues and as such, it may unwise to grant long period (say over thirty
days) credit.
• Collaterals: These are assets that client can pledge for the credit
granted. This C is more applicable to short-term bank loans and not for
trade credit.
While granting credit to a customer with whom volume of sales is expected
to be large, it is common to enlist services of credit agencies that have a
wide electronic network of credit data. They assist marketing and finance
to set credit goals and objectives together. One must note here that this
system is judgmental and has to be used with caution.

Video Link 1

Video Link 2

7.3 CASH DISCOUNT

This is the second (but not so popular in India) step to preempt

accumulation of large volume of trade receivables. A cash discount is an
incentive offered by a seller to a buyer for paying an invoice ahead of the
scheduled due date. Businesses that want to encourage prompt payment
and thus bring down levels of receivables offer a cash discount to buyers. A
cash discount, also known as a sales discount or an early payment
discount, is applied if the customer pays the balance within an allotted
period. 2/10, net 30 credit terms indicates that the customer is eligible for
2% cash discount if invoices are paid within ten days of presentation.
Otherwise the last date for payment is thirty days after the presentation of
the invoice.

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Cash discounts improve business cash flow and reduce bad debts, but they
cut into the seller’s profit margin. Fewer collection efforts and faster cash
flow are main gains from cash discount. Many customers have a system for
arranging payments regularly. Offering cash discounts to them will have no
significant effect on cash inflows from them but sales income will get
reduced. Because it is hard to know how many customers will take
advantage of a sales discount, generally accepted accounting principles
require businesses with cash discounts to create a reserve for cash
discounts. This reserve is updated regularly based on the fact whether
customer pays on time and avails of the discount. If prompt payment is not
forthcoming, the customer loses cash discount and reversal entries need to
be passed by accounting staff. Some customers do not pay promptly but
still claim the cash discount and again efforts are needed to collect those
small amounts held back by customers.

Cash Discount
Benefits Drawbacks
Quick Cash Inflow Lesser Profit Margin
Low Level of Receivable Sour Customer Relations – when
discount is not availed
Savings in Collection Efforts Addition in Accounting Efforts

Reduction in Bad Debts

Video Link 1

Video Link 2

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7.4 CUSTOMER CREDIT INDEX – CCI

We observed how five C’s are used to classify customers into various credit
categories as per their individual credit risk scenario. This method is
judgmental. There is one more method that uses systematic numerical
credit scoring system.
It has a six-step approach to determine a customer’s credit rating:
1. Select factors that decide customer creditworthiness.
2. Determine the criticality of each such factor and allot weights.
3. Usually, a five point scale now is employed to rate each customer on the
factors selected as above.
4. For each factor, multiply the factor rating (step # 3) by the factor
weight (step # 2).
5. Once you add the scores obtained in the step # 4, you are ready with
the customer credit index.
6. Consider customer’s CCI when you extend credit for any transaction.

CCI for Shreeram Industries Ltd.

Rating
Factor Factor Weight CCI
1 2 3 4 5
Current Ratio 20 √ 0.40
Debt/Equity Ratio 15 √ 0.45
Payment Performance 30 √ 1.20
Return on Assets 20 √ 0.40
Net Profit Ratio 15 √ 0.60
Total 100 3.05

A customer with the best credit standing will have rating of five on all
factors and thus will score CCI of five which is the maximum.

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Shreeram Industries Ltd. as shown above has scored 3.05 which is equal to
61%.

Availability of CCI helps management to arrange for correct credit granting

decisions that increase on-time payments and decrease chances of bad
debts.

Self-training Exercise: 01

On 1st April, the CFO decided to revise factor weights for credit parameters
of Shreeram Industries Ltd. as below. There were no changes against the
rating for each factor. Calculate fresh CCI for Shreeram Industries Ltd. with
these new weightages.

Factor Factor Weight Rating CCI

1 2 3 4 5
Current Ratio 25 √
Debt/Equity Ratio 20 √
Payment Performance 20 √
Return on Assets 15 √
Net Profit Ratio 20 √
Total 100

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7.5 ASSET MANAGEMENT COMMITTEE

Whenever there is a delay in payment from customer, it is associated with

customer’s financial constraints. May be, that is the case sometimes. But in
several other cases, the payments get delayed due to customer’s
unwillingness to pay. This dissatisfaction is not always expressly stated
through oral or written complaints. Unsatisfied customers would simply
express their dissatisfaction by delaying payments; the easy way out to
express reaction to a bad service.

In managing trade receivables, it has to be borne in mind that prompt

collection is the combined responsibility of all functions that contribute to
customer satisfaction. Delighted customers take all required efforts to
arrange payments; that too on time.

This recognition of contribution from all functions demands that an asset

management committee be formed in each business unit to monitor trade
receivables, to detect and remove through corrective action any
inconvenience caused to the customer. This committee in addition to
Finance shall have senior representatives from sales, materials
management, technical and after sales service functions of the business
entity as its members. Meetings have to be arranged at regular intervals
which are determined by volume and gravity of receivables.

The typical agenda consists of review of all large receivables as and when
they are generated. The review requires all functions to assert that
activities under their control were satisfactorily concluded; if not, how the
deficiencies were identified as conveyed by the customer. The function
representative then reports progress on the plan of action that was
presented to the customer. This arrangement ensures that the trade
receivables are followed after customer is satisfied in all respects and
yields the desired results.

The committee also reviews overdue receivables to determine which

function has meaningful contacts with concerned customer and how can it
liquidate the receivable. If there was a malfunction in the equipment
delivered to the customer and after sales function had worked to put it
back into smooth operation, then that service mechanic would be perhaps

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the best person to seek payment from the customer and resolve the trade
receivable.

Based on the valuable experience gathered over a period of time, this

Asset Management Committee can improve quoting, invoicing, distribution
and delivery, installation, after sale servicing and such other operations
that directly affect the customers and ensure they become customer
friendly. This preventive process yields customer satisfaction that results
into timely liquidation of all receivables.

Video Link 1

Video Link 2

7.6 CONTROL OF RECEIVABLE LEVELS

7.6.1 Ratio Analysis/Collection Period

Ratio analysis offers a tool for finance and marketing to hold control over
the size of the receivables. Receivables Turnover ratio is determined by
dividing annual (or any other period) credit sales of a business entity by its
average receivables during the selected period. Higher the ratio lesser the
quantity of working capital locked in trade receivables. This ratio can be
compared with industry average to determine the degree of success in
managing receivables. Separate ratios can be calculated for different
branches of an entity to determine efficiency of each branch manager in
managing its receivables. Branches with lower ratios can learn about some
practices followed by branches with highest turnover.

Average collection period allows management to compare actual period

with the collection period as planned for the year, product line or the
location. The actual collection period is calculated by dividing the total
trade receivables by the average daily sales over a year or for a particular
product line or location.

On September 30, 20XX, the marketing manager of Arunoday Pharma

observes following from the accounting data provided by the finance
function. The firm’s policy aimed at collection period of thirty days.

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Location Credit Sales for six months Trade Receivables

in Rs. crores in Rs. crores
Mumbai 6,240 850
Delhi 3,866 760
Chennai 2,700 425
Kolkata 2,400 430

To examine how this thirty-day collection policy is being implemented by

the regional managers, it is necessary for the marketing manager to
calculate actual average collection period for each region as under:

Location Average Daily Credit Sales Collection Period

in Rs. crores in days
Mumbai 35* 25
Delhi 21 35
Chennai 15 28
Kolkata 13 32

*(6240 ÷ 180)

Now, marketing manager knows that greater collection efforts are required
in Delhi and Kolkata to bring back their collection period to thirty days.
Here, it is necessary to find what Mumbai region is doing differently to
maintain the collection period around twenty-five days. What are collection
practices adopted by them?

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Self-training Exercise: 02

On March 31, 20XX, the marketing manager of Arunoday Pharma calls for
fresh receivables data as all branch managers had attempted to improve
their receivables position by adopting successful practices of the Mumbai
Region. Following accounting data was provided by the finance function.
The firm’s policy aimed at collection period of thirty days.

Find out which region now has the lowest collection period.

Credit Sales for Six

Trade Receivables
Location Months
in Rs. crores
in Rs. crores
Mumbai 6,740 900
Delhi 3,200 560
Chennai 3,300 375
Kolkata 2,100 380

7.6.2 Aging Receivables

The aging of receivables is one more report that works as a primary tool
used by collection personnel to determine which invoices are overdue for
payment. Given its use as a collection tool, the report may be configured to
also contain contact information for each customer. The report is of use to
marketing and finance managers to determine the effectiveness of the
credit and collections functions.

A typical aging report lists invoices in 30-day “buckets,” where the columns
contain the following information:
(a) The left-most column contains all invoices that are 30 days old or
less.
(b) The next column contains invoices that are 31-60 days old.
(c) The next column contains invoices that are 61-90 days old.
(d) The final column contains all older invoices.

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Shrikrishna Industries
Receivables Aging Report
All amounts in Rs. 000s as of 30.09.20XX
Customer Total 0 to 30 31 to 60 61 to 90 Over 90
Receivables days days days days
Anand 15.655 9,055 3,600 2,095 995
Industries
Bajaj Mart 18,450 11,560 4,090 1,950 850
Chennai 26,473 14,050 6,083 3,275 3,065
Depot
Detroit 38,955 19,570 10,560 5,665 3,170
Express
Total 83,893 54,235 24,333 12,985 8,080

If the report is generated by an accounting software system (which is

usually the case), then you can easily reconfigure the report for different
date ranges. For example, if payment terms are net 15 days, then the date
range in the left-most column should only be for the first 15 days. This
drops 16-day old invoices into the second column, which highlights that
they are now overdue for payment.

If you want to compare the aging of receivables of each customer with the
company average, you can add %s in the columns as shown below,

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Shrikrishna Industries

Receivables Aging Report

All amounts in Rs. 000s as of 30.09.20xx

Total
0 to 30 31 to 60 61 to 90 Over 90
Customer Receivable
days days days days
s
Anand
15,655 9,055 3,600 2,095 995
Industries
100% 57% 23% 13% 7%

Bajaj Mart 18,450 11,560 4,090 1,950 850

100% 62% 22% 11% 5%

Chennai
26,473 14,050 6,083 3,275 3,065
Depot
100% 53% 23% 12% 12%
Detroit
38,955 19,570 10,560 5,665 3,170
Express
100% 50% 27% 15% 8%

Total 99, 533 54,235 24,333 12,985 8,080

100% 53% 24% 13% 8%

You can now see that Bajaj Mart is better pay master (84% paid within 60
days) and Chennai Depot and Detroit Express need more collection efforts
as they have over 23% beyond 60 days.

The aging report is also used as a tool for estimating potential bad debts,
which are then used to revise the allowance for doubtful accounts. The
usual method for doing so is to derive the historical percentage of invoice
dollar amounts in each date range that usually become a bad debt, and
apply these percentages to the column totals in the most recent aging
report.

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Problem:

Past records indicate that Oxford Leather Mart historically experiences 1%

bad debts on items in its 30 day time bucket, 5% bad debts in its 31-60
day time bucket, and 15% bad debts in its 61+ day time bucket. From the
above data, how will Oxford Leather Mart CFO prepare a provision for bad
debts as of 30.09.20XX.

Solution:
All amounts in Rs. 000s

0 to 30 days Rs. 54235 @ 1% Rs. 542.35

31 to 60 days Rs. 23333 @ 5% Rs. 1216.65
61 and above Rs. 21065 @ 15% Rs. 3159.75
Total Provision Rs. 4918.75

An additional use of the aging report is by the credit department, which

can view the current payment status of any outstanding invoices to see if
customer credit limits should be changed. This is not an ideal use of the
report, since the credit department should also review invoices that have
already been paid in the recent past. Nonetheless, the report does give a
good indication of the near-term financial situation of customers.

Finally, the company’s auditors may use the report to select invoices for
which they want to issue confirmations as part of their year-end audit
activities.

Video Link 1

Video Link 2

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7.6.3 ABC Analysis

Another tool that is used by Finance Managers to control trade receivables

is ABC analysis. To use this tool, it is necessary to arrange receivables in
descending value with the largest receivable at the top and the lowest at
the bottom. You are required to add a column for cumulative values of
these receivables. It is general observation that first 20% of the accounts
generate 80% of business entity’s total receivables. There is no fixed
threshold for each class, different proportion can be applied based on
objective and criteria. ABC Analysis is similar to the Pareto principle in that
the ‘A’ items will typically account for a large proportion of the overall
value but a small percentage of number of items.

Two typical ways of classification are:

• ‘A’ items – 20% of the items accounts for 70% of the annual
consumption value of the items.

‘B’ items – 30% of the items accounts for 25% of the annual consumption
value of the items.

‘C’ items – 50% of the items accounts for 5% of the annual consumption
value of the items.

• “A” approximately 10% of items or 66.6% of value

“B” approximately 20% of items or 23.3% of value

“C” approximately 70% of items or 10.1% of value

Differential credit collection efforts are called for customers belonging to A,

B or C category. For few but high value customers in A category, frequent
visits by business entity’s senior executives from marketing, finance and
other related (e.g., customer relations) functions have significant effect to
maintain receivables within acceptable limits. Business entity’s asset
management committee (Refer 7.05 above) also needs to keep its focus on
Class A customers for quick results.

Regular follow-up at predetermined intervals will serve the purpose so far

as customers belonging to B and C category are concerned.

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Video Link 1

Video Link 2

7.6.4 Trend Analysis

Another receivables control tool available to the Chief Finance Officer is

termed Trend Analysis. Earlier, tools in the form of Collection Period or
Aging Receivables have a typical drawback in the sense that when the
sales per month are rising and even though receivables are getting
liquidated, at the same rate improvement in collection efforts is wrongly
indicated by falling collection days. With receivables turnover as a tool, you
will observe that with the equally successful debt collection efforts,
incorrect results are obtained.

Let us examine this.

April May June July

Sales per month in Rs. 000s 4,800 6,000 7,200 8,000
Cumulative sales in Rs. 000s 4,800 10,800 18,000 26,000
Receivables in Rs. 000s 4,800 6,000 7,200 8,000
Receivables Turnover* 0.90 0.83 0.81

*Cumulative sales per month ÷ Receivables at end of month.

The figures of receivables above are based on an assumption that they are
fully collected in 30 days leaving no balance for the following month. Thus
collection efforts and results are constant from April to July. But if you
judge collection efforts just by receivables turnover you will (wrongly)
conclude that there is a steady deterioration.

To remove this drawback Chief Finance Officers, prepare a Trend Analysis

Chart that indicates payment behaviour of customers. The matrix that is
constructed for this analysis lists percentage of receivables collected each
month for four months from the date of credit sale. The chart takes the
following form.

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Percentages of Credit Sales Collected in Following four Months

% Receivables April May June July August

Collected Sales Sales Sales Sales Sales
In the 1st month 22 20 18 26 28
In the 2nd
40 42 38 40 38
month
In the 3rd month 30 22 25 25 30
In the 4th month 8 10 17 9 4
Uncollected Nil 6 2 Nil Nil

In this case, we do not know volume of sales each month but we know
collection efforts are bearing fruits and 2/3rds of credit sales were
converted into cash within 60 days in July and August and credit sales in
full collected in 120 days.

If such trend analysis charts are prepared for, say four regions (north,
east, south and west) of all-India operations, the Chief Finance Officer can
determine which region is the most successful in collecting cash and
liquidating receivables. The practices followed in the best region can then
be repeated in other regions.

Video Link 1

Video Link 2

7.6.5 Bad Debts Analysis

However efficient your credit control system and methodical your efforts to
collect trade receivables, bad debts – some customers failing to make
payments over a long time and forcing you to write them off as your claims
– is a fact of business life. No doubt having good credit control is certainly
important for maintaining a healthy cash flow and a profitable business.
While good credit control can help avoid late payments becoming a serious
problem, there may still be times when a customer cannot or just will not
pay.

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A review of the size of bad debts as percentage of total credit sales is

another technique used by Finance Officers to control their trade
receivables management. Tight credit control is your first line of defence. It
is the best way to avoid or limit your exposure to bad debts by a few
critical steps such as:
1. Complete thorough business and reference checks before you offer
credit to new customers.
2. Set reasonable but fair credit limits and instruct your staff to notify you
if a customer wishes to exceed an agreed credit limit. Here, you need to
balance your sales targets with the need for realistic revenue generation
goals. After all, each bad debt is a loss of revenue.
3. Approve additional credit extensions if requested by customers well in
advance after full scrutiny of changed circumstances and past
performance.
4. It is necessary to include clear payment conditions in your sales
quotations or terms of trade agreement on all occasions.

You can structure business entity’s payment terms to encourage prompt

payment. For example, you could offer a 5% discount for payments made
within fixed period in days or prefer to charge interest on outstanding
balances. Once offered, the discount terms are not to be changed. Be firm
– do not allow the discount if the payment is delayed beyond agreed
period, even if it is only by a day. You can vary this if the situation
warrants for good customers as a once-off exception, but make it clear
that you are breaking the rules this one time because you value the
business relationship. Make sure your terms of trade specify when you will
start to charge interest on overdue amounts and the rate of interest you
will be charging.

Good credit control systems discussed as preventive measures at 7.01

above are the best steps to avoid bad debts and the problems involved in
writing them off. It is time to repeat a few of them:
a. Submit your invoices and statements on time, preferably as soon as
materials delivered or the job is completed. Late invoices indicate that
your organization is cash rich, there is no urgency and often, as logical
consequence, get paid late. So, prompt invoicing means you are less
likely to miss the next payment cycle.

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b. Keep an up-to-date record of what each customer owes you and note
any customers approaching their credit limit.
c. Follow up immediately once payment is noticeably overdue or payment
has not been made. Try to uncover the problem. You do not want to
appear desperate for the money, but small invoices can often be
missed, especially if your client is a large business.
d. By your collection efforts, you need to make it clear that you expect to
be paid on time, every time, and always making certain there is a
follow-up if payment is late. This way you are more likely to be in front
of mind when customers schedule payments. This means a customer
juggling payments because of cash flow problems is more likely to allot
you higher priority than a business whose systems are more relaxed.
Many people or businesses ‘pay the ones that make the most noise’.
e. Stop supplying to defaulting customers who failed to pay their accounts
on time. You can use the fact that they need your goods or services as a
lever to get paid promptly. This might cost you some business, but it
will also reduce the risk of being exposed to bad debts. Similarly, stop
supplying goods to customers in excess of their credit limit. This does
not mean that you will not increase the limit if requested, but it gives
you the opportunity to reassess the creditworthiness of your customer
before increasing your debt exposure.

The investigation into the reasons why your customer has not paid that
resulted into loss through bad debts is required to avoid repetitive losses.
Some probable causes could be:
a. The customer has a problem with your product, service or invoice. If so,
identify the issues as soon as possible and reach an acceptable
solution.
b. The customer has some sort of accounting or payment system glitch.
This can usually be resolved amicably within days of the problem being
identified.
c. Sometimes, the customers can have a temporary or long-term cash flow
problem. These are usually more difficult to deal with. You may be able
to negotiate a repayment schedule that allows them to trade out of the
current tight spot. If so, be sure to confirm the agreed repayment
schedule in writing and make it clear that any part payments will not be
considered as settlement in full.

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d. If all else fails, then debt collection agencies or your lawyer will help you
find the most effective way to recover your debt. But before you take
this step, carry a cost-benefit analysis. Firstly, find out exactly how
much the collection service will cost. Ask your auditors to recommend a
few debt collectors or lawyers who specialize in debt collection. You can
then compare costs and services.

Last but not the least, the loss through bad debts is a part and parcel of
risks involved in carrying any business. So, accept them but always
minimize the loss.

7.7 INDIAN SCENARIO

Except for a few professionally managed business entities, systematic

articulation and presentation of business entity’s credit policy is
conspicuous by its absence. Firm’s credit policy is the set of principles on
the basis of which it determines whom it will lend money to or gives credit
(the ability to pay for goods or services at a later date). It highlights the
terms and conditions for supplying the goods on credit, how is customer
creditworthiness determined, company’s collecting procedure and
precautionary steps in case of customer default. In most companies, the
credit policy evolves over years. The companies that do have a credit
policy express it philosophically and in very general terms. A typical credit
policy statement may read “Our credit policy is geared to maximize sales
growth without in any way affecting collection of trade receivables.”

Normal credit period offered varies from 0 to 90 days. Business entities

supplying consumer goods offer least credit period while those engaged in
manufacturing capital goods or assemblies to other business units offer
maximum credit. The system of offering cash discounts is not very popular
with industry in India.

References from two other business entities satisfy the Indian businessman
to extend credit. Prospective customer’s income statement and balance
sheet are hardly sought and never analyzed. Credit rating agencies are just
appearing on the scene and may be business units will start employing
them as competition gets fierce over next few decades.

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It is a common practice among major business units to classify customers

into three-four groups based on the credit reliability. They also call for
bank references, but response from banks is very general and does not
help the credit granting process of the business unit effectively.

The control over trade receivables is considered to the responsibility of

finance function and other function heads are neither aware of changes in
receivables turnover/collection period nor do they participate to improve
them.

Based on data provided here on preventive and curative measures to

control receivables, you have a great scope to bring about improvements
in this Indian scenario.

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7.8 SUMMARY

Trade receivables occupy prominent compartment in the current assets of

most of the larger corporations who enjoy growth in sales volume and
breadth of their customer base. Inflationary conditions in the economy are
further adding to the pressure on this part of current assets. The past
records of private local companies indicate that number of day’s sales
locked in trade receivables is on rise, partly caused by changeover from
seller’s market to competitive buyer’s market the world over. But main
reason for this increase is often laxity exercised by management in its
focus on working capital in general and trade receivables in particular.
Preventive measures adopted by business entities to manage receivables
include:
(a) Set trade credit terms,
(b) Offer cash discount,
(c) Set customer credit index – CCI and
(d) Constitution of Asset Management Committee.
Curative measures include:
(a) Ratio analysis/collection period,
(b) Aging receivables,
(c) ABC analysis,
(d) Trend analysis and
(e) Bad debt analysis.

Credit policy of a business unit is a guide for use by marketing and finance
personnel. It sets limits on how credit is to be granted to attract customers
to place orders with the business unit and when the sale takes place; its
finance function is able to collect cash with the least efforts. Financiers
usually talk about five C’s while granting credit to any account – character,
capital, capacity, conditions and collaterals. These five C’s decide whether
payment after delivery of goods is going to be arranged on agreed dates or
on dates thereafter or never.

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Cash discount offers benefits such as: (i) quick cash inflow, (ii) low level of
receivable,(iii) savings in collection efforts and (iv) reduction in bad debts.
But it has certain drawbacks as:(a) lesser profit margin, (b) sour customer
relations – when the customer cannot avail the discount and (c) addition in
accounting efforts.

Customer Credit Index is another measure where customer’s

creditworthiness is calculated by selecting applicable liquidity or earnings
factors in the form of financial ratios from client’s published financial
reports and providing factor rating for selected factors.

Another preventive measure for receivables control is Asset Management

Committee. In managing trade receivables, it has to be borne in mind that
prompt collection is the combined responsibility of all functions that
contribute to customer satisfaction. Delighted customer takes all required
efforts to arrange payments; that too on time.

This recognition of contribution from all functions demands that an asset

management committee be formed in each business unit to monitor trade
receivables, to detect and remove through corrective action any
inconvenience caused to the customer. This committee in addition to
Finance shall have senior representatives from sales, materials
management, technical and after sales service functions of the business
entities as its members.

After consideration of preventive measures, let us look at corrective

measures for receivables control. Ratio analysis offers a tool for finance
and marketing to hold control over the size of the receivables. Receivables
Turnover ratio is determined by dividing annual (or any other period) credit
sales of a business entity by its average receivables during the selected
period. Higher the ratio lesser the quantity of working capital locked in
trade receivables.

Next, the aging of receivables is one more report that works as a primary
tool used by collection personnel to determine which invoices are overdue
for payment. Another tool that is used to control trade receivables is ABC
analysis. To use this measure, it is necessary to arrange receivables in
descending value with the largest receivable at the top and the lowest at
the bottom.

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Many times, Finance Officers prepare a trend analysis chart that indicates
payment behaviour of customers. In the matrix that is constructed for this
analysis lists percentage of receivables collected each month for four
months from the date of credit sale.

However efficient your credit control system and methodical your efforts to
collect trade receivables, bad debts – some customers failing to make
payments over a long time and forcing you to write off your claims – is a
fact of business life. The investigation into the reasons why your customer
has not paid that resulted into loss through bad debts is required to avoid
repetitive losses.

Except for a few professionally managed business entities, systematic

articulation and presentation of business entity’s credit policy is
conspicuous by absence in India. Based on data provided here on
preventive and curative measures to control receivables, you have a great
scope to bring about improvements in this Indian scenario.

7.9 MULTIPLE CHOICE QUESTIONS

Mark (x) against the most reasonable alternative.

1. The published accounting records of private local companies indicate

that the number of day’s sales locked in trade receivables are on rise.
This rise in receivables is due to __________.
(a) The recent changeover from seller’s market to competitive buyer’s
market
(b) Laxity of management in its focus on trade receivables
(c) Both of the above
(d) None of the above

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2. The 2/10, net 30 credit term indicates that the customer is

__________.
(a) Required to pay the invoices in thirty days
(b) Two per cent cash discount is available
(c) To avail of the cash discount customer needs to make payment
within ten days
(d) All of the above

3. In managing trade receivables, it has to be borne in mind that prompt

collection is the combined responsibility of all functions that contribute
to customer satisfaction. Delighted customer takes all required efforts to
arrange payments; that too on time. This is the basic philosophy behind
formation of __________.
(a) Asset Management Committee
(b) Company’s Annual Credit Policy
(c) Total Receivables Management
(d) Total Cash Satisfaction

4. For customers in __________ (under ABC classification of receivables),

regular visits by business entity’s senior executives from marketing,
finance and other related (e.g., customer relations) functions have
significant effect to maintain receivables within acceptable limits.
(a) C
(b) B and C
(c) More often D
(d) A

5. For customers in __________ category (under ABC classification of

receivables), Quarterly follow up by the sales person handling customer
account is often adequate to maintain receivables within acceptable
limits.
(a) C
(b) B and C
(c) More often D
(d) A

Answers: 1. (c), 2. (d), 3. (a), 4. (d), 5. (a).

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REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter

Summary

PPT

MCQ

Video Lecture

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Chapter 8
Management Of Inventory
Objectives
After studying this chapter, you should be able to understand:
• Categories of inventory
• Inventory management is a multi-function task
• When do business entities hold large inventory?
• Inventory carrying costs and inventory ordering costs
• Decisions on economic order quantities
• Ways of classifying inventory for greater control
• Alternative methods to value inventory
• Benefits from Just-in-time inventory

Structure:
8.1 Introduction
8.2 Fundamentals of Inventory
8.3 Cost of Carrying Inventories
8.4 Cost of Ordering Inventories
8.5 Inventory Management Techniques
8.6 Economic Order Quantity
8.7 EOQ vs. Quantity Discounts
8.8 Inventory Analysis
8.9 Methods for Valuing Issues
8.10 Just-in-time Inventory (JIT) Management
8.11 Summary
8.12 Multiple Choice Questions

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8.1 INTRODUCTION

8.1.1 Nature of Inventory

After trade receivables, inventory is another major component of working

capital required to run operations. In a manufacturing company, inventory
is classified into three basic categories:
a. Raw materials: Used for processing into final product.
b. Work-in-progress: Represents inventory removed from stocks for
conversion into final product.
c. Finished products: Stored in the factory or warehouse/s ready for sale
awaiting delivery to customers.

All the three categories have to be financed through working capital of the
business entity and their efficient management has a direct impact on
firm’s revenues. Business entity does not have full control over its volume
as quantity of materials required is determined by supply chain, market
conditions, production cycles, distribution channels and customer demand.
For many items like, say, automobiles, the demand is seasonal. So, stocks
have to be built up prior to festive seasons. If the festive demand is
underestimated, the automaker can lose market share for want of ready
stocks for delivery. On the other hand, if it is overestimated, there would
be a huge pile up of idle stocks at the end of the season.

You must bear in mind that inventory is the least liquid of current assets
and hence it must provide the highest yield to justify investment. While
you as a Chief Finance Officer have a certain degree of control over
management of cash, marketable securities and trade receivables, control
over inventory is a joint effort that has to be shared with assistance from
purchasing, production and marketing heads of your business entity.

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8.1.2 Management of Inventory

Traditionally, the responsibility for inventory management of a business

unit rested with marketing, production and finance departments
individually reporting to the CEO. The desired results were not forthcoming
as there was a conflict among the objectives of these three individual
departments. In an attempt to realize the goals of his function, the
manager was inadvertently jeopardizing the objectives of other functions.
To understand complexity of inventory management, you need to study
the conflict between marketing and finance functions while optimizing
revenues for their business entities.

Marketing department sets an objective to increase and maintain revenue

by providing the best service to its customer base. To achieve this
objective, marketing has to:

a. Maintain high inventories so that customer demand is met on all

occasions;
b. Interrupt production line so that an odd high value order from the
customer for item not in inventory can be quickly fulfilled and
c. Create an extensive and costly distribution system so that goods can be
shipped to customers located all over the country overnight.

Finance must retain investments and costs in inventory at a low level in

line with its goal to maximize profits for the organization through
minimization of expenses. To achieve this objective, finance department
always focuses its efforts on the projects that would:
a. Reduce inventory so capital tied up in stocks is at its absolute minimum;
b. Decrease the number of plants and warehouses with the same objective
in mind;
c. Produce large quantities of using long production runs so that overheads
are widely spread and unit product cost is minimum and
d. Manufacture only to customer order and get quick return on investment.

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To resolve this conflict, business entities undertake supply chain

management approach that is the synchronization of a business unit’s
processes with those of its suppliers and customers to match the flow of
materials, services and information with the customer demand.

Supply Chain Management is the integration of key business processes

from end-user – the customer, through original suppliers who provide
products, services, and information that add value for customers and other
stakeholders.

Video Link 1

Video Link 2

8.2 FUNDAMENTALS OF INVENTORY

8.2.1 Inventory Cycle

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Illustration 8.1

Inventory is stock of material maintained to satisfy customer demand or to

support the production of goods and services. Illustration 8.1 shows how
inventories are created at one node in a supply chain through the analogy
of water tank. The flow of water into the tank raises the water level. The
inputs of raw component parts, cost of converting them into finished
product ready for sale, office supplies or even a finished product increase
the water (or inventory) level. The water level represents amount of
inventory held at a plant, service facility, distribution center, as well as
warehouse or retail outlet.

Outward flow of water represents demand for materials in the inventory,

such as customer orders for motor bikes or service requirements for
supplies like lubricants, spares, etc. The rate of the outward flow also
reflects the ability of the business unit to match the customer demand for
services or products. Another possible outward flow is that of scrap which
also lowers the level of useable inventory. Together the difference between
inflow rate and outflow rate determines the level of inventory. One factor
to remember here is that it is not the amount of inventory held in the tank
that determines profits of the business unit. This profit is primarily decided
by how much material outflow is there from the tank in the form of
products demanded by the customers. Not inventory levels but inventory
turnover drives business unit’s earnings for any period. A fundamental
question in supply chain management is how much inventory to have. The
answer to this question involves a trade-off between the advantages and
disadvantages of holding inventory.

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8.2.2 Pressures for Larger Inventory

When funds are utilized to build inventory, they seize to earn income.
Thus, there is carrying cost involved in holding inventory. In spite of these
costs, there are business pressures that encourage business units to hold
large inventories. Creating large inventory, speeds delivery to customers
and improves the business’s record of on-time delivery of goods and
services. Whatever customers want is always maintained in this high level
of inventory. This holding of all items creates customer goodwill and builds
business unit’s brand equity, a must for long-term returns. Large
inventories reduce the potential for stock-outs and back orders which are
key concerns of both wholesalers and retailers. A large stock of raw
materials ensures no interruptions in production. On the other hand, any
stock-out means:

a. Interruption in processing of materials into finished products, idle time

of men and machinery.

b. A failure to fulfill a customer order that results in customer complaints

and possible loss of an order. You lose not just that particular customer
order, but may be all future orders from that customer. You lose
customer confidence and this can have a far-reaching negative impact
on your sales growth.
Contractual penalties and the payments of liquidated damages are also
possible.

You know that ordering costs per year increase with the number of orders
placed throughout the year. They remain constant whatever be the batch
size that is on order. If you need to reduce number of orders per year, you
have to hold larger inventory. Costs incurred each time an order is placed
include the following five elements:
a. Salaries of the purchase personnel.
b. Travelling and living and other expenses of expeditors who have to visit
suppliers.
c. Transportation and shipping expenses for delivery to warehouse.
d. Costs of receiving and incoming inspection.
e. Costs of accounting, vendor payments and auditing.

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It is quite common for vendors to announce extra quantity discounts for a

limited period. If larger inventory levels are permitted by the business unit,
quantity orders can be placed during this period and such discounts
enjoyed. Now the business unit has another opportunity to reduce raw
material costs and increase margins. In addition, there is substantial
savings in freight and handling charges associated with bulk purchases.
Next, suppliers manufacture and supply raw materials in certain batch
sizes determined by them. The business unit has to place orders to suit
those batch sizes.

Hedge against raw material price fluctuations can be obtained by holding

larger stocks. In industries where raw materials are traded globally, like
gold for jewellery, raw material cost is as high as 80% of the total cost to
make and sell. Even a small variation in prices of raw material gold can
have major impact on the gross margin. It is prudent for business units to
buy gold immediately after receipt of a customer order irrespective of
delivery dates.

For manufactured items, you incur set-up cost which is common for the
industry where production takes place in batches. The cost involved in
changing over a machine or workspace after one batch has been completed
and a new batch has to be commenced to produce a different item,
referred to as ‘changeover’ cost is often termed the set-up cost. It includes
labour and time, to arrange the changeover, cleaning and sometimes
mounting new tools and equipment. By holding larger inventory, one can
reduce a number of orders in a year and consequently annual set-up costs.

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By creating larger inventory through high volume purchase or production

orders, business unit can increase labour productivity and facility utilization
in four different ways:
a. Direct reduction in the number of production set-ups which add no value
to a service or the product;
b. No costly rescheduling of production orders for want of input;
c. Stabilizing the output rate all through year even though demand for the
product is cyclical or seasonal, no overtime nor rush purchases of inputs
and
d. Reduction on outward freight charges as by increasing inventory levels
dispatches are arranged in an organized manner as per predetermined
schedules.

Finance managers must build these cost advantages into account when
they decide levels of inventory to be maintained for smooth and profitable
business operations and for customer satisfaction or delight.

Video Link 1

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8.3 COST OF CARRYING INVENTORIES

Illustration 8.2

The inventory carrying cost (or holding cost) is the sum of cost of funds
invested in stocks of materials plus the variable costs of maintaining
materials on hand such as storage and handling costs; shrinkage,
deterioration and obsolescence costs; taxes and insurance. As these
expenses change with inventory levels, so does the holding cost. (Refer to
Illustration 8.2 above.)

At this stage, one must remember that cost of invested funds in inventory
could be out-of-pocket costs or opportunity costs for the funds tied up in
inventory. To finance inventory it holds, a business unit may obtain loan
finance from its banks at an interest charge or forgo the opportunity of
assigning its accumulated funds in most promising investment. Inventory
needs to be received, stored, counted and issued. This activity can be
carried in business unit’s own premises or in a rented facility. In both
cases, there is expense involved in the form of opportunity cost of unit’s
own property or the rent paid to the outside warehouse owner. And this
expense directly increases with the volume of the inventory carried by the

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business unit. When the inventory is stored on business unit’s own

premises, it has to incur expenses in the form of depreciation of the
building that houses inventory. Then there are expenses involved in
maintaining the warehouse, cleaning, ventilating, illuminating, securing,
and repairing as and when required. The business unit has to employ
labour force to handle inventory and its wages/salaries and ancillary
expenses also form a major part of inventory storage costs.

Like any other asset, inventory also has to be insured against theft, fire,
deluge and other risks that can destroy it. Insurance premiums also form a
part of inventory handling cost. Sometimes, a business unit is required to
pay taxes on inventory held to local or state authorities and this also
constitutes inventory handling cost. Over a time, material stored in
warehouses suffers from shrinkage in value.

This shrinkage takes three forms:

a. Pilferage or theft of inventory by customers or employees;
b. Obsolescence occurs when inventory cannot be used or sold at full value
owing to engineering modifications, fashion changes or unexpected fall
in demand (Obsolescence is a major cost in retail clothing, electronic
gadgets and fashion industry. Heavy discounts have to be offered on a
frequent basis to minimize the losses) and
c. Deterioration through physical spoilage or damage due to rough or
excessive material handling that result in loss of value of goods stored.
Food and beverages lose value if not consumed within their shelf life.
Sometimes, they have to discard at an expense to the business unit.
When the rate of deterioration is high, it is unwise to build large
inventories.

Total inventory carrying costs can vary from 18% to 30% of the
inventories held. (Refer Illustration 8.3 below for the detailed break-up). If
a business unit is carrying inventory of, say, 20% of its sales, then its
profit margins are affected by 4% to 6% just by inventory carrying
expenses. Thus, it is prudent for management to keep its inventories lean
and trim.

Video Link 1

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Video Link 2

Table 8.1: Cost of Carrying Inventory

Cost Elements Cost as % of Average Valued Stock

Minimum Maximum
Cost of capital 10 14
Loss/breakage 2 5
Inventory management 1 2
Depreciation 1.5 2
Plant maintenance 1 2
Disposal/obsolescence 1 2
Taxes 1 2
Insurance 0.5 1
Total stockholding costs 18 30

8.4 COST OF ORDERING INVENTORIES

8.4.1 Order Quantity Decisions

To replenish inventory levels, regular orders need to be issued. They can

be issued using different systems.

A. You can arrange Lot-for-lot Ordering: A simple method of deciding

upon the order quantity is to order lot-for-lot. Under this rule, quantity
order will be exactly equal to what is required – no more, no less. The
order quantity changes whenever a change occurs in requirements. The
materials manager requires time-phased information such as provided
by a material requirement plan or master production schedule. Since
items are ordered as per exact requirements, there is no surplus
inventory. It is, therefore, a highly suitable method to order large value
class A items of inventory. The materials manager in effect is now
practicing ‘Just-in-time’ inventory management system. While inventory

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holding costs are under control here, the system may result in multiple
orders that will increase business unit’s ordering costs.

B. You can also practice Fixed Order Quantity: Here, the business has
fixed some arbitrary quantity for each unit in stock that has to be
ordered when stocks need to be replenished. This is a very simple
system to operate. But other than simplicity in its operation, it has no
other advantage. While determining the fixed order quantity for an item,
effect of the chosen quantity on neither the inventory holding cost not
the ordering cost is considered. This system is often employed along
with what is known as minimum/maximum inventory levels. Here, an
ordering point is determined for each item of inventory by adding safety
stock quantity and estimated quantity that will be consumed during the
lead time for the order placed to realize. (Receipt in stores of ordered
quantity.)

C. There is a third choice in the form of orders after fixed interval:

Some business units adopt a policy of placing orders after fixed intervals
rather than on the item stock reaching re-order point. They have pre-
determined maximum and minimum levels. After a fixed interval of say
a month, the materials manager checks the quantity of an item on
hand. An order is placed for that item. The quantity to be ordered is
determined as under:

Maximum level less stock on hand = Order quantity

D. Most business entities follow the economic order quantity

method: This EOQ attempts to minimize the total cost of ordering and
carrying inventory. It is based on the assumption that pre-determined
quantity can be ordered when stock level reaches re-order point. In
reality, that is not the case, particularly in material requirements
planning, and using the EOQ does not produce the minimum cost.

E. The period order quantity lot size: This concept is based on the
same theory as the economic order quantity. It uses the EOQ formula to
calculate the economic time between orders. This time interval is
calculated by dividing the EOQ by demand rate. This provides a time
interval for which orders are placed. Instead of ordering the same
quantity as per EOQ method, orders are placed for requirements for
that item for the time interval decided earlier as above.

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The number of orders placed is same as in the EOQ system, but the
quantity ordered each time differs as per requirements. Thus, the ordering
costs are same, but since the quantity ordered each time varies, inventory
carrying cost is reduced.

8.4.2 Costs per Order

Ordering costs are incurred by a business unit every time stocks have to be
replenished by placing order on vendor or on the business unit’s factory.
This cost has no bearing on quantity ordered as it is one-time cost that
occurs once the order is released until it is completed. Every order to be
released has to be scheduled, released, expedited and closed. Lot of
technical data has to be collated and attached to the order. Full-fledged
materials control or production control organization has to work to handle
on-time release of orders on outside suppliers and business unit’s factory
or factories. These production control costs form a main component of
inventory ordering costs. They include staff salaries, records and
maintenance of software used.

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When order is released on business unit’s own factory work centers have to
set up equipment for the new item has to be procured and dismantled
when the order quantity is delivered. This one-time cost does not change
with quantity ordered but with number of orders released in a year.
Whenever production of a new item is commenced, there are initial startup
problems, rejections or seconds until the production process is stabilized.
This waste also forms a part of ordering cost. The time taken in setting up
the production line for the new item and time taken to tear it down

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constitutes factory idle time and this lost capacity cost is second
component of ordering cost.
When the item is outsourced, there is a one-time purchasing cost. These
expenses are for preparation of enquiries and purchase order, follow-up,
receiving, incoming inspection, record keeping accounting and release of
payment. Like production control costs above, this purchase cost varies
with number of purchase orders and not with the quantity of the purchase
order.

This ordering cost can be reduced by releasing fewer orders but with larger
quantities. As noted earlier while ordering costs are reduced by this action,
it generates larger inventory and resulting higher inventory holding costs.
We need a solution to this conflict and Economic Order Quantity attempts
to provide one.

Video Link 1

8.5 INVENTORY MANAGEMENT TECHNIQUES

8.5.1 Three Types of Management Techniques

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Chart 1

Maintenance of trim and agile body provides you with many benefits in
your career development as well as in your personal life. Maintenance of
bare minimum inventory to run operations with maximum efficiency offers
similar benefits to the financial well-being of every business unit. The
primary reason for keeping inventories small is that inventory represents a
temporary monetary investment. As such, the business unit incurs an
opportunity cost, which is termed the cost of capital, arising from the
money tied up in inventory that could be beneficially put to use for other
business purposes.

Larger inventories need storage place, greater handling and personnel to

protect them from deterioration, pilferage and obsolescence. Steps
arranged to keep inventories at minimum practical levels directly add to
the earnings of a business unit. Three categories of techniques are in use
to manage inventory within acceptable limits:
(a) Managing stock levels and order quantities
(b) Classifying inventory items for different degrees of control

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(c) Keeping appropriate inventory records for control

Let us examine stock level control of inventories first.

8.5.2 Stock Level Control

For low value Class V items (Refer ABC Analysis 8.8.1 below), this simple
stock level control can be exercised to have good results with the least
efforts. When re-order level is reached, an order of predetermined quantity
is released and stock levels remain within prescribed limits so long as
consumption pattern remains the same and materials are delivered per
agreed lead times. When stocks cross the prescribed levels, signals are
provided to management to intervene for corrective action.

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Graph 8.1

(A)Minimum Stock Level

This is the level of stock that has to be maintained by the business unit all
throughout the year. Under inventory management, normal care is taken
to ensure that required materials are available for further processing when
needed. But if there is any failure in obtaining material of right quantity at
right time (delays in delivery from a vendor), the stocks on hand fall below
this minimum level. Such situation arises also when the requirements for
the item suddenly increase over the average consumption. Steps are
immediately initiated to expedite supplies against pending orders. If there
is consumption of the material over and above the previous normal usage,
additional procurement of the item has to be arranged by placing fresh
orders to cover shortfall. With these steps, inventory levels increase and
balance stays over the minimum prescribed.

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The Minimum Stock Level quantity is calculated as under:

Minimum level = Re-order level – (Normal consumption per day × Normal

delivery period in days)

But if the replenishment of stocks does not happen as planned, stocks dip
further below to danger level. At this point in addition to expediting fresh
supplies, issues are rationed until stocks get replenished. The item is
issued under controlled conditions and to avoid any production stoppage.
And efforts for replenishment doubled.

Danger level = Average consumption per day × Maximum re-order period

in days for emergency purchase

(B) Maximum Level

This is the maximum quantity that stock of an item is allowed to form. It is

normally reached when there is a fresh replenishment on supply against
order due. It can be calculated by formula:

Maximum level = (Re-order level + Re-order quantity) – (Minimum

consumption × Minimum delivery period)

If stocks cross this level, management has to re-examine inventory usage

assumptions to check whether there has been fall in average consumption
of an item and if so, reset inventory levels. The situation can also arise if
receipts occurred before the due dates for delivery.

(C) Re-order Level

When stocks of an item reach this level, arrangements have to be initiated

for replenishment through a fresh order for pre-determined quantity. The
re-order level is calculated by the formula:

Maximum consumption per day × Maximum lead time in days for

replenishment order

Video Link 1

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8.6 ECONOMIC ORDER QUANTITY

8.6.1 The Concept

You will recall that in a continuous or fixed order quantity system, when
inventory reaches a specific level, referred to as the re-order point, a pre-
fixed quantity is ordered. The most widely used and traditional means for
determining how much to order in a continuous system is the Economic
Order Quantity (EOQ) model, also referred to as the economic lot size
model.

EOQ is a continuous inventory system. A good starting point for balancing

conflicting inventory holding cost and inventory ordering cost and finding
the best cycle inventory (that part of inventory which varies with order
quantity) is determining the economic order quantity. EOQ is the lot size
that minimizes total annual cost of holding and ordering materials.

The concept of economic order quantity presumes that:

a. Demand rate for an item is constant.
b. Materials manager does not have any constraints (like plant capacity,
vendor schedules, lead times, etc.) in determining the lot size of the
order.
c. Decision on order quantity of Item X can have no effect in deciding on
order size of any other item to be ordered on a vendor or on factory.
d. In material handling there are only two costs – ordering and holding –
that are to be considered.
e. Materials are delivered per agreed lead time and always in a single lot.
There are neither delays in deliveries nor partial deliveries either from
the factory workshop or from the vendor.

It is obvious that above requirements of EOQ are not likely to be satisfied

in actual practice. In spite of this fact, EOQ concept does offer
opportunities to optimize inventory.

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Graph 8.2

8.6.2 Determining Economic Order Quantity

Let us assume that 7,800 units of Part Y are used annually and 300 pieces
are ordered every time to replenish the stocks. Since 300 units are ordered
each time, this quantity should last 2 weeks; so, every 2 weeks, new
stocks will arrive and inventory will move between 0 to 300 pieces
resulting in average inventory of 150 pcs. Please note that if annual
consumption of the item was to be 5,200, with the same order quantity of
300, fresh stocks will arrive after every 3 weeks but average inventory
continues to be 150. On the other hand, with the same annual
consumption of 7,800 units, if 500 pieces were ordered every time, the
average inventory will increase from 150 pieces to 250 pieces as shown in
the Graph 8.7. You will observe that now orders are placed after 3.3 weeks
instead of every two weeks earlier.

Graph 8.3

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Now, we know that while determining order quantities, we need to consider

effect of quantity on number of orders that have to be released to fulfill
annual requirements and cost of such orders. Ordering cost is reduced
when order quantity increases as shown below.

Graph 8.4

Inventory carrying cost increases when order quantity is enlarged and

inventory levels go up. This relationship can be graphically shown as
under:

Graph 8.5

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Thus, it is clear that if the order quantity increases,

• Number of orders per year decrease and ordering costs are reduced
(Illustration 8.6).
• There is increase in average inventory and therefore holding costs
increase (Illustration 8.7).

We should now draw a graph that combines curves for holding costs and
ordering cost. The point of intersection will minimize the total of the two
costs (Illustration 8.8 below.

Graph 8.6

Any business unit, therefore, has to release orders of that quantity where
the curve of ordering costs meets the one of inventory carrying/holding, as
at that point total of the ordering and holding costs would be minimum.
This then is known as Economic Order Quantity. There is a formula
available to arrive at the economic order quantity.

Video Link 1

Video Link 2

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This relationship between inventory ordering and carrying costs is reflected

in the equation below.

EOQ =
where,
EOQ is economic order quantity
D is annual demand for the inventory item in units
Co is ordering cost per order
p is unit price and
Ci is inventory holding cost in %
A business unit consumes 1,000 units of component GF 78 a year. Its
purchase price is Rs. 5 and the unit’s ordering costs are Rs. 20 per order.
Let us now calculate EOQ for GF 78 using above formula and decide how
many orders will the purchase officer have to be placed in a year?

EOQ =

=
= 200 units
Five orders have to be released in a year.
Inventory carrying cost assumed at 20%.

Activity

Arundhati Cutting Tools Pvt. Ltd. needs 4,000 units of hammer heads every
year. The cost of the hammer head is Rs. 40 each. The company has
inventory carrying cost of 20%. What should be the EOQ for the hammer
head?

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8.7 EOQ VS. QUANTITY DISCOUNTS

8.7.1 Is EOQ the Only Order Quantity?

EOQ determined as above need not be always the final quantity that the
business unit utilizes. The materials manager has to modify the EOQ under
certain circumstances like:
a. When the vendor offers significant price discount for quantity purchases,
the EOQ may have to be increased to avail of the lower prices.
b. EOQ cannot be used if the order size is constrained by capacity
limitations such as the size of the business units processing tanks or
amount of testing equipment or delivery trucks.
c. The annual demand divided by the EOQ may not result in whole number
(if annual demand is 5,300 and the EOQ 500, the materials manager
has to place 10.6 orders) Here, the EOQ has to be modified to 530.
d. The vendor may stipulate a certain minimum order quantity acceptable.
If that quantity exceeds EOQ, change in EOQ is necessary to comply
with vendor’s requirement.
e. Transportation costs play an important role in purchases from a vendor
located far off the production site. Here, EOQ may have to be modified
to optimize transportation costs.
f. The item may have to be imported in which case the import licence
decides quantity to be ordered.

Use of the EOQ is justified when you follow a “make to stock” strategy and
the item has relatively stable demand. It is also recommended when the
business unit observes that carrying cost per unit and set-up or ordering
costs of the unit are known and relatively stable. The EOQ was never
intended to be inventory optimizing tool. Nevertheless if you need to
determine a reasonable lot size for purchase of an item, it can be helpful in
many situations.

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8.7.2 How Do We Decide Whether to Accept Quantity Discounts?

We indicated above that EOQ may have to be increased to take advantage

of the price discounts available on purchase orders of larger than EOQ.
How do we decide whether the discount offered is beneficial to the
business unit to increase order quantity?

To answer this question, in addition to ordering cost (CO) and inventory

holding cost (CI), we must consider the cost of inventory purchased in the
year (DP). Let us use the following equation:
TC = D/Q + Co + Q/2 Cc + Dp
where, TC is total cost
D/Q Co is cost of ordering for the year
Q/2 Cc is cost of carrying inventory for the year
Dp is cost of inventory purchased in the year (D – Annual demand and p –
price)
Since, for the first time, we are considering two prices (one normal and
other lower with quantity discount) Q/2 Cc as well as Dp values will change
with prices. Hence, we shall have to modify the above equation to take
care of this situation.
Optimum order quantity with normal price
TCEOQ = D/Qopt Co + Qopt/2 pCi + Dp Equation A
Discount order quantity with lower price
TCDisc = D/QDisc Co + Qdisc/2 pdiscCi + Dpdisc Equation B

Let us apply these two equations to assist Laxmi Stores which sells 25,000
soft drink bottles a year at Rs. 10 each. The store has determined its
ordering cost at Rs. 10 each and its inventory carrying cost of 20%. It was
ordering soft drinks bottles at the EOQ so far, but now the supplier has
offered 2% discount if order is placed for Rs. 10,000 or more.

Should Laxmi Stores accept the discount and revise its order quantity?

Let us first find out the present EOQ.

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EOQ =

=
= 500
First, let us apply Equation A to find total cost with EOQ.
TCEOQ = D/Qopt Co + Qopt/2 pCi + Dp
TC (no discount `) = 25,000/500 * 10 + 500/2 * 10 * 0.2 + 25,000 * 10
= 500 + 500 + 2,50,000
= 2,51,000
Now, we need to apply Equation B to arrive at total cost with 2% discount
offered.
TCDisc = D/QDisc Co + Qdisc/2 pdiscCi + Dpdisc Equation B
TC (2% discount `)= 25,000/1,000 * 10 + 1,000/2 * 9.8 * 0.2 + 25,000
* 9.8
= 250 + 980 + 2,45,000
= 2,46,230
Thus, if the discount is accepted, there is a saving of Rs. 4,770 (2,51,000 –
2,46,230).

While deciding whether to revise economic order quantity to accept

quantity discount offered by any supplier, the business unit has to
recognize that:

• There is a saving due to discount in the purchase cost.

• There is another saving in ordering costs as increased order quantity has

resulted into lesser number of orders per year.

But there is increase in inventory carrying cost as we have to order larger

quantity.

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The business unit has to weigh the first two against the last and find out if
there is a saving to accept the discount. Then there is a non-monetary
issue about availability of additional storage space. After Laxmi Stores
accepts the discount, it will have to carry average inventory of 500 bottles,
instead of 250 bottles as per earlier EOQ ordering (EOQ * 1/2).

8.7.3 Effect of Inflation on Order Quantity

When we apply EOQ formula for determining the most profitable order
quantity, we assume that the price per unit is constant through the year.
But in our Indian economy, prices are always on the increase. Let us
consider how the inflation in the economy alters the EOQ. If the rate of
inflation can be predicted with any degree of accuracy, the above EOQ
formula can be certainly applied with just one modification. We need to
readjust the annual carrying cost by deducting the rate of inflation. The
rise in inventory value caused by inflation offsets the carrying cost
associated with inventory holding to some extent. This adjustment
suggests that the EOQ and therefore the average inventory during the year
increases due to inflation factor.

However, this is not the whole truth. Just like inflation increases, the unit
price of the item held in inventory, it also correspondingly increases the
percentage of inventory holding cost. This lowers the EOQ and then
average inventory levels throughout the year. As a result, the effect of
inflationary trends in the economy have on EOQ are marginal but still
should be explicitly considered.

Video Link 1

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8.8 INVENTORY ANALYSIS

8.8.1 ABC Analysis

The ABC principle is based on the common observation that a small

number of items often dominate the results achieved in any situation. This
observation was first established by an Italian economist Wilfred Pareto
and is known as Pareto Principle in management circles. The ABC analysis
suggests that inventories of an organization are not of equal value. Hence,
the inventory is grouped into three categories (A, B, and C) in order of
their estimated importance. ‘A’ items are very important for an
organization. Even though they are a few items, they account for a large
part of total consumption. They are consumed with high frequency.
Because of the high usage value of these ‘A’ items, frequent consumption
analysis is required to not any major variations. In addition to that, an
organization needs to choose an appropriate order pattern (e.g. ‘Just-in-
time’) to avoid excess inventory.

‘B’ items are important, but of course less important than ‘A’ items and
more important than ‘C’ items. Therefore, ‘B’ items are intergroup items.
‘C’ items are many but marginally important and cause about 20% of total
material consumption. A set ordering pattern can be set for them which
then can be reviewed may be at quarterly intervals.

The advantages of ABC analysis:

• ABC analysis is very easy to use and can be carried from data that, in
most cases, already exists in the organization. Most IT software contains
ABC analysis modules. Separation into three classes can be carried by
adopting uniform A = 10%, B = 20% and C = 70% formula or by
modifying it to suit your individual business unit.

• This technique has universal application and can be fruitfully employed

for analysis of, in addition to inventory, customer sales distribution,
vendor purchase volumes or distribution costs per sales rupee. Use of
ABC analysis does not depend on analyzed objects.

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• The results of the analysis can be graphically presented with ease

thereby providing clear overview of the analyzed data. This allows you to
understand trends clearly and quickly as compared to tabular data.

The ABC technique has to be practiced with some caution in view of its
three limitations:

1. To be effective the data fed for analysis has to be consistent,

standardized and codified. You should, therefore, pay specific attention
to the quality of available data.

2. The separation into three classes A, B and C is very rough. It may be

necessary to add one or two more classes to suit your business unit
requirements. Such subdivision is often required of class C items as it
contains large volume of items.

3. Every time there is a major price variation, analysis has to be carried

again.

8.8.2 Classification into A, B and C

The segmentation of inventory items into A, B and C classes and their

typical value and quantity percentages can be illustrated by using the
simplified normal pattern.

The breakup of materials usually reflects

Quantity Consumption Value

A class 10% approx. 70% approx.
B class 20% approx. 20% approx.
C class 70% approx. 10% approx.
100% 100%
Total 100% 100%

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A general problem that occurs when performing ABC analysis (or XYZ
analysis) is the precise definition of the borders among the classes. The
definition of class boundaries for specific critical value portions is,
therefore, a subjective decision and depends on the characteristics of
individual business unit. Available SAP or MRP software does provide some
standard classifications and these can modified for your business
requirements.

The main objective of ABC analysis is to enable management to focus on

essential processes in the supply chain by separating the (few) essential
from (numerous) non-essentials. The essential items are to be controlled
by regular intervention while non-essentials are taken care of established
processes.

ABC technique is also beneficial in purchase function to sort vendors by

invoice value, in production to classify centers by scrap value or in plant
maintenance to segment equipment by downtime hours.

8.8.3 Class A Inventory Main Characteristics

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Thus, Class A items, termed vital few, are most important and have
maximum scope for inventory optimization. These vital but few items in
Class A are selected for very strict control which is exercised by high
authority. Safety stocks for A items are very low (or nil) and service levels
are maintained through frequent ordering and staggered supply.

8.8.4 Class B Inventory

Safety stocks for B items are larger than those for A items and orders for B
items can be released once in two months or a quarter. Past consumption
can be safely used for materials planning. Three to four reliable vendors
are supposed to maintain supplies of Class B items. The Class B contains
roughly 15% to 20% of inventory items that account for equal percentage
of the entire annual material consumption in the business unit. It is
worthwhile to loosen the controls for these average materials.

This moderate control can be supplemented by fortnightly consumption

control.

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8.8.5 Inventory Class C

This class covers the least important around 70% of the inventory items
that account for approximately 20% of entire annual usage of materials.
Consequently, business unit can afford to keep more buffers in safety
stocks of class C items and arrange their bulk purchases once or twice a
year. Quantities would be decided either on the basis of past consumption
or rough estimates.

8.8.6 Aging Schedule of Inventories

Inventory items are classified according to the number of days of their
remaining in stock. This method helps to identify the movement of the
inventories and apply varying degree of management focus accordingly.
Sometimes, the analysis is also called as, FNSD analysis —
where,
F = Fast moving inventory: Full management focus
N = Normal moving inventory: Limited Focus
S = Slow moving inventory: Nil Focus
D = Dead moving inventory: This class is mainly identified for the purpose
of taking disposal decision of the inventory. A team is appointed for
arranging sale/transfer to spares, etc.

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8.8.7 VED Analysis

This technique is ideally suited for spare parts inventory management like
ABC analysis. Stocks of spares are classified by maintenance engineers into
three categories on the basis of their usage.
V = Vital item of inventories – Frequent scrutiny
E = Essential item of inventories – Periodical scrutiny
D = Desirable item of inventories – No scrutiny

Video Link 1

Video Link 2

8.8.9 HML Analysis

Under this analysis, inventories are classified into three categories on the
basis of the value of the inventories held on hand. Instead of annual usage
which is the key for ABC analysis, individual price of an item is the criterion
applied for classification.
H = High value of inventories
M = Medium value of inventories
L = Low value of inventories

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8.9 METHODS FOR VALUING ISSUES

You have option to use a typical method of pricing inventory issues which
suits your business unit and your objective. Inventory valuation methods
are used to calculate the cost of goods sold (or materials issued from
stock) and cost of ending inventory. If the changes in the price at which
you receive materials are not significant, each method will provide you with
more or less same results. However, in rising and falling prices, there can
be a pronounced difference. The method you decide to adopt for pricing
issues has no relationship with the actual physical movement of items.
Physically oldest items in the stock are always issued first to ensure stock
on hand is fresh and obsolesce is minimized.

Different methods available to you for pricing issues include:

(a) FIFO – First in First Out
(b) LIFO – Last in First Out
(c) Average Price and Weighted Average
(d) Actual Price
(e) Replacement Price or Current Value
(f) Standard Price or Standard Cost
(g) Inflated Price

8.9.1 FIFO – First in First Out

According to FIFO, it is assumed that items from the inventory are sold (or
issued) in the order in which they are purchased or produced. This means
that cost of older inventory is charged to cost of goods sold first and the
ending inventory consists of those goods which are purchased or produced
later. Materials are issued in strict chronological order. This is the most
widely used method for inventory valuation. FIFO method is closer to
actual physical flow of goods because companies normally sell goods in
order in which they are purchased or produced. In the economy with rising
prices (which is the normal trend in India), this method understates the
cost of sales as replacements are at higher prices than that used in cost of
sales. If there are many changes in the prices, the process becomes very
cumbersome.

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8.9.2 LIFO – Last in First Out

The last in, first out (LIFO) method is used to place an accounting value on
inventory. The LIFO method operates under the assumption that the last
item of inventory purchased is the first one sold or issued. Picture a store
shelf where a clerk adds items from the front, and customers also take
their selections from the front; the remaining items of inventory that are
located further from the front of the shelf are rarely picked, and so remain
on the shelf – that is a LIFO scenario. While valuing issues under LIFO, the
last price paid for the item available in stock is applied. If a company were
to use the process flow embodied by LIFO, a significant part of its
inventory would be very old, and likely to get obsolete. Nonetheless, a
company does not actually have to experience the LIFO process flow in
order to use the method to calculate its inventory valuation.

The reason why companies use LIFO is the assumption that the cost of
inventory increases over time, which is a reasonable assumption in times
of inflating prices. If you were to use LIFO in such a situation, the cost of
the most recently acquired inventory will always be higher than the cost of
earlier purchases, so your ending inventory balance will be valued at
earlier costs, while the most recent costs appear in the cost of goods sold.
By shifting high-cost inventory into the cost of goods sold, a company can
reduce its reported level of profitability, and thereby defer its recognition of
income taxes. Since income tax deferral is the only justification for LIFO in
most situations, it is banned under international financial reporting
standards (though it is still allowed in the United States under the approval
of the Internal Revenue Service).

As stated earlier, in rising prices (which is the normal trend in India), this
method understates the cost of inventory on hand as it is valued based on
old (lower) prices. To that extent, current value of this asset is not
reflected in the balance sheet. If there are many changes in the prices, the
process becomes very cumbersome.

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8.9.3 Average Price and Weighted Average Price

Average Price

In this method, the issues are valued on the basis of a simple average
price. The prices of purchases prior to any issues are added and average
price is calculated by dividing the total value by number of prices used.
Issues as well as stock are valued at this average price.

The method has only one advantage and that is it is easy to use. If price
fluctuations are minor, it can provide realistic valuations. But if prices
fluctuate, the method does not provide a true picture as prices are not
weighed by the quantities purchased at each price.

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Weighted Average Price

In this method, the issues are valued on the basis of a weighted average
price of materials in stock from which the issues is arranged. The value
(Price × Quantity) of purchases prior to any issues is divided by the
quantity to arrive at the weighted average price. It is a realistic method as
it reflects the price levels resulting in stabilization of cost figures. A new
rate for issue needs to be calculated at each new purchase and can be
used to value issues until a fresh purchase takes place.

As this method is simple to operate and provides balanced results, it is

being used by most business units. As it reflects actual costs, it is
acceptable to income tax authorities.

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8.9.4 Actual Price

In this method, actual cost of purchase is charged for the materials to be

issued from the store room. The method is of use when the purchases are
made for the specific purposes such as spare parts, special dies, jigs and
fixtures and other special purpose equipment. Usually, a separate ledger is
maintained for each purchase and issues from this quantity are valued at
the purchase cost rate. In jobbing industry, when few costly items or non-
standard components are purchased to meet production requirements
against a specific customer order, this method is appropriate.

8.9.5 Replacement Price or Current Value

This method is also known as market value method. When this method is
adopted, the material issues are priced not at the rates at which the stock
was purchased, but at the current market price of the item ruling on the
date of issue. The principle applied here is that materials issued for sale or
production of any job on a particular date should be charged at the rate at
which the materials consumed could be replaced immediately from fresh
purchases. This ensures that costs are current and profit earned indicates
correct margins on the transaction and the price at which materials were
purchased (either higher or lower) has no influence on reported profits.
The impact of price variations based on date of purchase is neutralized.

We had observed that under inflationary conditions, LIFO attempts to

achieve this objective but FIFO tends to overstate the profit on the
transaction by using old (lower) prices to value issues. The method is
normally used for materials of standard grades which are traded at the
commodity exchanges such as cotton, cereals, and certain metals for which
prices are published in the media.

The method enjoys two advantages. First, it considers current market

prices for materials thereby reporting current material costs. Thus,
unbiased margins are calculated. And second, it enables comparison of
operating efficiencies with those of competitors.

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It is, however, difficult to obtain the ruling market price every time the
materials are issued from the store room. Under inflationary conditions,
stock on hand is understated as issues are priced at the rates that are
higher than the rates paid to acquire materials. In case the prices were to
fall, the stock will be overvalued requiring write-offs to bring it to realistic
levels.

8.9.6 Standard Price or Standard Cost

Standard costing is the practice of substituting an expected cost for an

actual cost in the accounting records, and then periodically recording
variances that are the difference between the expected and actual costs.
This approach represents a simplified alternative to cost layering systems,
such as the FIFO and LIFO methods, where large amounts of historical cost
information must be maintained for items held in stock.

Here are some potential uses for standard costs: (1) Budgeting, (2)
Inventory costing, (3) Overhead application and (4) Price formulation.

Under this method, the most realistic price to be used for pricing issues is
pre-determined after considering all the economic factors – market
conditions, usage rates, market trends, etc. Unless there is any major
change to any of these factors, this rate – termed standard rate – is used
all throughout the accounting period. Materials receipts are recorded at
actual costs and issues are priced at standard rate. The difference between
the two is charged to material price variance account. This account is also
known in accounting terms as Purchase Price Variance or PPV. The net
balance to this account at the yearend is charged to the income statement
directly and thus amount does not form a part of product cost. If standard
prices are determined with required accuracy and market prices behaviour
stays as anticipated when the standard price was fixed, the PPV balance at
the end of accounting period is not a concern. But if these conditions do
not exist and PPV balance is significant, net income figure seizes to be
realistic, that can create audit and tax complications.

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8.9.7 Inflated Price

In this method, the purchase prices are inflated by a certain percentage

and used for issues. This percentage takes care of losses that occur during
processing on account of theft, breakage, obsolescence, evaporation, etc.
The method allows this loss to be distributed over entire production in an
even manner. In an industry where the material wastage in process is say
10%, inflated price used for issues will be 10% or more.

The use of inflated price method has resolved the problem of how to
account for wastage by spreading the same evenly over total production.
The success of the method again depends upon how correctly the wastage
percentage used for inflation of price is determined.

8.10 JUST-IN-TIME (JIT) INVENTORY MANAGEMENT

JIT inventory management was designed for Toyota by the Japanese and
now enjoys universal acceptance. Business entities adopting JIT have
reported significant reduction in the inventory to net sales ratio some very
significant. The JIT inventory management is a part of total production
concept that interfaces with Total Quality Management (TQM).
JIT requires management to ensure three preconditions:
• Quality production that continuously meets customer requirements.
• Close ties among vendors, manufacturers and customers.
• Close monitoring and reduction in lead times all over.

Fulfillment of these conditions results in reduction in inventory levels.

Suppliers are generally located in close proximity of the manufacturer. This

allows suppliers to deliver inputs in small batches at frequent intervals.
Manufacturers too reduce number of vendors (vendors are assured of
higher volumes) and enter into long-term attractive contacts (eliminating
complexity of ordering, invoicing and disbursements). Up-to-date
computerized production and inventory data is available on the terminals of
both the manufacturer and suppliers.

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In addition to lesser investment in inventories, JIT allows the parties to

reduce floor space required for operations thereby minimizing one time and
recurring cost of operations. JIT believes in elimination rather than
detecting defects and these cost savings need to be recognized by financial
analysts.

It is important to note that JIT is compatible with EOQ system. The focus is
to balance reduced carrying costs from maintaining less inventory stocks
with increased ordering costs. With annual contracts and online materials
management, cost per order is on the decline.

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8.11 SUMMARY

After trade receivables, inventory is another major but less liquid

component of working capital. It takes three forms: (a) Raw materials –
used for processing into final product; (b) Work-in-progress – represents
inventory removed from stocks for conversion into final product and(c)
Finished products – ready in the factory or warehouse/s for sale awaiting
delivery to customers

Traditionally, the responsibility for inventory management of a business

unit rested with marketing, production and finance departments
individually reporting to the CEO. The desired results were not forthcoming
as there was a conflict among the objectives of these three departments.
To resolve this conflict, business entities undertake a supply chain
management approach that is the synchronization of a business unit’s
processes with those of its suppliers and customers to match the flow of
materials, services and information with the customer demand.

In spite of the fact that funds get locked in inventory, there are business
pressures that encourage business units to hold large inventories. These
include – assured on-time (sometimes on demand) deliveries to customers,
fear of stock-outs and resulting production stoppages, desire to reduce
number of orders and anticipated increase in prices, etc.

The inventory carrying cost (or holding cost) is the sum of cost of capital
plus the variable costs of keeping materials on hand such as storage and
handling costs; shrinkage, deterioration and obsolescence costs; taxes and
insurance. As these expenses change with inventory levels, so does the
holding cost. These costs can vary from 18% to 30% of the inventories
held.

Ordering costs are incurred by a business unit every time stocks have to be
replenished by placing order on vendor or on the business unit’s factory.
This cost has no bearing on quantity ordered as it is one-time cost that
occurs once the order is released. Every order to be released has to be
scheduled, released, expedited and closed.

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Management goal is to place orders in such a way that above two costs of
holding and ordering inventory together are minimized. EOQ or economic
order quantity technique is the answer here. The EOQ needs revision in
certain cases when quantity discounts are offered or prices are expected to
increase.

Three categories of techniques are in use to manage inventory within

acceptable limits. A – Managing stock levels and order quantities; B –
Classifying inventory items for different degrees of control and C – Keeping
appropriate inventory records for control.

ABC analysis of inventory allows management to focus on a few but

important large consumption value A items leaving balance large items to
routine control. Under aging schedule of inventories, items are classified
according to the number of days of their remaining in stock. The analysis is
also called as, FNSD analysis— where, F = Fast moving inventory: that
demands full management focus; N = Normal moving inventory: for
limited management focus; S = Slow moving inventory: Nil Focus and D =
Dead moving inventory: This class is mainly identified for the purpose of
taking disposal decisions. A team is appointed for arranging sale/transfer
to spares, etc.

VED analysis technique is ideally suited for spare parts in the inventory
management like ABC analysis. Stocks of spares are classified into three
categories on the basis of their usage V = Vital item of inventory. Frequent
scrutiny carried out; E = Essential item of inventory – Periodical scrutiny
and D = Desirable item of inventory – No scrutiny.

Under HML analysis, inventories are classified into three categories on the
basis of the value of the inventories held on hand. Instead of usage which
is the key for ABC analysis, individual price of an item is the criterion
applied for classification. H = High value of inventories; M = Medium value
of inventories and L = Low value of inventories.

You have option to use that method of evaluating inventory which suits
your business unit and your objective. Different methods available to you:
(a) FIFO – First in First Out; (b) LIFO – Last in First Out; (c) Average Price
and Weighted Average; (d) Actual Price; (e) Replacement Price or Current
Value; (f) Standard Price or Standard Cost and the last (g) Inflated Price.

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JIT inventory management was designed for Toyota by the Japanese and
now enjoys universal acceptance. Business entities adopting JIT have
reported reduction in the inventory to net sales ratio some very significant.
The JIT inventory management is a part of total production concept that
interfaces with Total Quality Management (TQM). JIT requires management
to ensure: (a) Quality production that continuously meets customer
requirements; (b) Close ties among vendors, manufacturer and customers
and (c) Close monitoring and reduction in lead times all over.

8.12 MULTIPLE CHOICE QUESTIONS

Mark (x) against the most reasonable alternative.

1. Ashok and Ravi did not agree in determining responsibility for inventory
control. Ashok, appearing for M.Com., insisted that the CFO is
responsible; while Ravi appearing for B.E. Claimed, it was the marketing
manager’s responsibility so that customer orders are delivered on time.
What is your decision in the matter? Who should manage inventory?
(a) CFO
(b) Marketing Manager and Purchase Manager
(c) Supply chain managers
(d) Both marketing and finance managers

2. Asha claims that ordering costs are fixed. Do you agree? If not, what is
the factor that influences them?
(a) Order Quantity
(b) Number of orders issued
(c) None above
(d) Both (a) and (b) above

3. Materials manager of Pune Electricals follows EOQ method while issuing

purchase orders. Their class A vendor offers a quantity discount of five
per cent if orders are placed for 1,000 parts and above. The materials
manager finds that the EOQ for that part is 750 parts. What will
you advise the materials manager?
(a) Do not change Economic Order Quantity
(b) Place order for 1,000 parts and enjoy trade discount
(c) Compare added cost of carrying inventory with trade discount to
take a decision
(d) Either (a) or (b) above

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4. Any business firm implementing ABC analysis for inventory

management shall maintain nil or very minimum stocks for _________
class items.
(a) A
(b) B
(c) C
(d) All three

5. __________ requires management to ensure: (i) Quality production

that continuously meets customer requirements; (ii) Close ties among
vendors, manufacturer and customers and (iii) Close monitoring and
reduction in lead times all over.
(a) VED
(b) JIT
(c) HML
(d) ABC

Answers : 1. (c), 2. (d), 3. (c), 4. (a), 5. (b).

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REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter

Summary

PPT

MCQ

Video Lecture - Part 1

Video Lecture - Part 2

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Chapter 9
Financial And Operating Leverage

Objectives
After studying this chapter you should be able to understand:
• Role of fixed assets in operating leverage
• Role of debts in financial leverage
• Leverages magnify earnings
• Risks involved in leverages
• How risks stack in combined leverage

Structure:
9.1 Introduction
9.2 Operating Leverage
9.3 Financial Leverage
9.4 Combined Leverage
9.5 Summary
9.6 Multiple Choice Questions

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9.1 INTRODUCTION

The term leverage is normally used to indicate employment of special

steps, forces to obtain more than normal, above average results from the
action. In business, leverage is employed with the same objectives of
seeking magnifying results from employment of debts and fixed assets.
Here, we must notice that this leverage is two-edged sword. If business
activities go your way, it produces highly favorable results for owners/
shareholders. But if they do not, then the business unit can as well end up
into bankruptcy.

Figure 9.1

To understand the concept of business leverage, assume you are planning

to start a new venture. You wish to manufacture electrical components,
switches, transformers, meters, etc. for the industrial use. Before you get
started, you need to decide how much money you wish to invest in plant
and machinery as they generate costs that remain fixed:

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1. Quite large investment: You have plans to install latest line of

automated equipment with mechanical handling and employing bare
minimum workforce. Your strategy is to operate on mass scale so that
heavy overheads are spread over large volume of output rendering your
unit cost competitive. But you run a risk here, because at a low volume
of sales your unit will not be able to bear high overheads and stay
competitive. Businesses leverage their operations by using fixed cost
inputs when revenues are expected to be variable. An increase in
revenue will result in a larger increase in operating income. Hedge funds
may leverage their assets by financing a portion of their portfolios with
the cash proceeds from the short sale of other positions.

2. Not significant investment: You have plans to install minimum

essential equipment manned by skilled and expensive workforce. Here,
your unit costs are greater than in the option (a) above, as a result, you
earn smaller margin of profit. But you can start producing (smaller)
volume of output as demanded by the market and increase output by
employing more labour (starting second shift). You profits are restricted
but so is your exposure to business risk.

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Next, it is now time to decide how you will finance your investments, with
your own capital or with debts, and in what proportions:

a. Here, again if you rely on debt financing and business is successful,

certainly you will generate attractive profits as an owner. But if business
does not grow as per your expectations, you are saddled with fixed
interest costs of debts which you may not be in a position to service or
repay. In extreme case, you may be forced to declare a bankruptcy.
While leverage magnifies profits when the returns from the asset more
than offset the costs of borrowing, losses are magnified when the
opposite is true.

b. You have an alternate course of action available where you sell equity
rather than borrow, a step that will lower your own profit to a certain
degree (you are sharing it with others) but minimize your business risk
exposure substantially. With higher debt and lesser capital, you share
firm’s profits among a smaller group thereby increasing your own
individual earnings.

In both these investment decisions, you are employing ‘leverage’ or

‘gearing’ as is known in the UK.

If you elect to invest heavily in automatic plant and machinery, you have
opted for ‘operating leverage’. And in the next decision where you seek the
option to utilize debt to finance your operations, you are employing what is
termed as ‘financial leverage’ – the use of borrowed money to increase
production volume, and thus sales and earnings. It is measured as the
ratio of total debt to total assets. The greater the amount of debt, the
greater the financial leverage. Since interest is a fixed cost (which has to
be written off against revenue), a loan allows an organization to generate
more earnings without a corresponding increase in the equity capital
requiring increased dividend payments (which cannot be written off against
the earnings).

However, while high leverage may be beneficial in boom periods, it may

cause serious cash flow problems in recessionary periods because there
might not be enough sales revenue to cover the fixed interest payments.
A business entity that borrows too much money might face bankruptcy or

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default during a business downturn, while a less-leveraged corporation

might survive.

9.2 OPERATING LEVERAGE

As we noticed in the definitions above, operating leverage of a business

entity reflects the extent to which fixed assets and resulting fixed costs are
utilized in its business to generate business income on a regular basis.
Expenses of a business entity are partly constant and partly variable with
volume of production and sales. Investment in fixed assets results in
higher proportion of fixed costs to variable costs. Lease, rent and taxes,
depreciation and senior management salaries are some other components
of fixed costs.

Expenses like raw material, wages and salaries, power, etc., on the other
hand, constitute components of variable expenses that increase or
decrease directly with the volume of production and sales. There are in
addition semi-variable expenses like repairs, maintenance, electricity,
supervision, etc. which are partly constant and partly vary with volumes of
production and sales. For our financial analysis hereafter, we shall include
these into variable expenses for the sake of simplicity.

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9.2.1 Break-even Analysis

This analysis is carried by business units to determine how does the

volume of operations affects its costs and therefore profits. At what
volume, the unit must operate if it wants to recover all its fixed costs so
that thereafter it can start making money. These questions are answered
by drawing a break-even chart as shown in Graph 9.1 below. Normally,
volume of units produced and sold is shown across horizontal X axis and
volume of sales revenue and all costs on vertical Y axis.

Let us now attempt to determine a break-even point of sales for Oxford

Shoes Ltd. which it must achieve to be in a position to recover all its costs.
Selling price of shoes is Rs. two thousands and variable cost Rs. 800 per
unit. Oxford’s fixed costs amount to Rs. 60 million.

Graph 9.1: Unit Produced/Sold in Thousands

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You can now observe that Oxford incurs fixed costs of sixty million A – B
irrespective of volume of sales and variable cost at Rs. 800 per unit is
added to obtain total costs A – C. The total revenue P – Q is indicated by
multiplying sales units by its selling price of Rs. two thousands. You should
now also notice that up to sales volume of 50,000 pairs the line AC total
costs is higher than the line PQ of sales revenue and the firm is incurring
loss. But after the break-even point of 50,000 units (where AC = PQ),
Oxford is making profits as now PQ is higher than AC.

You can use a formula too, in order to determine the break-even.

BEP = Fixed Costs ÷ Contribution Margin
= Fixed Costs ÷ (Selling Price – Variable Cost per piece)
= Rs. 60 million ÷ Rs. 1,200 or 50,000 units

With a proportion of 60% contribution, it is assumed that Oxford is

operating with a high degree of leverage. Its operating income starts only
after fifty thousand pairs of shoes are sold. But once this threshold is
crossed, operating income increases very rapidly – as shown in Table 9.1
below.
Table 9.1
Units Sold Fixed Total Sales Profit % D to C
Costs Costs Revenue
A B C D
50,000 60 100 100 0 0
60,000 60 108 120 12 10
70,000 60 116 140 24 17
80,000 60 124 160 36 22.5

This cost structure is typical of an airline that must carry a certain number
of passenger-miles to break-even. But thereafter the journey shows
excellent returns on investments. This also is one of the reasons for the
airlines to announce lower fares to attract passengers.

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But not all business entities would show the courage to operate at such a
high degree of operating leverage. The fear of failing to reach the target of
selling at least 50,000 pairs discourages companies form heavy
employment of fixed assets. Such companies may prefer to move over to
more expensive variable costs by employing skilled workforce that can
operate less sophisticated or automated plant equipment. The reduction in
total fixed costs results in a fall in the break-even point that will not be
very difficult to cross every year. Such business entities need to be
satisfied with more certain but less significant profit margins.

The Cambridge Footwear Ltd. is conservative and plans to have a lower

break-even point to be in a position to recover all its costs. Its selling price
of shoes is Rs. two thousands, but its variable cost now has increased to
Rs. 1,200 per unit as a result of less fixed costs amounting to Rs. 30
million only. Now, its break-even point is conservative 37,500 pairs (Graph
9.2 on the next page).

If the sale of these two companies was, say 50,000 pairs each, Oxford will
hit the break-even and will have no profit to declare; while Cambridge will
have a profit of Rs. [( 50 × 2)100 revenue – (30 + 60)] 90 cost providing
a profit of 10 million to declare. Here, Cambridge’s conservative approach
has succeeded. But if both the companies were to sell 100,000 pairs, the
picture will change and Oxford will be earning more profits as under:

Oxford Cambridge
Revenue 200 200
Fixed Cost 60 30
Variable Cost 80 120
Total 140 150
Profit 60 50

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Graph 9.2: Cambridge Footwear Ltd.

For every additional 10,000 pairs sold, Oxford will add twelve million to its
profits, i.e., fifty per cent more against only eight million of Cambridge.
This is the payoff for risk undertaken by Oxford in arranging for operating
leverage in its business.

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9.2.2 Degree of Operating Leverage

The sensitivity of earnings to changes in sales is termed Degree of

Operating Leverage (DOL). It can be defined as the percentage change in
operating income that takes place as a result of a percentage change in
units sold. Highly leveraged firms (like Oxford Shoes above) enjoy rather
substantial increase in earnings as the volume enlarges. Less leveraged
firms (like Cambridge Footwear) participate in an increase in earnings at a
smaller extent. The period to be selected for determining DOL should be
profitable years of operations.

Let us now determine DOL for the two shoe firms we studied above.

Units Sold Fixed Costs Total Costs Sales Profit

Revenue
OXFORD
70,000 60 116 140 24
1,80,000 60 204 360 160

(a) Change in Volume 2 .6 times

(b) Change in Profit 4.4 times
2.5
(c) Degree of leverage b/a

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Figure 9.2

CAMBRIDGE

70,000 30 114 140 24

1,80,000 30 246 360 144

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9.2.3 Fallacy in Linear Function of Costs and Revenue

In the entire analysis of operating leverage, we indirectly assumed that

there exists a linear function for costs and revenue as volumes undergo
changes.

In graphs 9.1 and 9.2, we indicated that for volume of 20,000 to 1,80,000
pairs, both firms can charge Rs. 2,000 per pair. But in reality, the firms will
face resistance as they attempt to increase their market share. A price
weakness is most likely to take place. Similarly, unit costs face upward pull
beyond a certain optimum size of operations. Relationships as they exist
are not in fixed ratios as we assumed. Because of price weakness and cost
overruns, we may come to another (break-even?) high level of volume
where total costs will equal total revenue. [Refer Graph 9.3 below.] In spite
of this fact, the basic relationships depicted in Graphs 9.2 and 9.3 are valid
over a certain range of sales volume for most of the business entities.
These are challenged when volumes are extended to extreme levels.

Graph 9.3: Units Produced/Sold in Thousands

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After understanding the effect of fixed costs on the operations of a

business entity in the form of operating leverage, let us now attend to
second form of leverage where we study the role of debts in financing
operations.

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9.3 FINANCIAL LEVERAGE

Financial leverage represents the relationship between the company’s

Earnings Before Interest and Taxes (EBIT) or operating profit and the
earning available to equity shareholders. Financial leverage is the degree
to which a company uses fixed-income securities such as debt and
preferred equity. The more debt financing a company uses, the higher its
financial leverage. A high degree of financial leverage means high interest
payments, which negatively affect the company’s bottom-line earnings per
share. Financial risk is the risk to the stockholders that is caused by an
increase in debt and preferred equities in a company’s capital structure. As
a company increases debt and preferred equities, interest payments
increase, reducing EPS. As a result, risk to stockholder return is increased.

Figure 9.3

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A company should keep its optimal capital structure in mind when making
financing decisions. It needs to ensure any increase in debt and preferred
equity optimizes the value of the business entity. Once the sales volume
grows beyond the break-even point, the incremental earnings are available
to shareholders alone as interest cost is fixed. The common example of
exploitation of financial leverage is that of a typical builder who collects
hundred per cent funds from buyers of the tenements in consecutive
construction projects and operates on hardly any capital of his own and
earns profits on his zero investment. But if there is any problem in
completions or slump in real estate industry, this builder is the first to
declare bankruptcy. Financial leverage results from utilizing debt to finance
assets. The greater the ratio of funds contributed by creditors compared to
funds contributed by stockholders, the greater the firm’s financial leverage.
Financial leverage magnifies changes in net income compared to changes
in operating income. For example, financial leverage might cause a firm’s
reported net income to increase by 30% when operating income increases
by 20%.

9.3.1 Impact of Financial Leverage

To understand the impact, let us consider two different financial plans for
Godavari Tractors Ltd. It needs totally forty million rupees for its total
operations. Under plan A, it decides to have equity of ten million rupees
(1,000,000 shares of Rs. 10 each) and balance thirty million through long-
term debts at 10% interest per annum. Under plan B, it decides to have
equity of thirty million rupees (3,000,000 shares of Rs. 10 each) and
balance ten million through long-term debts at 10% interest per annum.
Corporate income tax is assumed at 30%. Now, let us tabulate earnings
per share of Godavari Tractors Ltd. at different levels of earnings before
interest and income taxes.

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Plan A Plan B
1 Earnings Before Interest and Taxes (EBIT) 20,00,000 20,00,000
Interest 30,00,000 10,00,000
Earnings Before Taxes (EBT) –1,000,000 10,00,000
Taxes 0 3,00,000
Net Earnings –1,000,000 7,00,000
EPS 0 0.23
2 Earnings Before Interest and Taxes (EBIT) 50,00,000 50,00,000
Interest 30,00,000 10,00,000
Earnings Before Taxes (EBT) 20,00,000 40,00,000
Taxes 6000,000 12,00,000
Net Earnings 14,00,000 28,00,000
EPS 1.40 0.93
3 Earnings Before Interest and Taxes (EBIT) 75,00,000 75,00,000
Interest 30,00,000 10,00,000
Earnings Before Taxes (EBT) 45,00,000 65,00,000
Taxes 13,50,000 19,50,000
Net Earnings 31,50,000 45,50,000
EPS 3.15 1.52
4 Earnings Before Interest and Taxes (EBIT) 95,00,000 95,00,000
Interest 30,00,000 10,00,000
Earnings Before Taxes (EBT) 65,00,000 85,00,000
Taxes 19,50,000 25,50,000
Net Earnings 45,50,000 59,50,000
EPS 4.55 1.98

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The results are dramatic. With equal increases in earnings before interest
and taxes, the EPS under the two plans shows a vast variance especially at
higher levels of earnings. Up to five million of earnings, EPS difference is
not significant. But beyond that level, EPS under plan A is almost double
that under conservative plan B. Under leveraged plan A, net earnings are
more as interest is tax deductible expense. At the EBIT of Rs. 7.5 million,
the tax payable under conservative plan B is Rs. 1.95 million while under
leveraged plan A, it is less T Rs. 1.35 million. Increase in after tax earnings
is distributed over just one million shares (against three under
conservative plan B) in the leveraged plan A thereby providing higher EPS.
EPS under Plan A and B is reflected in Graph 9.4 below.

Graph 9.4: Earnings before Interest and Taxes in Rs. Million

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9.3.2 Degree of Financial Leverage

Degree of financial leverage may be defined as the percentage change in

taxable profit as a result of percentage change in Earnings Before Interest
and Tax (EBIT). This can be calculated by the following formula,

Let us understand with an example.

A Company has the following capital structure

`
Equity share capital 1,00,000
10% Preference share capital 1,00,000
8% Debentures 1,25,000
The present EBIT is Rs. 50,000.

Calculate the financial leverage assuming that the company is in 50% tax
bracket.

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Solution:
Statement of Profit

Earning Before Interest and Tax (EBIT) 50,000

Interest on Debenture (125,000 × 8 × 100) 10,000
Earning before Tax (EBT) 40,000
Income Tax 20,000
Earning after Tax (EAT) 20,000

Degree of financial leverage at the EBIT of Rs. five million we discussed

above:
under leveraged plan A is 5,000,000/2,000,000 = 2.5 and
under conservative plan B is 5,000,000/4,000,000 = 1.25

Video Link 1

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9.3.3 Financial Leverage – Limitations

One question can now arise in your mind. If debt financing is so

remunerative, why should a business entity have any equity capital? Here,
we must clarify that financial leverage yields results; but only up to a
certain level. Beyond this point, it may be harmful to the firm. This risk is
there from financial institutes that provide debt finance. If adequate equity
is absent, the institutions either may not lend, or if they do the interest
burden will be very heavy. The lenders can demand certain restrictions on
the business entity’s operations. These cannot be denied as there is total
dependence on debt funding.

To summarize, the financial leverage does work to the benefit of the

business entity. Extreme care has to be exercised by management to make
this happen. It is a two-edged instrument. When used appropriately, it
yields significant gains to owners. If not, owners may lose their initial
investments.

Self-training Exercise: 01

The CFO of Ashok Mega Mart has following quarterly report for
presentation to the CEO.
Rs. crores
Net Sales 154
Gross Margin 64
Interest 40
Net Margin 24

The CEO is naturally going to be upset that almost 63% of the gross
margin is being eaten by interest expense.
Prepare a report addressed to the CEO explaining how and when this 63%
share taken up by interest is going to be less and less each quarter.
(Include projections.)

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9.3.4 Operating vs. Financial Leverage

The first leverage – operating is about how much the business entity
invests in plant and machinery and the second leverage – financial is about
how the operations are financed – with owner’s capital (equity shares) or
through preference shares and borrowings.

You can also perceive these two leverages as two parts of the business
entity’s balance sheet.
Balance Sheet
Assets Liabilities
Operating Leverage Financial Leverage
% Fixed Assets to Total % of Debts to Total

Video Link 1

Characteristics of these two types of leverages can be tabulated as under:

Financial Leverage Operating Leverage

Associated with funding Associated with investments
Consists of operating profits Consists of fixed operating expenses
Ability to use fixed assets Ability to employ debts
Ratio of debts to funds employed Ratio of fixed assets to total employed
Rate of interest and taxes not relevant Rate of interest and taxes is very
relevant
Calculated as OP ÷ PBT Calculated as Contribution ÷ OP
Degree calculated = % change in PBT Degree calculated = % change in PBIT
÷ % change in PBIT ÷ % change in Sales Volume

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9.4 COMBINED LEVERAGE

We observed that operating leverage and financial leverage each assists a

business entity earn larger returns. Can we then further increase earnings
by employing both of them? The answer is positive. Operating leverage
increases returns from operations and financial leverage determines how
these benefits are distributed among debt holders and equity holders.

Since returns to debt lending institutions are constant based on rates of

interest, incremental earnings accrue to equity holders. Thus, first leverage
provides more earnings to share owners and the second one larger share
in higher earnings.

Here are key figures of Godavari Sugars Limited.

You should observe that operating leverage is generated from the first four
items of the income statement that determine operating income. In the
subsequent items from the statement, we learn extent to which income
before interest and taxes is transferred into earnings per share.
Applicable tax rate assumed to be 30%.

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Table 9.2: Godavari Sugars Limited

Rs. 40 million earnings are the result of production, distribution and

marketing efforts that generated operating margin and Rs. 17.5 is the sum
available to equity holders after payment of interest and taxes. This
amount is used for distribution of dividends to equity holders.

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9.4.1 Impact of Combined Leverage

It is widely known that Japanese companies are ahead in employing

sophisticated latest technology – robotics – into their plants. The high
investment in plant and equipment allows them to reduce labour costs to
the minimum and thus become competitive in global markets. These
reduced labour costs are also ‘fixed’ costs in Japan, where unlike western
countries, employment is considered to a lifetime assignment. There is no
‘layoff’.

In addition to high operating leverage that is a part of Japanese economy,

these firms also have high financial leverage. Debt to equity ratio in
Japanese firms is more than double that of their counterparts in the USA.
This high combined leverage compels the Japanese firms to be aggressive
in global markets, as they cannot afford to lose their sales volume.
Combined leverage magnifies returns as volume increases (as shown in the
plan A under 9.3.1) but it also amplifies losses as volumes experience even
marginal fall. If we bring about just 8% drop in sales volume of Godavari
Sugars Ltd. (as shown in the Table 9.2 above), the resulting change in its
EPS is from Rs. 2.50 to Rs. 1.58 – a whopping 40% drop as can be
observed in Table 9.3 below.

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Table 9.3: Godavari Sugars Limited

With high combined leverage, business entities have to protect their sales
volume at all costs and take whatever action that is necessary to stop any
loss in sales volume. Such firms have to be aggressive and competitive to
justify their high fixed assets and high debts. By use of both leverages, the
firm is exposing itself by piling risk on risk. It could be a wise policy to
balance high operating leverage by adopting a conservative financial
leverage and vice versa.

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9.4.2 Degree of Combined Leverage

The sensitivity of profit before tax (or profit after tax or earnings per
share) to changes in quantity sold is denoted by degree of combined
leverage. This degree is defined as:

In use of both leverages, the firm is exposing itself by piling risk on risk. It
could be a wise policy to balance high operating leverage by adopting a
conservative financial leverage and vice versa.

Video Link 1

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9.5 SUMMARY

The term leverage is normally used to indicate employment of special

steps, forces to obtain more than normal, above average, results from any
management action. You need to decide how much money you wish to
invest in plant and machinery as they generate fixed costs. And then it is
time to decide how you will finance your investments, with your own
capital or with debts, and in what proportions. These two decisions
determine the operating and financial leverage of your business entity.
Operating leverage may be defined as the business entity’s ability to use
fixed operating costs to magnify the effects of changes in sales on its
earnings before interest and taxes. And financial leverage is the degree to
which a company uses fixed-income securities such as debt and preferred
equity. The more debt financing a company uses, the higher its financial
leverage.

Break-even analysis is carried by business units to determine how does the

volume of operations affects its costs and therefore profits. At what volume
the unit must operate if it wants recover all its fixed costs so that
thereafter it can start making money. The high operating leverage has
correspondingly high fixed costs and therefore demands that the entity
operates at high business volumes. With each increment in volume after
the break-even point, the leveraged firm enjoys significant earnings. This
sensitivity of earnings to changes in sales is termed Degree of Operating
Leverage (DOL). It can be defined as the percentage change in operating
income that takes place as a result of a percentage change in units sold.

In the analysis of operating leverage, we indirectly assume that there

exists a linear function for costs and revenue as volumes undergo changes.
This assumption however is valid only for volumes within a certain range.
Beyond this valid range, incremental sale volumes can be retained only by
dropping prices. Cost savings that accrue with increase in volumes also
disappear if you use the plant capacity beyond a certain limit.

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Financial leverage represents the relationship between the company’s

Earnings Before Interest and Taxes (EBIT) or operating profit and the
earning available to equity shareholders. Financial leverage is the degree
to which a company uses fixed-income securities such as debt and
preferred equity. The more debt financing a company uses, the higher its
financial leverage. A high degree of financial leverage means large interest
payments, which negatively affect the company’s bottom-line earnings per
share at lower levels of sales volume. With every increase in earnings
before interest and taxes, the EPS of a firm with high financial leverage
shows a significant jump especially at higher levels of earnings.

Degree of financial leverage may be defined as the percentage change in

taxable profit as a result of percentage change in Earnings Before Interest
and Tax (EBIT). This can be calculated by the formula percentage change
in Taxable Income ÷ Percentage change in EBIT.

Here, we must clarify that financial leverage yields results; but only up to a
certain level. Beyond this point, it may be harmful for the firm. This risk
arises from financial institutes that provide debt finance. If adequate equity
is absent, the institutions either may not lend, or if they do the interest
burden will be very heavy. The lenders can demand certain restrictions on
the business entity’s operations.

The first leverage – operating is about how much the business entity
invests in plant and machinery and the second leverage – financial is about
how the operations are financed – with owner’s capital (equity shares) or
through preference shares and borrowings. Can we then further increase
earnings by employing both of them? The answer is positive. Operating
leverage increases returns from operations and financial leverage
determines how these benefits are distributed among debt holders and
equity holders. Since returns to debt lending institutions are constant
based on rates of interest, increase in incremental earnings accrue only to
equity holders.

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9.6 MULTIPLE CHOICE QUESTIONS

Mark (x) against the most reasonable alternative.

1. Aditya was repeating that both operating and financial leverages are like
a two-edged sword. When Ameya questioned him why a two-edged
sword, his response was they __________.
(a) Provide liquidity but at extraordinary costs
(b) Assist build-up of sales volumes but at poor margins
(c) Provide above average earnings but can put equity owners into
bankruptcy
(d) There are better earnings but they do not last long

2. The analysis that is carried by business units to determine how does the
volume of operations affects its costs and therefore profits is termed
__________.
(a) Break-even analysis
(b) Degree of operating leverage
(c) Liquidity ratio
(d) Fund flow analysis

3. __________ leverage represents the relationship between the

company’s Earnings Before Interest and Taxes (EBIT) or operating profit
and the earning available to equity shareholders. At first, Sharad knew
how to fill the gap but now he is confused. Tell him which from the
following he should pick to fill the gap.
(a) Operating
(b) Combined
(c) Financial
(d) Total

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4. Four CFOs of Godavari Sugars, Irawati Sugars, Narmada Sugars and

Yamuna Sugars, all four firms enjoying more or less same sales
volumes; were at a club in Mumbai. Each claimed that his firm
employed a high financial leverage. EPS of these firms is Rs. 3.50,
Rs. 2.50, Rs. 1.50 and Rs. 0.50 respectively. Which of these firms is
most likely to have the highest financial leverage?
(a) Yamuna Sugars
(b) Narmada Sugars
(c) Irawati Sugars
(d) Godavari Sugars

5. The study of several large business entities in Japan established the fact
that by employing __________ leverage the firm is exposing itself by
piling risk on risk.
(a) Financial
(b) Combined
(c) Reverse
(d) Operating

Answers: 1. (c), 2. (a), 3. (c), 4. (d), 5. (b).

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REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter

Summary

PPT

MCQ

Video Lecture

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 COMMON AND PREFERRED STOCKS

Chapter 10
Common And Preferred Stocks

Objectives
After studying this chapter, you should be able to understand:
• Need for long-term finance and alternatives available to meet them
• Role of common stock to meet long-term finance needs
• Rights enjoyed by a common stockholder
• Common stock has certain advantages and a few shortcomings
• Features of preferred stock
• Classes in which preference stock is available
• Salient features of common stock, preferred stock and long-term debt
instruments

Structure:
10.1 Introduction
10.2 Categories of Equity Capital
10.3 Rights of Equity Holders
10.4 Common Stock – Benefits and Drawbacks
10.5 Preferred Stock – Features
10.6 Preferred Stock – Classification
10.7 Preference Stock – Benefits and Drawbacks
10.8 Common Stock, Preferred Stock and Debt Instruments – A
Comparison
10.9 Summary
10.10 Multiple Choice Questions

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10.1 INTRODUCTION

When an investor pays any company money in return for part ownership,
the corporation issues a certificate of ownership interest to the stockholder.
This certificate is known as a stock certificate, capital stock, or stock.
(Today, all corporations handle the shares or stock electronically.) Stock is
the evidence of an ownership interest, it is not a loan to the corporation;
common stock does not come with due date or maturity. A stockholder
owns the stock until he/she decides to sell it. If stockholders want to sell
their stock, they must find a buyer usually through the services of a
stockbroker. Nowhere on the stock certificate is it indicated what the stock
is worth (or what price was paid to acquire it). In a market of buyers and
sellers, the current value of any stock fluctuates moment-by-moment. It
has value on its face that indicates what proportion in total ownership the
owner enjoys. Total common stock consists of a certain amount (Rs. one
crore) divided into a certain number of shares (Rs. twenty lakhs) of face
value that is indicated in the share certificate (Rs. five).

A corporation’s accounting records are involved in stock transactions only

when the corporation is issuing shares as per its prospectus. However,
when the corporation itself is not the issuer, seller, or buyer of its own
stock, sale and purchase of its stock on exchanges have no effect in
records of the corporation. For example, if 500,000 shares of Tata Steel
stock are traded on the national stock exchange today, and if none of
those shares is issued, sold, or repurchased by Tata Steel, then Tata
Steel’s accounting records are not affected. The corporation will go about
its routine business operations without even noticing that there were some
changes in its ownership.

As per Section 2(46) of the Indian Companies Act 1956, “share” means
share in the share capital of a company, and includes stock except where a
distinction between stock and shares is expressed or implied.

Preferred stock is a hybrid source of long-term financing with some

characteristics of equity and some of the long-term debt.

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10.2 CATEGORIES OF EQUITY CAPITAL

10.2.1 Share Capital

Some investors may have large ownership interests in a given corporation,

while other investors own a very small part. To keep track of each
investor’s ownership interest, corporations use a unit of measurement
referred to as a “share” (or “share of stock”). The number of shares that an
investor owns is printed on the investor’s stock certificate (which is now in
an electronic form). This information is also noted in the corporate
secretary’s record, a record which is not connected to the corporation’s
accounting records. The ratio of investors to stock owned is different for
every corporation and it may change many times per day depending on
who is selling or buying stock. If an investor owns 1,000 shares and the
corporation has issued and has outstanding a total of 100,000 shares, the
investor is said to have a 1% ownership interest in the corporation. The
other owners have the combined remaining 99% ownership interest.

Most large public corporations have their equity distributed over a large
number of shareholders. They together enjoy the rewards and bear the
risks of ownership. It must be noted here that their liability, unlike the
liability of a proprietor or a partner of a business unit, is limited to the
amount they paid, get the shares in their name.

You can study how such spread in ownership of the business entity is
arranged by Larsen Toubro Ltd. from the data for 2014-15 published by
the company in its balance sheet for the year.

Video Link 1

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Distribution of Shareholding as on March 31, 2015

Shareholding
No. of Shares Shareholders Number %
%
Up to 500 7, 81,280 91.51 6,58,86,346 7.09
501 – 1000 39,256 4.60 2,78,31,827 2.99
1001 – 2000 18,171 2.13 2,55,51,969 2.75
2001 – 3000 5,663 0.66 1,40,84,226 1.51
3001 – 4000 2,425 0.28 84,38,946 0.91
4001 – 5000 1,511 0.18 68,17,391 0.73
5001 – 10000 2,836 0.33 1,96,83,512 2.12
10001 &
2,682 0.31 76,12,67,844 81.90
Above
Total 8,53,824 100.00 92,95,62,061 100.00

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10.2.2 Authorized Share Capital

When a business entity applies for incorporation to the Registrar of

Companies, its application will specify the classes (or types) of stock, the
par value of the stock, and the number of shares it is authorized to issue.
This constitutes authorized capital of the company (Rs. one crore
consisting of twenty lakh shares of five rupees each). Shares are often
issued in exchange for cash. However, shares of stock can be issued in
exchange for services or plant assets. When its articles of incorporation are
prepared, the business entity will often request authorization to issue a
larger number of shares than what is immediately needed. By planning
ahead this way, the business entity avoids the inconvenience of having to
go back to the Registrar if and when more shares are needed to raise more
capital.

To illustrate, assume that the organizers of a new corporation need to

issue 10,000 shares of common stock to get their corporation up and
running. They keep in mind, however, that in one year they will need to
issue additional shares to fund a planned factory expansion. Five years
from now, they foresee buying out another company and realize they will
need to issue more shares at that time for the acquisition. As a result, they
decide that their articles of incorporation should authorize 100,000 shares
of common stock, even though only 10,000 shares will be issued at the
time that the corporation is formed.

Leading Corporation Larsen and Toubro Ltd. shows an authorized share

capital of Rs. 325 crores.

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 COMMON AND PREFERRED STOCKS

10.2.3 Issued Share Capital

When a corporation sells some of its authorized shares, the shares are
described as “issued”. The number of issued shares is often considerably
less than the number of authorized shares. Corporations issue (or sell)
shares of stock to obtain cash from investors, to acquire another company
(the new shares are given to the owners of the other company in exchange
for their ownership interest), to acquire certain assets or services, and as
an incentive/reward for key employees of the corporation.

The “par value” of a share of stock is sometimes defined as the legal

capital of a corporation. The par value of common stock is usually a very
small insignificant amount that was required by state laws many years ago.
Because of those existing laws whenever a share of stock is issued, the par
value is recorded in a separate stockholders’ equity account in the general
ledger. Any proceeds that exceed the par value are credited to another
stockholders’ equity account. This required accounting (discussed later)
allows you to determine the number of issued shares by dividing the
balance in the par value account in the balance sheet by the par value per
share.

Leading corporation Larsen and Toubro has an authorized share capital of

Rs. 325 crores and as on March 2015, it showed Rs. 185.9 crores as its
issued capital in its balance sheet. It consisted of 92,95,62,061 shares at a
par value of two rupees.

In 2005, Larsen and Toubro had an authorized share capital of Rs. 26

crores.

The increase in the equity was partly due to declaration of bonus shares
(Refer to 10.3.5 below.)

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 COMMON AND PREFERRED STOCKS

10.2.4 Subscribed Capital and Paid-up Capital

If a share of stock has been issued, i.e., offered to the public for
subscription, and has not been reacquired by the corporation, it is said to
be “outstanding.” For example, if a corporation initially sells 2,000 shares
of its stock to investors, and if the corporation did not reacquire any of this
stock, this corporation is said to have 2,000 shares of stock outstanding.
The number of outstanding or subscribed shares is always less than or
equal to the number of issued shares. The number of issued shares is
always less than (or equal to) the authorized number of shares.

The actual amount paid by the investors against the number of shares they
had subscribed constitutes paid-up capital. Typically, the issued,
subscribed and paid-up capital of a corporation are the same. To quote
Larsen and Toubro Ltd., again its issued and paid-up capital stands at Rs.
185.9 crores in March 2015 (against a Rs. 26 crores in March 2005) as
indicated above.

10.2.5 Share Capital Values

When you examine the data published by corporates about common stock
in their published year end accounts, you will come across various terms
as:
• Par Value
• Issue Value or Price
• Book Value
• Market Value

Par Value: The par value of an equity share is the one which is indicated
in the memorandum of association of the corporation. It is also reflected in
the body of the share certificate issued to the equity holder. Equity capital
of the corporation is determined by multiplying the number of shares by
this par value. Par values generally are stated at Rs. 1, Rs. 2, Rs. 5, or Rs.
10. Higher par values are quite infrequent.

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 COMMON AND PREFERRED STOCKS

Issue Value or Price: Initially, new corporations entering the stock

market for the first time, issue their shares at a par value. At that stage,
they have just started the business activity and need long- term finance to
run operations by installing fixed assets. On many occasions, well
established firms with excellent earnings record enter the capital market
for seeking long-term finance for expansion as well as to liquidate (costly)
long-term debts. Other established corporations which had issued earlier
shares at par value too enter the market to satisfy their needs for long-
term finance. These business entities wish to seek returns on their financial
achievements and hence issue equity at prices higher than the par value.

Indigo Airlines operating for many successful years entered equity market
in 2015 with an issue in the price band of Rs. 700-765 per share having a
face value of Rs. 10 each.

This issue at a premium** of seven hundred and odd rupees was

oversubscribed.

** The difference between par value and issue price of the share is known
as share premium.

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 COMMON AND PREFERRED STOCKS

The issue price of these shares was ultimately determined at Rs. 765.
Investors are prepared to pay share premium in view of the past financial
record of the corporation that assures them of long-term returns. Investors
were so impressed with financial performance of Indigo Airlines that they
overwhelmingly responded to this initial public offer and the issue was
oversubscribed (the quantity of shares for which investors subscribed was
in multiples of that which was offered by the corporation). When the shares
were traded for the first time on exchanges, the price was 15% above the
issue price providing the investors immediate returns. It may well be noted
here that this issue value or issue price, by law, cannot be less than the
par value. In other terms, equity cannot be issued at discount.

Illustration

Rajesh Foundries Ltd. was incorporated with an authorized common stock

of Rs. ten crores consisting of one crore shares of face value of Rs. ten
each. It issued half a crore of shares at a premium of Rs. thirty. The issue
was fully subscribed and paid for. In view of encouraging increase in
earnings, it also declared a dividend of twenty per cent on the common
stock.

From this issue of the stock, RFL collected Rs. fifteen crores from common
stockholders. How can now its paid-up capital ( Rs. fifteen crores) be more
than its authorized capital? Will RFL distribute an amount of Rs. one-and-
half crores (10% of Rs. fifteen crores) as dividend to the common
stockholders?

Solution:

The amount of Rs. fifteen crores collected by RFL consist of Rs. five crores
only as paid-up capital and balance amount of Rs. ten crores belongs to
Share Premium account. Thus, its capital structure indicates Authorized
Capital of Rs. ten crores and out of this paid-up capital is Rs. five crores.
10% dividend declared has to be distributed on the paid-up capital and the
amount to be distributed is Rs. half crore.

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Book Value: The book value of an equity share is equal to a sum of paid-
up equity capital and reserves and surplus divided by number of
outstanding shares of the corporation. This book value increases as the
corporation starts earning profits and creating reserves. Larsen Toubro Ltd.
in its balance sheet as of 31.03.2015 showed

Paid-up capital Rs. 185.9 crores

Reserve and Surplus Rs. 36898.7 crores
Total Rs. 37084.6 crores
Outstanding Shares Rs. 929,562,061
Book Value Rs. 398.78

The fact that this successful giant corporation is adding to the

shareholders’ value is indicated by the increase in its book value over last
ten years from Rs. 55.67 to a whopping Rs. 398.78 as under.

2014-15 2013-14 2012-13 2011-12 2010-11 2009-10 2008-09 2007-08 2006-07 2005-06

398.78 362.95 317.09 274.35 238.96 202.46 141.54 108.63 67.43 55.67

This increase in book value goes a long way to prove that the corporation
is living to its vision statement below which states that it is committed to
enhance shareholder value.

L&T shall be a professionally-managed Indian multinational, committed to

total customer satisfaction and enhancing shareholder value.

Market Value: The market value of an equity share is the day-to-day

changing price at which it is traded in the market known as stock
exchange. For a company to have its shares traded on an exchange, it has
get them listed (registered) on that exchange. In India, most shares are
actively traded on the National and Bombay Stock Exchanges (NSE and
BSE). Market prices of all listed shares are displayed online by these
exchanges. Continuing with our Larsen and Toubro Ltd. illustration, the
corporation’s market prices for the year 2014-15 on the National Stock
Exchange were as under:

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Month National Stock Exchange Prices

2014 High Low Month Close
April 1,388.50 1,242.00 1,294.10
May 1,627.35 1,251.20 1,545.50
June 1,776.60 1,539.00 1,701.70
July 1,765.90 1,499.30 1,502.90
August 1,557.90 1,440.00 1,526.50
September 1,632.70 1,431.65 1,458.25
October 1,663.50 1,401.00 1,655.45
November 1,692.90 1,593.50 1,639.35
December 1,655.00 1,450.20 1,494.65
2015
January 1,750.00 1,485.55 1,700.55
February 1,799.90 1,532.15 1,768.10
March 1,893.80 1,613.45 1,719.65

This table once again indicates how shareholders benefit from the rise in
market prices of the L&T shares in which they decided to invest. These
market prices in addition to the past financial performance of the company
depend on many factors like current earnings, growth prospects, risk and
company size. These prices are further governed by external factors like
state of the industry, national economy and mood prevailing on the stock
exchanges both domestic as well as international.

If the company is listed but if its shares are not traded frequently, the price
at which shares were traded last is available but that prices fails to reflect
company’s current share market price. For the companies which are not
listed on the stock exchanges, no such prices are available and their share
market price can be just anybody’s estimate.

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10.3 RIGHTS OF EQUITY HOLDERS

10.3.1 Right to Income

All incoming cash flow is utilized by business entities to pay out for its
expenses and its creditors. If it has issued preference stock, then the
preference stockholders have a claim on the balance. Thereafter the
residual income belongs to equity holders. Whether it is distributed to
stakeholders by way of dividends or retained as reserves in the company
does not affect their claim. It is just a matter of timing. In the fiscal
2014-15, ITC Ltd. reported net Profit After Tax (PAT) of Rs. 3,711 crores
which was available to equity holders. Out of this amount, Rs. 601 crores
was distributed as dividends, Rs. 153.80 crores paid as tax on dividends
(ITC paid it as shareholders receive dividend income tax free) and rest
transferred to reserves and surplus which then accounted for Rs.
20,261.70 crores. This surplus is for re-investment in the business for the
benefit of equity holders; with the hope of providing even greater income,
dividends and price appreciation in the future.

You can now understand how the ITC shareholders have benefitted from
ITC earnings for the year 2014-15. First, they received tax free dividend
income of Rs. 601 crores as the dividend tax of Rs. 153.80 crores were
paid by ITC Ltd. Next, they can now expect appreciation in market value of
their shares through reinvestment in business of Rs. 447 crores.

This right to income is not legal and cannot be enforced in courts of law.
Declaration of dividends is entirely a prerogative of the Board of Directors
of ITC Ltd. If it declares lesser dividends or skips it altogether in any year,
shareholders do not have any recourse to legal action. This needs to be
contrasted with the rights of long-term lenders and bondholders who on
non-payment of interest can force ITC Ltd. into bankruptcy. Equity owners
have to accept circumstances about dividends as they are or attempt to
change the management if a revised dividend policy is desired. This
objective can be reached by exercising their next right “to vote” explained
in 10.03.02.

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All companies do not show spectacular results as illustrated earlier through

examples of ITC Ltd. or Larsen & Toubro Ltd. Many companies fail to
perform successfully in each consecutive year. This results in depreciation
of book as well as market value of equity. In view of this risk in equity
investment, the latest trend indicates that more and more individual
investors are staying away from investing directly into specific joint stock
companies. Instead they prefer to invest indirectly through financial
institutes and mutual funds.

To quote shareholding pattern of L&T Ltd. again, about 37% of shares are
held by three financial groups as under:

Life Insurance Corporation of India 15,55,22,285 16.73

L&T Employees’ Welfare Foundation 11,16,06,174 12.01
Unit Trust of India 7,59,25,962 8.17
Rest 58,65,07,640 63.09
Total 92,95,62,061 100.0

10.3.2 Right to Vote

Equity holders, being owners of the joint stock company, exercise their
right to vote and appoint a Board of Directors to manage operations of the
company. Directors to this board are elected in the corporation’s annual
general body (of equity holders) meeting every year. These board directors
serve on different committees that look after Risk Management, Corporate
Social Responsibility, Employee Administration and Welfare, Internal Audit,
etc. Shareholders are also required to vote on resolutions on all significant
financial matters presented in this meeting. The shareholders either can
vote themselves or appoint a proxy (either in management or in any
outside group) to vote on their behalf.

In India, most companies are managed by business families (Birla,

Mahindra, Tata and others) who hold twenty or more per cent of equity
capital. Balance of eighty or less per cent shares is held by financial
institutes and individuals and they do not wish to take up the management
of the company. As a result with less than 50% of shareholding, these
family groups can manage their companies perpetually.

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10.3.3 Poison Pills

In the last two decades, a new wrinkle was added to the meaning of rights
of equity shareholders. As stated above, many business families were able
to manage large joint stock companies with shareholding of about 20% to
25%. These families in control of the corporation often perceive a threat
from another business unit which is gradually acquiring more and more of
their company’s share capital to gain control of the company from these
families. To thwart these attacks, these families have provided new thrust
to the rights of the shareholders.

When the acquisition minded group is observed to be in possession of

about say 15% of the equity capital, the present management arranges for
sale of preference shares or debentures that get converted into equity.
When the acquisition minded group is about to possess more than 20% of
the capital, the present management of the company announces
conversion of the above preference shares or debentures into equity. This
step increases total paid-up capital of the company and thereby
significantly reduces the percentage of shares held by the acquisition
minded group which does not get any additional shares.

This action of the present management is known in financial circles as

administration of poison pills to the acquisition minded group.

10.3.4 Right to Acquire New Shares

In addition to right on residual income, right to vote in the shareholders’

meetings equity holders have one more right of a privileged position in the
offer of fresh shares of the company. This pre-emptive right permits
existing equity shareholders to maintain their proportional ownership.
When their company issues additional shares to public, the total paid-up
capital increases and with existing shareholding, their proportion in total
capital decreases. To maintain that proportion, correspondingly more
shares have to be acquired by them. The company law requires
corporations to reserve a certain part/quota of the additional shares being
offered to the public, so that if they purchase shares from this quota, their
proportion in the total paid-up capital remains constant. This type of public
offering of shares is known as “Rights Issue.”

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Tata Consultancy Services Ltd. has paid-up share capital of Rs. 1958.7
million as of 31.03.15. Suppose it plans to issue additional capital of Rs.
195.87 million to meet its financial needs. The existing shareholder Shri
Ramnik Shah owns 10,000 shares. In this public offer, Shri Shah has the
right to acquire 1,000 shares and these have to be reserved for him. Shri
Shah may, however, decide to buy only 500 shares or ignore the offer
totally. However, if Shri Shah fails to take advantage of the ‘rights’ shares,
the value of his portfolio is bound to suffer a loss as under. Let us assume
that market price of TCS share is Rs. 2,500 today and the rights offer is at
Rs. 2,000. After the rights issue is fully subscribed, TCS paid-up capital will
increase by 10% and its market price (theoretically speaking) will drop by
10% to Rs. 2250.
Value of Portfolio

If Rights Shares If Rights Shares

Ignored Acquired
Initial Value of Holdings 10,000 × 2,500 = 10,000 × 2,500 =
20,500,00 25,000,000
Value of Rights Shares 0 1,000 × 2000 =
2,000,000
After Rights Issue 10,000 × 2250 = 11,000 ×2250 =
22,500,000 24,750,000

10.3.5 Right to Bonus Shares

Every year, profit-making companies reward shareholders. They do so by

distributing a (usually increasing) portion of profits to shareholders. This
we know is called dividend. Sometimes, however, the company may
announce bonus shares – additional shares for all existing shareholders
without requiring any payment from them – in other words for free. This is
also called ‘stock dividend’. As part of a bonus issue, the company uses its
surplus reserve to convert it into share capital. Normally, a company can
use its surplus money in multiple ways – reinvest into the company,
distribute the cash as dividends or issue more shares as a bonus. The last
two aim at giving back money to the shareholders. As a result, investors
usually rejoice when a company announces a bonus share issue. After all,
they are getting extra shares of the company for free. The increased
number of shares means an opportunity to earn extra dividends.

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A bonus share issue indicates that the company is confident about the
business’s capacity to generate value for a larger capital owned by
investors. It also helps boost trading of the shares in the stock market as
more number of shares is traded. The drop in the share price after bonus
issue can attract small investors into the share market. Moreover, while
issuing more shares, the company avoids paying the ‘dividend distribution
tax’. This helps reduce costs for the company as well as stockholders. Like
in earlier years, Infosys issued bonus shares along with the usual dividend
payment in 2014. The IT major has a large cash reserve of around Rs.
30,000 crores. Investors have been asking the company to use the cash –
either for acquisitions or return it to shareholders. This amount could have
been used for expansion or purchasing a new company – either of which
could help improve its profitability. This acquisition is a continuous process
for this profitable company. But it also arranges bonus issues. This shows
the company values giving back to shareholders more and does not foresee
better use for the money lying idle.

When a company announces a bonus share issue, it gives a ratio with it.
Infosys said it will issue bonus shares in the 1:1 ratio. This means, for
every share an investor already holds, it will issue one additional share. So,
effectively, your portfolio will double in size. For example, if you held 1,000
shares of Infosys, you will now hold 2,000 shares. Not every bonus share
issue has the same ratio. The company decides how many new shares it
wants to issue.

After any company announces a bonus issue, the actual distribution

happens not immediately but at a later date. Like the dividend distribution,
there is a particular day when the new changes are incorporated. This day
is called the ‘Record’ date. If you already have the shares on this date, you
will be eligible to get the bonus shares.

Until the ‘Record’ date, price of the stock usually rises as more investors
want to be eligible for the extra stocks. However, it may not be so if the
company is under performing or it has poor fundamentals. The day after
the bonus is distributed, the share price is adjusted. This is called the ex-
bonus price. So, if the company has issued a 1:1 bonus share, then the
price of the shares will fall to nearly half of its original price. Share’s price
is a reflection of the company’s value in the market. A bonus issue does
not change the share’s inherent value. Only the total number of shares
floating in the market is increased. So, the prices of the shares fall

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temporarily. One study observed that of the top thirty companies which
announced bonus issues between January 2001 and July 2010, the share
price of twenty-one companies rose till the record date. Also, stocks of
twenty-four companies rose in the year after the record date.

We must also know how different the bonus issue is from a stock split. On
the face of it, a bonus share issue is remarkably similar to a stock split –
the number of shares a person holds increases while the price falls in
tandem. However, there are some differences. Firstly, every share has a
face value. It could be Rs. 1, Rs. 5 or Rs. 10. In a stock split, the face
value of the share falls. So, if your shares had a face value of Rs. 10 before
a 1:1 stock split, you would now have two shares with a face value of Rs.
5. This is not so in a bonus stock issue. There you will hold two shares with
a face value of Rs. 10. This means you get a greater piece of the surplus
available for distribution to share owners.

10.4 COMMON STOCK – BENEFITS AND DRAWBACKS

• When common stocks are issued to meet long-term needs of an
organization, earnings can be retained to meet further financial
requirements as there is no compulsion on management to declare
dividend and divert a part of earnings to shareholders.
• Similarly, unlike long-term debts, common stock does not have any
maturity date on which the shares have to be redeemed. Common stock
is a permanent fund.
• Higher common stock base allows managers to get larger amount of
debts at lower interest rates. This advantage accrues from the fact for
lenders larger common stock offers a cushion.
• Investors do not have to pay the income tax on dividends they receive.
• However, company has to pay dividend distribution tax (15% in the year
2015) with surcharge and cess. Plus unlike interest on long-term debt,
dividends can be distributed only out of after tax earnings of the business
entity. Interest paid is a tax deductible expense but not dividends.
• The cost of equity capital is high as rate of return expected by
shareholders is greater than the one expected by long-term lenders.
• Underwriting commission, brokerage costs and issue expenses cause
high cost for issue of equity as compared to other long-term debts.

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• Equity stockholders can be obstacles in management of the company if

they organize themselves and challenge management decisions by voting
against the resolutions put up by the board of directors during
shareholders’ meetings.

10.5 PREFERRED STOCK – FEATURES

Preferred stock is a hybrid form of long-term finance available to

corporations. It has some characteristics of equity and some of the long-
term debts. The term preferred attached to this category of financial
instrument is very questionable as it does not possess desirable
characteristics of either equity or debt.

Common stockholders have claim on residual income while bond or long-

term security holders have a contractual claim on the company for their
refund of the principal and interest payments. They can put the company
into bankruptcy if these are not arranged per schedules. No such privilege
exists for preference stockholders.

Central Government Act

Section 85(1) in the Companies Act, 1956
“Preference share capital” means, with reference to any company limited by
shares, whether formed before or after the commencement of this Act, that part
of the share capital of the company which fulfills both the following
requirements, namely:
(a) That as respects dividends, it carries or will carry a preferential right to be
paid a fixed amount or an amount calculated at a fixed rate, which may be
either free of or subject to income tax; and
(b) That as respects capital, it carries or will carry, on a winding up or
repayment of capital, a preferential right to be repaid the amount of the
capital paid up or deemed to have been paid up.

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Common stockholders are the owners of the company and as such have a
right on residual income while preferred stockholders are entitled to a fixed
amount of dividend and must receive it before the payment of dividends to
common stockholders is arranged. But this right of preference stockholders
to dividend is not mandatory as is the case with interest on long-term debt
instruments. Dividends on preferred stocks can be skipped if the board of
directors feels that the earnings of the year are inadequate.

The finance structure of Abha Metals Ltd. is as under:

Share Capital Rs. 75 crores
10% Preferred Stock Rs. 25 crores
9% Debentures Rs. 15 crores

Abha Metals Ltd. has to arrange payment of interest at 9% to the

debenture holders each year, even when in a particular year, earnings are
in the negative. This interest payment is a contractual obligation.

In the year when there are positive earnings and if the board of directors
feels they are adequate for declaration of dividends, it may declare and
pay the dividend to preference shareholders. The amounts so paid have to
be at the stipulated rate of 10%.

After dividend on preference stock is paid, the board has discretion to

declare dividend on common share capital. This dividend, however can be
at different rates as the common stockholders have unlimited potential in
company’s earnings once preference stock dividend is disbursed. To judge
this potential, let me quote from the accounting statements of L&T Ltd. for
the year 2014-15 which indicated that total dividend of Rs. 16.25 was
disbursed in that year on common stock of Rs. 2 (eight times the face
value of the stock).

Even though normally preference stockholders do not possess any voting

rights at the stockholders meeting, there are certain exceptional
circumstances when they are empowered to vote along with common
stockholders. (A) Preference stockholders have a right to vote on
resolutions that directly affect the privileges attached to the preference
stock. Thus, preference stockholders have a right to vote on a resolution
for winding up of the company; or for repayment or reduction of company’s
share capital. This right arises because such resolutions affect preference

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stockholders’ interests. (B) Preference stockholder acquire voting rights if

the company fails to pay them dividends for two years prior to the annual
general meeting in case of cumulative and three years non-cumulative
stocks.

Corporations wish to issue preference stock to achieve balanced growth in

capital structure. The objective is to prevent any dilution of common stock
and avoid contractual obligations from heavy debts.

Video Link 1

Video Link 2

10.6 PREFERRED STOCK – CLASSIFICATION

10.6.1 Classification Based on Income

Non-cumulative Preference Stock

As stated earlier, preference stockholders have priority for claim on

dividends. Unless dividends are declared, the company cannot declare
dividends on common stock. At the same time, there is no compulsion on
the board of directors to declare dividend whenever earnings are available.
The board can very well invest all the earnings back in business.
Distribution of dividends, thus, is a priority of the management alone.
Dividends when declared are at the rate specified at the time of issue of
the preference stock and this rate does not change. In case in any year
dividend is not declared, preference shareholders’ loss is permanent as
there is no provision to pay earlier year’s dividends for this category of
preference stock (hence non-cumulative).

Normally, companies ensure that dividends on preference stocks are

declared each year as if in any year dividends are skipped, the credit
standing of the company in the markets gets severe blow.

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Cumulative Preference Stock

For this class of stock, if dividend is not declared in any year, it does not
lapse. Unpaid dividend is carried over and holders have a claim of unpaid
dividends on future earnings of the company. Until this accumulated
dividend amount is paid, the company cannot declare dividend on common
stock. Thus, due to inadequate earnings, a company does not pay dividend
on 10% Cumulative Preference Stock for, say, three years, preference
shareholder has to receive Rs. thirty before common stockholder can
receive any dividend.

In case a company is unable to declare a dividend on its cumulative

preference shares for a long time, it is common for the company to
recapitalize itself. Under such circumstances, fresh common or preference
stocks are offered against the unpaid dividends.

Cumulative preference shares are more attractive to investors as they are

assured of a steady flow of income without any dilution in value of their
initial investment. For companies they offer additional source of finance,
but if there are unpaid dividends on preference shares, the company loses
its credit rating and finds it extremely difficult to float any fresh common
stock.

10.6.2 Classification Based on Maturity

Irredeemable Preference Stock
Normally, preference stocks along with common stocks have no maturity.
The company has no obligation to repay the capital amount to stockholders
unless there is a liquidation of the business entity. Both the stocks are a
permanent source of finance for the enterprise.

Redeemable Preference Stock

However, the Articles of Association can be framed to permit redemption or
calling back of preference stocks at management’s discretion. The terms
and conditions under which these stacks can be recalled have to be
specified in the company’s Articles of Association. Redemption is arranged
in a manner that provides premium to the stockholders. Redemption can
take place out of accumulated profits or out of sale proceeds of assets and
property of the company. Such redemption can also be arranged through
issue of fresh issue of common stock.

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Redeemable preferred stock contains a call option that allows the issuer to
forcibly redeem the shares on or after a specified call date. You call shares
by canceling them and paying a preset price plus any dividends due.
Issuers value the call option because it allows them to replace preferred
shares with lower yielding ones if interest rates fall. You are under no
obligation to call the shares if interest rates remain steady or rise. Because
call options favor issuers, redeemable preferred stock will raise less money
than will equivalent shares without the call option. Unlike equity shares,
redeemable preference shares allow Indian companies to access capital
without any equity dilution of the existing Indian equity shareholders.
Further, such redeemable preference shares could be allotted to foreign
investors without offering them any voting rights or control in respect of
the Indian company. There is a prescribed limit on the maximum dividend
that can be paid. So, preference shares could not work as an instrument
for unfettered outflow of the profits of Indian companies. Also, there has
never been any guaranteed payout of dividends on preference shares
since, under Indian Companies Act, dividends can be paid only out of
distributable profits.

In addition to the favourable features set out above, redeemable

preference shares presented a source of capital funds for Indian companies
without offering the foreign investor any recourse to the Indian company’s
assets (as could be the case when debt finance are accessed). Thus,
redemption feature is introduced to serve as an additional inducement to
investors.

Convertible Preference Stock

Convertible preferred stock is defined as a stock that includes an option for
the holder to convert the preferred shares into a fixed number of common
shares, usually any time after a pre-determined date. Usually, the stock
certificate specifies that the preference share of Rs. one hundred is
convertible into say ten shares of Rs. ten each any time after, say, three
years. Until the price of common stock is below the par value of Rs. ten,
the investor is not interested in conversion. But once the common stock
trades at a premium, the stockholder stands to benefit by opting for the
conversion.

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Under a specific circular (New Circular) dated 8 June 2007 issued by the
Reserve Bank of India (RBI), it has revised its guidelines pertaining to
issue of preference shares to foreign investors. Now, only those preference
shares that are fully and mandatorily convertible into equity shares within
a specified time will be considered a part of the investee company’s share
capital—and only such preference shares will be issued to foreign investors
under the automatic approval route (that is, without requiring permission
from the Ministry of Commerce). Foreign investments in non-convertible,
optionally convertible or partially convertible preference shares are now
considered to be debt finance, that is, akin to a loan, and are required to
conform to the stringent guidelines relating to External Commercial
Borrowings (ECBs).

Video Link 1

10.7 PREFERENCE STOCK – BENEFITS AND DRAWBACKS

Benefits
• The board of directors has flexibility in decision about payment of
dividends to preference shareholders. There is no compulsion, like in
case of interest on long-term debt, to arrange payments every year.
• There is again no compulsion to set aside a part of earnings into a
sinking fund for redemption of preference stock. Redemption can be
delayed without any adverse financial consequences.
• Being a part of a net worth of the company, issue of preference stock
enhances company’s creditworthiness.
• Since preference shares do not carry (in normal circumstances) any
voting rights as a result with issue of preference stock, there is no
dilution of control.
• Issue of preference stock does not call for any mortgage of company’s
assets which remain available for raising debt as and when required.

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Drawbacks
• Preference stock as a source of long-term finance is very expensive vis-
à-vis debt capital as dividends have to be paid from after tax earnings
and not as a tax deductible expense.
• Dividend payments need to be arranged each year, even though not
mandatory, as skipping dividend in any year has adverse effects on
company’s creditworthiness.
• Dividends on common equity capital cannot be declared unless dividend
is paid on preference stock in that year.
• If dividends are skipped for a certain years, preference stockholders
acquire voting rights and thereby cause dilution of control.

Self-training Exercise: 01

Investment Form Risk/Return to Investor

1 Bank Savings Account

2 Government Long-term Bonds/Securities

3 Common Equity

4 Secured Debt

5 Preference Stock

6 Unsecured Debt

Shalini was analyzing above six alternatives available for investment. She
wants to rearrange them in such a way that the option with the least risk/
return appears first (1) and the one with the highest risk/return appears
last (6). Can you assist her by inserting 1 to 6 in the above boxes?

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10.8 COMMON STOCK, PREFERRED STOCK AND DEBT

INSTRUMENTS – A COMPARISON

All business entities have three major sources for long-term financing, viz.,
• common stock,
• preference stock and
• long-term debt instruments like bonds and debentures.

Each source has its own advantages and costs. These have been defined in
the table below.

Debt
Features Common Stock Preferred Stock
Instruments
Ownership control Full control Limited control Limited control in
through voting when dividends case of interest
right and claim on are skipped default/s
residual income
Claim to income None Must receive Must pay per
dividends before contractual
common obligations
stockholders
Claim to assets in Lowest/last Next to debt First claim
case of bankruptcy holders
Cost of distribution Highest Moderate Lowest
Risk/return Highest risk and Moderate risk and Lowest risk and
hence highest fixed return fixed return
return
Tax burden on Dividends paid out Dividends paid out Interest paid as an
company of after tax of after tax expense as charge
earnings earnings to earnings
Tax burden on Dividends received Dividends received Interest received
investor are tax free. are tax free is taxable

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10.9 SUMMARY

When an investor pays any company money in return for part ownership in
it, the company issues a certificate of ownership interest to the
stockholder. This certificate is known as a stock certificate, capital stock, or
stock. Of course, these days, all stock records are handled electronically.
Most large public corporations have their equity distributed over a large
number of shareholders to ensure control over the company continues with
its promoters. They together enjoy the rewards and bear the risks of
ownership.

It must be noted here that their liability, unlike the liability of a proprietor
or a partner of a business unit, is limited to the amount they paid to get
the shares in their name. When a business entity applies for incorporation
to the Registrar of Companies, its application will specify the classes (or
types) of stock, the par value of the stock, and the number of shares it is
authorized to issue. This constitutes authorized capital of the company.
Companies ask for a larger amount of authorized capital to avoid any
revision when the need for capital increases with the growth of the
business.

When a corporation sells some of its authorized shares, the shares are
described as “issued”. The number of issued shares is often considerably
less initially than the number of authorized shares. The value of issued
shares constitutes company’s subscribed capital. If a share of stock has
been issued, i.e., offered to the public for subscription, and has not been
reacquired by the corporation, it is said to be “outstanding”. Value of such
shares when fully subscribed constitutes company’s paid-up capital.

Value indicated on the share certificate is its face or par value. Shares are
often issued at a premium, face value plus such premium is termed paid-
up value. After satisfying the claims of all others, value of assets with the
company that belongs to common stockholders when divided by number of
fully paid shares provides you with the book value of the common stock.
The prices at which the shares are bought and sold on stock exchange are
termed its market value.

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All incoming cash flow is utilized by business entities to pay out for its
expenses and its creditors. If it has issued preference stock, then the
preference stockholders have a claim on the balance. Thereafter equity
holders have sole right on the residual income. A company can retain this
net balance as reserves to meet company’s future requirements of long-
term finance or distribute it to equity holders as dividends. Common
stockholders enjoy another right to vote on resolutions presented by
company’s board of directors. This right provides them with a control over
the company in proportion to the number of shares owned.

Common stockholders have one more right of a privileged position in the

offer of fresh shares of the company. When the company wants to meet its
long-term finance requirements by issue of fresh equity capital, it has to
offer it first to its existing shareholders. This offer is termed ‘Rights Issue’.
By participating in the rights issue, stockholders can further increase their
gains.

Every year, profit-making companies reward shareholders by distributing a

portion of profits to shareholders and balance is retained as reserves in
business. When reserves get built up and they are no more required for
long-term finance, companies distribute them to common stockholders
through issue of bonus (free) shares again in proportion to shares owned
by stockholders.

The major advantages of common stock as source of long-term finance are

the funds are available forever and there is no contractual obligation to pay
the investors. Dividends can be paid when surplus earnings are available.
Secondly, common stock increases the net worth of the company and
along with it company’s creditworthiness. The current income tax
provisions call for tax free dividends at the hands of stockholders.
However, company has to pay dividend distribution tax (15% in the year
2015) with surcharge and cess. The cost of equity capital is high as rate of
return expected by shareholders is greater than the one expected by long-
term lenders. Underwriting commission, brokerage costs and issue
expenses cause high cost for issue of equity as compared to other long-
term debts.

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 COMMON AND PREFERRED STOCKS

Preferred stock is a hybrid form of long-term finance available to

corporations. It has some characteristics of equity and some of the long-
term debts. Preferred stockholders are entitled to a fixed amount of
dividend and must receive it before the payment of dividends to common
stockholders is arranged. Even though normally preference stockholders do
not possess any voting rights at the stockholders’ meeting, there are
certain exceptional circumstances when they are empowered to vote.

Preference stock is classified as: (a) Non-cumulative Preference Stock (if

dividend is skipped in any year it is lost forever); (b) Cumulative
Preference Stock (unpaid dividends are carried forward for payment in later
years); (c) Irredeemable Preference Stock (stock cannot be paid back);(d)
Redeemable Preference Stock (company has right to pay back the capital
and eliminate its dividend liability); and (e) Convertible Preference Stock
(company can convert preference shares into common stock).

10.10 MULTIPLE CHOICE QUESTIONS

Mark (x) against the most reasonable alternative.

1. Ashok Industries Ltd. started business operations a decade ago. It has

completed all its expansion plans and has built up significant financial
reserves. The management feels it should reward stockholders. What
would you recommend? Arrange __________ issue?
(a) Rights
(b) Preference
(c) Bonus
(d) Debenture

2. Bharat Ceramics Ltd. announced a rights issue at 1:1 basis. Anil owned
1,000 equity shares in this company and wanted to participate in this
rights issue. How many shares can he apply for?
(a) 1000
(b) 500
(c) 250
(d) Any one of above

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 COMMON AND PREFERRED STOCKS

3. Charusheela was reading a balance sheet of Sunrise Power Ltd. Under

capital, she could read: (a) Rs. 10 crores, (b) Rs. 5 crores, (c) Rs. 4.5
crores and (d) Rs. 4.25 crores. Because of an ink blot, she could not
read other details on that page. Can you correctly guess for her to
which capital type the amounts belonged?
(a) (i) issued, (ii) subscribed, (iii) authorized and (iv) paid up
(b) (i) authorized, (ii) issued, (iii) subscribed and (iv) paid up
(c) (i) issued, (ii) authorized, (iii) subscribed and (iv) paid up
(d) (i) issued, (ii) paid up, (iii) authorized and (iv) subscribed

4. Which of the following long-term finance instrument has maximum risk?

(a) Common stock
(b) Preference stock
(c) Debenture
(d) Each one above

5. Common stock is treated as a costly long-term finance option.

(a) Rate of dividends are high
(b) Dividends have to be declared each year
(c) Dividend on common stock can be paid after dividend is paid on
preference stock
(d) Dividend has to be paid from after tax earnings

Answers: 1. (c), 2. (d), 3. (b), 4. (a), 5. (d).

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 COMMON AND PREFERRED STOCKS

REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter

Summary

PPT

MCQ

Video Lecture - Part 1

Video Lecture - Part 2

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 DEBENTURES

Chapter 11
Debentures
Objectives
After studying this chapter, you should be able to understand:
• Debentures as tax attractive source of long-term debt
• Various terms associated with debentures
• Interest, redemption options offered in Debenture Issues
• Role of debenture indenture

Structure:
11.1 Introduction
11.2 Attributes
11.3 Terminology Associated with Long-term Debt
11.4 Debenture Indenture
11.5 Debenture Classification
11.6 Benefits and Drawbacks
11.7 Two Debenture Issues
11.8 Bonus Debentures – A New Concept
11.9 Popularity of Debentures
11.10 Summary
11.11 Multiple Choice Questions

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11.1 INTRODUCTION

A debenture is a fixed-income debt paper issued by a company. In other

words, the issuer agrees to pay a fixed interest on your investment. As the
name suggests, these debentures cannot be converted into shares of the
issuing company like convertible debentures where investors have the
option of getting shares in the issuing company on conversion. This
debenture issue can be both for secured as well as unsecured debentures.
For secured debentures, which are backed by assets, in case the issuer is
not able to fulfill its obligation, the assets are liquidated to repay the
investors holding the debentures. No such recourse is available to the
holders of non-secured debentures.

In view of the safety offered, secured NCDs (Non-convertible Debentures)

offer lower interest rates compared with unsecured ones. If you want a
regular income from NCDs, you can pick those that pay interest on a
monthly (very rare), quarterly or annual basis. If you just want to grow
your wealth, you can opt for cumulative option where the interest earned is
reinvested and paid at maturity. In corporate finance, a debenture is a
medium- to long-term debt instrument used by large companies to borrow
money, at a fixed rate of interest.

The legal term “debenture” originally referred to a document that either

creates a debt or acknowledges it, but in some countries the term is now
used interchangeably with bond, loan stock or note. A debenture is, thus,
like a certificate of loan or a loan bond evidencing the fact that the
company is liable to pay a specified amount with interest to the holder of
the instrument. Although the money raised by the debentures becomes a
part of the company’s capital structure, and thus its net worth, it does not
become share capital. Debenture holders have no rights to vote in the
company’s general meetings of shareholders, but they may have separate
meetings or votes, e.g., on changes to the rights to the debentures.
Neither do the debenture holders have any prior claim if the company
decides to issue fresh equity shares.

Debentures are generally freely transferable by the debenture holders.

Debentures of large companies are traded on stock exchanges. The
interest paid on debentures is an expense and hence a charge against
profit in the company’s financial statements.

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 DEBENTURES

Indian Companies Act, 1956 does not provide for any definition of a
debenture. Any debenture stock, bonds and any other securities of a
company whether constituting a charge on the assets of the company or
not, as per the Act, are included in the term debenture.

11.2 ATTRIBUTES

A debenture is a movable property issued by the company in the form of a

certificate of indebtedness. Most debentures are backed by the assets of
the company issuing this long-term finance instrument. Some debentures
are backed by specific assets of the company while others have general
claim on all assets not pledged otherwise. Unless claims of debenture
holders are satisfied, payments cannot be arranged to common
stockholders.

Debenture holders are creditors of the company. As such, they do not have
a right to vote and so they do not possess any controlling power over the
company. Nor do they have a privilege to attend the annual general body
meetings of the company.

Interest paid on debenture is a charge against income of the company or

expense and hence paid from earnings before tax. This attribute turns this
source of finance attractive for the company.

The debenture certificate needs to specify the date of redemption for

repayment of the principal and specified dates on which interest on the
capital of the instrument is due for payment.

Failure of a company to repay a bond after its maturity date effectively

means bankruptcy of the said company. Bondholders who have not
received their interest can throw an offending company into bankruptcy, or
seize its assets if that is stipulated in the contract

A secured debenture is one in which specific assets are pledged to

bondholders in the event of default. Very rarely are these pledged assets
sold and the proceeds distributed to debenture holders. Instead, when
default is likely, the concerned company arranges for reorganization of its
capital structure and existing claims are satisfied by issue of new equity
and or securities.

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 DEBENTURES

Most debentures are released on electronic forms and (if issued by larger
companies) they are listed on the stock exchanges thereby offering
liquidity to the investors. The trades in debentures take place in their
demat format.

Payment of specified interest and return of capital on maturity is arranged

by direct transfer to investor’s bank account through Direct Credit/ECS/
RTGS/NEFT mode like in case of dividends to preference and ordinary
shareholders.

A company wishing to issue debentures need to enjoy a good credit rating

in the financial markets. Companies seeking to raise money through
debentures have to get their issue rated by agencies such as CRISIL, ICRA,
CARE and Fitch Ratings. Debentures with higher ratings are safer as this
means the issuer has the ability to service its debt on time and carries
lower default risk. Any Indian company can raise money through
debentures if it has a tangible net worth of at least Rs. 4 crore and has
been sanctioned loans by banks or financial institutions which is classified
as ‘standard asset’ and not as bad debt.

Video Link 1

Video Link 2

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 DEBENTURES

11.3 TERMINOLOGY ASSOCIATED WITH LONG-TERM DEBT

1. Call Option: A call provision that allows the company to retire the
debenture before its date of maturity. If this provision is included in the
indenture of the debenture, the company usually offers a premium of
five to ten per cent over par value. This option is exercised after a lapse
of a few years after the issue and when the ruling interest rates in the
market allow the company to obtain funds at rate cheaper than the
coupon rate.

2. Convertibility: Companies adopt a subtle method of reducing

outstanding debt by introducing conversion clause into the indenture of
the debenture. Convertibility clause allows the company to convert
outstanding debentures into common stock at rates specified in the
indenture (e.g., one equity share for five units of debentures). When
company converts debentures into equity stock, it does not have to pay
cash to bondholders and its liquidity remains unchanged. Instead of
interest from income before tax, now the company pays dividends from
after tax earnings as tax benefit is lost after this conversion.

3. Coupon rate: This reflects the actual rate of interest payable on the
principal amount to the debenture holder. The extent to which the rates
of interest prevailing in the market fluctuate from this coupon rate is
reflected in the market price of debentures. Usually, this rate is fixed
throughout the life of the bond. Interest can be paid at different
frequencies: generally semi-annual, i.e., every six months, or annual.

4. Maturity: Reflects the period after which the issuer has to repay the
principal amount to the bondholder. The principal amount is due for
repayment on the maturity date. As long as all due payments have been
made, the issuer has no further obligations to the bondholders after the
maturity date. Virtually, all bonds have a maturity date and company
agrees to pay off in cash the outstanding debentures at a fixed date.

5. Nominal, principal, par or face value: This is the initial value of the
bond. The interest is paid to the debenture holder on this amount.

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 DEBENTURES

6. Put Option: A put provision allows the holder to redeem the debenture
at specified time before its date of maturity. If this provision is included
in the indenture of the debenture, the prices at which such redemption
can take place are specified.

7. Security: Most debenture issues in India are secured by mortgages on

immovable properties of the issuer company. However, the order of
priority of mortgagees varies from debenture to debenture.

8. Tenor: The length of time until the maturity date is often referred to as
the tenor of a bond. Thus, a debenture that matures after ten years for
repayment carries a ten-year tenor.

9. Indenture: The bond agreement is supplemented by a much detailed

document termed bond indenture. It spells out collaterals pledged for
the issue; methods of repayments, restrictions on the company to
protect interests of debenture holders, etc.

10.Trustee: Trustee is a financially independent person appointed to

administer the provisions contained in the above indenture.

11.4 DEBENTURE INDENTURE

A bond indenture is a legal document or contract between the bond issuer

and the bondholder that records the obligations of the bond issuer and
benefits owed to the bondholder. The bond indenture also includes the
details of the rights of ownership as well as the rights of the bondholder to
receive interest payments and principal payments in the future.

The bond indenture is created during the bond issuing process when bond
issuers are receiving approval from state and central governments to issue
bonds to the public. After an agreed upon amount of bonds is authorized
by the applicable government agency, the company issuing the bonds must
construct a bond indenture.

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 DEBENTURES

Students should not get the two terms indenture and debenture confused.
A bond indenture is the contract between the bond issuer and the
bondholder. A debenture is simply a financial instrument with certain terms
and conditions. Indenture is essentially a legal document while debenture a
financial one.

Bond indentures are not issued to individual bondholders. It would be

pretty impractical for a company to try to enter into a contract with every
single bondholder. That is why the bond indenture is actually issued to a
trustee or third party that represents the bondholders.

This trustee is most often a bank or some other financial institution. If the
company breaks the agreement set forth in the bond indenture, the trustee
can sue the company on behalf of the bondholders.

The indenture specifies all the important features of a bond, such as its
maturity date, timing of interest payments, method of interest calculation,
callable/convertible features if applicable and so on. The indenture also
contains all the terms and conditions applicable to the bond issue. Other
critical information included in the indenture includes the financial
covenants that govern the issuer and the formulas for calculating whether
the issuer is within the covenants.

Should a conflict arise between the issuer and bondholders, the indenture
is the reference document used for conflict resolution. As a result, the
indenture contains all the minutiae of the bond issue. The bondholders can
also voice complaints to the trustee in an effort to raise legal action against
the issuing company.

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 DEBENTURES

Typical contents of such indentures are included in various articles of the

indenture as listed below. These fourteen articles cover the scope of the
indenture.
Article 1 Interpretation
Article 2 The debentures
Article 3 Registration, transfer, exchange and ownership
Article 4 Redemption and purchase of debentures
Article 5 Subordination of debentures
Article 6 Conversion of debentures
Article 7 Covenants of the corporation
Article 8 Default
Article 9 Satisfaction and discharge
Article 10 Successors
Article 11 Compulsory acquisition
Article 12 Meetings of debenture holders
Article 13 Notices
Article 14 The trustees

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11.5 DEBENTURE CLASSIFICATION

Debentures are issued by companies in many forms of bonds with varying

features as regards to interest rates or payments, redemption values or
methods and tax burden on interest income. All of them are not common in
India.

Seven such types are described below:

1. Zero-coupon Bonds: This is a type of bond that makes no coupon
payments but instead is issued at a considerable discount to par value.
For example, a zero-coupon bond with a Rs. 10,000 par value and ten
years to maturity is trading at Rs. 6000 ; if you buy this bond, you pay
Rs. 6,000 today for a bond that will be worth Rs. 10,000 in 10 years.
The issue price of Zero-coupon Bonds is inversely related to their
maturity period, i.e., longer the maturity period lesser would be the
issue price and vice versa.
2. Deep Discount Bonds: They are similar to zero-coupon bonds. For
these debentures, discounts offered on the par value are larger and
correspondingly maturity period longer. IDBI set a record by offering
bonds with a face value of Rs. 0.1 million for just Rs. 2,700. The
maturity period for these bonds was twenty-five years.
3. Floating Rate Bonds: Floating rate bondholders receive interest at the
interest rate that varies with the interest rate prevailing in the money
market. The interest rate paid to the bondholder at regular intervals
comprises of the interest rate prevailing in the market and ‘spread’,
which is a rate that is fixed when the prices of the bond are being
determined and it remains constant till the maturity period of the bond.
The upper and lower limit on the interest rate on such instruments is
termed collar.

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 DEBENTURES

4. Government Bonds: These are the bonds issued by government of a

country in its own currency. They are usually referred to as risk-free
bonds. Bonds issued by national governments in foreign currencies are
referred to as sovereign bonds. In India, many public undertakings have
issued bonds in the market to raise finance. Usually, a major portion of
such bonds is placed with financial institutions. But they are also offered
to the general public. Interest on these bonds is taxable but often tax-
free government bonds are issued to attract more funds and holders do
not pay income tax on interest received. This instrument is relevant to
individual in high tax brackets.
5. Cumulative or Non-cumulative Bonds: Cumulative bondholders are
not paid interest at regular intervals; instead it gets accumulated over a
period of maturity. The accumulated interest on maturity is merged
along with the principal and lump sum payment is arranged. In case of
non-cumulative debentures (which are more common), interest is paid
at regular intervals during the year until maturity of the bond.

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6. Convertible Debentures: Bonds that can be converted into equity

shares of the issuing company after a pre-determined period of time.
“Convertibility” is a feature that companies may add to the bonds they
issue to make them more attractive to buyers. In other words, it is a
special feature that a corporate bond may carry. As a result of the
advantage, an investor enjoys from the ability to convert, convertible
bonds typically offer lower interest rates than that available on non-
convertible bonds. This provides the advantage to companies to source
long-term funds at a lesser costs, defer sale of equity stock and prevent
dilution of earnings to available to current stock holders. It is not
necessary to create reserves for redemption of debentures. Investors in
convertible debentures enjoy threefold benefit in the form of certainty of
income, priority in claim on company’s income and chance to share in
company’s earnings on conversion. This conversion option can be for
the full amount of the debenture or only for a part of it (say fifty per
cent). Partly convertible debenture holders receive equity stock for a
part of face value and the remaining portion is redeemed on maturity.
The remaining part of debenture after conversion is often referred to in
money markets as ‘Khoka’ – an empty box.
Zero-coupon versions of convertible debentures are also in use by some
companies (Mahindra & Mahindra).
7. Non-convertible Debentures: These debentures, on the other hand,
carry higher interest rates as investors do not have option of conversion
into company’s equity.

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11.6 BENEFITS AND DRAWBACKS

Issue of debentures for financing long-term needs provides certain benefits

as well as drawbacks to the company. These are enumerated below.

Benefits

Interest payable on debentures is a tax deductible expense unlike equity

and preference dividends which are paid out of profit after tax. This is an
important benefit while considering alternate modes for long-term
financing.

Debenture holders do not acquire any control over company as they do not
possess any voting rights. Thus, debenture financing does not result in
dilution of control.

Liability of company to debenture holders is limited to contractual payment

of principal and interest. Value created by the company stays with its
equity owners.

Maturity period of debentures can be tailored to match with company’s

funds requirements. This flexibility again makes this instrument attractive
to companies selecting most beneficial source of long-term finance.
Debentures provide protection to the company against inflation as the
interest burden stays constant through the maturity period of the
instrument.

Debentures are beneficial to investors also as they provide an opportunity

to earn 2-3 percentage points higher return than other fixed-income
instruments such as bank fixed deposits. Investors can use them wisely to
diversify their debt portfolio.

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Drawbacks

For the issuer company, debentures create a permanent interest and

principal repayment obligation. Failure to meet these commitments in
adverse circumstances, can result in a major financial embarrassment and
in some cases firm’s bankruptcy.

Issue of debentures to meet long-term need for the finance increases

Issuer Company’s debt-equity ratio. As a result, the debenture issue raises
cost of equity to the firm. Company’s credit rating stands corrected in the
money markets.

In unlikely possibility of low inflation, the issuer company is forced to pay

interest on debentures that is higher than the one prevalent in depressed
markets. All throughout the maturity period debentures carry a fixed rate
of interest as stated in its indenture.

Video Link 1

Video Link 2

11.7 TWO DEBENTURE ISSUES

NEW DELHI: Country’s largest mortgage lender HDFC Ltd. said the bid to
raise up to Rs. 5,000 crore via Non-convertible Debentures and warrants
opens today. “Committee (of Directors) be and is hereby accorded to open
the issue in accordance with SEBI regulations.” In respect of the issue, the
bid opening date for the issue shall be September 30, 2015,” it said in a
filing on the BSE. HDFC Ltd. in its annual general meeting held in end of
July had said that it will issue non-convertible debentures (NCDs) and
warrants to qualified institutional buyers QIBs up to Rs. 5,000 crore.

Let us have look at two recent debenture issues arranged by HDFC Bank
(shown above) and Axis Bank.

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 DEBENTURES

“We will issue, offer and allot warrants exchangeable for equity shares
simultaneously with secured redeemable non-convertible debentures of
face value of Rs. 1 crore each to eligible Qualified Institutional Buyers
(QIBs) by way of Qualified Institutional Placement (QIP),” it said in the
filing.

“In case warrants are exchanged with equity shares of the company, it
would result in a maximum issue of 3.65 crore equity shares of face value
of Rs. 2 each of the Corporation. The floor price of the warrants shall be
Rs. 1,189.66 per warrant,” it added.

The company said the NCDs will mature in March 2017, while the exercise
period of the warrants will be 36 months from the date of allotment of
warrants. Also, it said the bidder will be entitled and eligible to apply for at
least 7,300 warrants for each NCD applied for in the issue.

The Housing Development Finance Corporation (HDFC) Ltd. will use the
proceeds from the issue to boost lending operations and meet its future
capital needs.”

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 DEBENTURES

Axis Bank announced resolution passed by Circulation on October 30, 2015

allotted 30,000 Senior Unsecured Redeemable Non-convertible Debentures
(Series 2) of the face value of Rs. 10 lakh each for cash at par aggregating
to Rs. 3,000 crores, on a private placement basis. The said Debentures will
be listed on the Wholesale Debt Market segment of the BSE Limited and
National Stock Exchange of India Limited. The said Debentures are rated
“AAA” by CRISIL, CARE and ICRA.

11.8 BONUS DEBENTURES – A NEW CONCEPT

Usually, for equity investors, bonuses come in free bonus shares – ‘x’
number of bonus shares on ‘y’ number existing shares held. But sometime
back, NTPC declared the issue of bonus debentures to its shareholders. A
bonus debenture is a free debt instrument issued to a company’s
shareholders as a reward. When the company declares a bonus debenture,
you will receive bonds from the company for a specific face value. Interest
will be paid on these debentures every year. They will be redeemed after a
specific period, when you will receive a lump-sum payment. Take NTPC’s
case. Suppose you hold 100 shares of the company, you will receive 100
debentures with a face value of Rs. 12.5 each, valued at Rs. 1,250. The
interest paid on this debenture is at a floating rate. The interest rate is
pegged 50 basis points higher than the prevailing yield of 10-year
government bonds. The debentures are valid for 10 years and will be
redeemed in three installments at the end of which you would have
received Rs. 1,250.

Only a few companies have issued bonus debentures in the past —

Hindustan Unilever, Britannia, Blue Dart Express and Dr. Reddy’s Labs.

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 DEBENTURES

Benefits

Bonus debentures serve many purposes.

One, as the debentures are redeemed after many years, the company will
not see its reserves deplete drastically at one go as is the case with bonus
shares. The company will be able to hold on to them for expansion
projects.

Two, it manages to ‘borrow’ from shareholders at lower rates.

Three, the interest paid is claimed as an expense and bonus debentures

reduce tax incidence. Shareholders get free interest-earning bonds. The
debentures are fully secured. Companies can also list the debentures on
the exchanges and investor can sell them in the markets when they need
cash.

Unlike bonus shares, a bonus debenture issue does not increase the equity
share base, which dents the earnings per share. They do not squeeze
return on equity, or bump up valuations.

Drawbacks

Bonus debentures do sound like an all-round winner, but they are not.
Here is the flip side. When your company declares a bonus share issue, the
entire lot of shares is credited to you at zero cost. If you sell them, you can
stand to make gains. These gains are tax-free if you hold them for more
than a year, as they are equity instruments.

But for bonus debentures, the redemption amount will come in only at the
end of the period, which can be long. In NTPC’s case, given that the
interest is linked to G-Sec yields, the amount you receive will fluctuate and
is uncertain. Bonus debentures also do not enjoy similar tax breaks to
bonus shares. First, under Income Tax rules, the amount of the bonus
issue is considered to be ‘deemed dividend’ and will attract dividend
distribution tax. Two, the interest will be taxable in your hands at your slab
rate just like your fixed deposit interest.

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 DEBENTURES

Next, even if you can exit debentures on the exchanges, it is hard to do so

in reality due to lack of trading volumes. Assuming that you do manage to
exit at a profit, short-term or long-term, capital gains tax will apply. But in
order to calculate the gains, it is unclear what exactly will tax authorities
determine as an acquisition cost.

11.9 POPULARITY OF DEBENTURES

LIC Housing Finance to raise up to Rs. 47,000 crore

September 7, 2015 | PTI
NEW DELHI: LIC Housing Finance Ltd.
today said it will raise up to Rs. 43,000 crore via
non-convertible debentures.

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 DEBENTURES

11.10 SUMMARY

The legal term “debenture” originally referred to a document that either

creates a debt or acknowledges it, but in some countries the term is now
used interchangeably with bond, loan stock or note. A debenture is, thus,
like a certificate of loan or a loan bond evidencing the fact that the
company is liable to pay a specified amount with interest. Although the
money raised by the debentures becomes a part of the company’s capital
structure, and thus its net worth, it does not become share capital.
Debenture holders have no rights to vote in the company’s general
meetings of shareholders, but they may have separate meetings or votes,
e.g., on changes to the rights to the debentures.

A debenture is a movable property issued by the company in the form of a

certificate of indebtedness. Debenture holders are creditors of the
company. Interest paid on debenture is a charge against income of the
company or expense and hence paid from earnings before tax. Failure to
pay a bond effectively means bankruptcy. A secured debenture is one in
which specific assets are pledged to bondholders in the event of default. A
company wishing to issue debentures need to enjoy a good credit rating in
the financial markets.

Several specific terms are associated with debentures. Call Option is a call
provision that allows the company to retire the debenture before its date of
maturity. Convertibility clause allows the company to convert outstanding
debentures into common stock at rates specified in the indenture. Coupon
rate is the rate of interest payable on the principal amount to the
debenture holder. Maturity denotes the period after which the issuer has to
repay the principal amount to the bondholder. Nominal, principal, par or
face value is the initial value of the bond. Put Option allows the holder to
redeem the debenture at specified time before its date of maturity. The
length of time until the maturity date is often referred to as the tenor of a
bond.

A bond indenture is a legal document or contract between the bond issuer

and the bondholder that records the obligations of the bond issuer and
benefits owed to the bondholder. The bond indenture also includes the
details of the rights of ownership as well as the rights of the bondholder to
receive interest payments and principal payments in the future.

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 DEBENTURES

Debentures are issued by companies in many forms of bonds with varying

features as regards to interest rates or payments, redemption values or
methods and tax burden on interest income. Zero-coupon Bonds carry no
interest obligation hence they are issued at discount. Floating Rate Bonds
provide variable rates of interest generally based on market rates plus a
fixed ‘spread.’ Cumulative bondholders are not paid interest at regular
intervals; instead it gets accumulated over a period of maturity and both
principal and interest are merged and paid together at the time of
redemption. Interest is paid at regular intervals on non-cumulative bonds.

Convertible Debentures are bonds that can be converted into equity shares
of the issuing company after a pre-determined period of time in the ratios
specified at the time of issue. Convertibility clause turns bonds of profitable
companies more attractive to investors and can be issued at lesser rate of
interest. Non-convertible debentures, on the other hand, carry higher
interest rates as investors do not have option of conversion into company’s
equity.

Debentures, as a long-term debt instrument, have many benefits. Interest

payable on debentures is a tax deductible expense unlike equity and
preference dividends are paid out of profit after tax. Debenture financing
does not result in dilution of control. Liability of company to debenture
holders is limited to contractual payment of principal and interest. Maturity
period of debentures can be tailored to match with company’s funds
requirements. Debentures provide protection to the company against
inflation as the interest burden stays constant through the maturity period
of the instrument.

A major drawback of debentures for the issuer company is they create a

permanent interest and principal repayment obligation. Failure to meet
these commitments in adverse circumstances can result in a major
financial embarrassment and in some cases firm’s bankruptcy. They
increase Issuer Company’s debt-equity ratio and thereby decrease its
credit rating.

Usually, for equity investors, bonuses come in free bonus shares – ‘x’
number of bonus shares on ‘y’ number existing shares held. But sometime
back’ NTPC cleared the issue of bonus debentures to its shareholders. A
bonus debenture is a free debt instrument issued to a company’s

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shareholders as a reward. Unlike bonus shares, a bonus debenture issue

does not increase the equity share base, which dents the earnings per
share. They do not squeeze return on equity, or bump up valuations.

11.11 MULTIPLE CHOICE QUESTIONS

Mark (x) against the most reasonable alternative.

1. Ashok, a retired professor, was interested in investing in debentures

that would provide him with regular interest at higher rates to meet his
expenses. Which from the following options you should recommend to
Ashok?
(a) Zero coupon debenture
(b) Cumulative debenture
(c) Non-cumulative secured debenture
(d) Non-cumulative unsecured debenture

2. __________ provision that allows the company to retire the debenture

before its date of maturity. If this provision is included in the indenture
of the debenture, the company usually offers a premium over par value
of five to ten per cent.
(a) Call option
(b) Put option
(c) Pull option
(d) Zero coupon

3. To make debentures more attractive to regular investors it is common

for companies to add feature of ___________ into the indenture at the
time of issue.
(a) Call option
(b) Put option
(c) Convertibility
(d) Floating rate

4. Maximum advantage companies derive from issue of debentures as a

long-term source of finance is that __________.
(a) The instrument has long maturity period
(b) Interest along with redemption is a contractual obligation
(c) Interest is a tax deductible expense
(d) Cumulative as well as non-cumulative options are available

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5. ___________ issue has a unique characteristic. It does not result in

dilution of control.
(a) Rights
(b) Bonus share
(c) Fraction
(d) Bonus debenture

Answers: 1. (d), 2. (a), 3. (c), 4. (c), 5. (d).

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REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter

Summary

PPT

MCQ

Video Lecture

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 CAPITAL STRUCTURE – EQUITY VS. DEBT

Chapter 12
Capital Structure – Equity Vs. Debt

Objectives
After studying this chapter, you should be able to understand:
• Objectives of optimum capital structure
• The cost of different sources of capital
• Weighted average cost of the source of finance represents cost of capital
• Common errors financial analysts commit in determining cost of capital
• Internal and external factors that affect cost of capital

Structure:
12.1 Introduction
12.2 Cost of Capital Theory
12.3 Ideal Capital Structure
12.4 Ensure Your Capital Structure Decision is Error-free
12.5 Factors Affecting WACC
12.6 Summary
12.7 Multiple Choice Questions

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12.1 INTRODUCTION

12.1.1 Capital Structure

A firm’s capital structure is the composition or ‘structure’ of its liabilities.

For example, a firm that has Rs. twenty billion in equity and Rs. eighty
billion in debt, is said to be 20% equity-financed and 80% debt-financed.
The firm’s ratio of debt to total financing, 80% in this example is referred
to as the firm’s leverage. In reality, capital structure may be highly
complex and include dozens of sources of capital. Leverage (or gearing)
ratios as we studied represent the proportion of the firm’s capital that is
obtained through debt (either bank loans or bonds).

A typical capital structure pattern may be anyone of following forms:

a. Equity Shares and Debentures (i.e., Long-term debt including Bonds,
etc.),
b. Equity Shares and Preference Shares,
c. Equity Shares, Preference Shares and Debentures (i.e., Long-term debt
including Bonds etc.).

However, irrespective of the pattern of the capital structure, a firm must

try to maximize the earnings per share for the equity shareholders and
also to enhance the value of the firm.

Looking from other perspective ‘capital structure is essentially concerned

with how the firm decides to divide its cash flows into two broad
components, a fixed component that is earmarked to meet the obligations
toward debt capital and a residual component that belongs to equity
shareholders. This part can be retained in the business or distributed to
equity holders. Hence, capital structure implies the composition of funds
raised from various sources broadly classified as debt and equity. It may
be defined as the proportion of debt and equity in the total capital that will
remain invested in a business over a long period of time. Capital structure
is concerned with the quantitative aspect. A decision about the proportion
among these types of securities refers to the capital structure decision of
an enterprise.

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If it is assumed that there are no transaction or bankruptcy costs, perfect

information is available, firms and individuals can borrow at the same
interest rate and there are no taxes, Modigliani and Miller theorized that
how a firm is financed, either through equity or through debt, is irrelevant
to its value.

But these assumptions are not valid in real economic environment. Each
source of long-term finance has its own costs and returns and hence
capital structure needs to be composed in such a way that business entity’s
value is maximized.

Video Link 1

Video Link 2

12.1.2 Objectives

Optimum capital structure has following five comprehensive objectives:

1. Value Maximization: Capital structure maximizes the market value of

a firm, i.e., in a firm having a properly designed capital structure, the
aggregate value of the claims and ownership interests of the
shareholders are maximized. This value is indicated in two directions:
a. First, by growth in the firm’s net worth and
b. Secondly, through increase in rates at which dividends are declared
from year to year.

2. Cost Minimization: Capital structure minimizes the firm’s cost of

capital or cost of financing. By determining a proper mix of fund
sources, a firm can keep the overall cost of capital to the lowest. The
current cost of capital for each source of funds is important when
making a capital budgeting decision.

3. Increase in Share Price: Capital structure maximizes the company’s

market price of share by increasing earnings per share of the ordinary
shareholders. It also increases dividend receipt of the shareholders.

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4. Firm’s management arranges the decisions that raise its credit

worthiness and this action allows it to borrow long-term funds at lower
interest rates and raise equity at higher premium value. (Rights issue of
share with par value of Rs. 10 at say Rs. 500.)

You can understand from following table how some companies floated
shares at an offer price as high as Rs. 1,020 for a share with par value of
Rs. 10 each.

Issuer Company Offer Price (Rs.)

Narayana Hrudayalaya Ltd. IPO 245 to 250
Alkem Laboratories Ltd. IPO 1020 to 1050
Dr. Lal PathLabs Ltd. IPO 540 to 550
S H Kelkar & Company Ltd. IPO 180
Interglobe Aviation Ltd. IPO 765
Coffee Day Enterprises Ltd. IPO 328
Sadbhav Infrastructure Project Ltd. IPO 103
Prabhat Dairy Ltd. IPO 115

5. Investment Opportunity: Capital structure increases the ability of the

company to find new wealth creating investment opportunities. The
firm’s business can grow both horizontally (more volumes of the
existing products) or vertically (adding new product lines). With proper
capital gearing, it also increases the confidence of suppliers of debt.

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12.2 COST OF CAPITAL THEORY

To sustain and expand business, every entity needs funds. How does the
firm determine the cost of these funds required or, more properly stated,
the cost of capital? The knowledge of cost of capital is necessary to decide
earnings that can be achieved through different investment proposals. If
the cost of capital is 10% and investment proposal to install a conveyer
system is expected to yield 8%, then it has to be dropped. But investment
proposal to open a new sales depot with 12.5% rate of return can be put
through. A factor to remember here is that, for such investment decisions,
we have to consider total cost of capital and not that of debt or equity
alone. Similarly, historical cost of capital is not relevant here as with
changed economic circumstances that cost has undergone changes. We
need to find out the yield on the capital employed as explained next.

12.2.1 The Cost of Debt

The cost of debt is measured by the interest rate or yield earned by

bondholders. If a bond trading at Rs. 1000/- in the market earns Rs. 100
each year to the bondholder, the yield is 10%. If a firm is wishing to issue
new debt, its likely cost will be the yield on its current debt. Assume that
earlier this firm had issued bonds of Rs. 25,000 at 8%. The current market
price of the bond is Rs. 23,500 and the bond is to mature after five years.
To arrive at the current yield on this bond, first determine interest earned
per year and add to it difference in face and market value of the bond
divided by years left to maturity. Next divide this numerator by the total of
0.6 of the market value and 0.4 of the face value.

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The equation is produced below:

To arrive at cost of debt, this yield has to be adjusted for the tax effect, as
interest on debt is an expense to be reduced from taxable income. If the
corporate tax happens to be 30%, the cost to the business entity for this
debt comes down to 6.68%.

Yield on current debt =

Cost of debt = Yield on current debt × (1 – Rate of tax payable)

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12.2.2 The Cost of Preferred Stock

The cost of preferred stock is similar to the cost of debt as earnings per
year are constant. But dissimilar as there is no maturity date on which
repayment has to be arranged. So, to determine the cost of preference
stock, we divide annual dividend payable by the market price of the stock.
A minor adjustment needs to be carried here to subtract cost of floating
preference stock from its market price.

Yield/cost – Preference share=

As dividends on preference shares are not expenses and are paid out of
after tax earnings, the adjustment for tax effect is not necessary while
determining cost of preference stock. The yield to the stockholder is equal
to the cost for the issuer.

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12.2.3 The Cost of Common Equity

A business entity has two alternatives while determining cost of equity.

One is to find out cost of retained earnings which exist because net
earnings that have not been distributed as dividends to equity stock
holders. It is the opportunity cost of retained earnings. Other, of course, is
to find the cost of issuing additional equity. Therefore, whether the firm
funds its capital requirements through retained earnings or through issue
of new common stock, cost of capital to the firm is the same. Here, for the
time being, we are not considering the cost of floatation of equity stock
which can vary between two to ten per cent.

The cost of common equity cannot be determined in the manner we

adopted for arriving at cost of debt and preference stock. Common stock
with face value of Rs. 10 of Bhargav Sugars Ltd. is traded in the market at
Rs. 525. This year, the firm declared a dividend of Rs. 40 per share. If we
adopt the earlier approach, used in 12.02.01 and 12.02.02 above, the cost
of common stock for Bhargav Sugars Ltd. works out to 40/525 = 0.76% –
certainly a ridiculous number. One option available to us to value common
stock realistically is to take into consideration the pricing and performance
demands of current and future stockholders who determine the market
price of the common stock.

One available approach to determine cost of common stock is based on

constant growth dividend valuation model. Under this approach, common
stock value is decided by two factors. The first is the dividend at the end of
the year divided by price of the stock in the market today. The second
factor is the constant growth rate in dividends. Investors prefer to invest in
a stock of a company that declares dividends that grow at a constant rate
of say 8%. Two factors together provide the required rate of return on
common stock expected by the investors.

ITC declared a dividend of 6.25 in the year 2015 on its common stock and
market price of the stock was around 350/-. Thus, for ITC, the first factor
dividend/price is 1.8% and if we assume factor B to be 8%, the required
rate of return is 9.8% or 10%. For publicly traded companies, we can
easily obtain the dividends declared by them over last, say six years, to
determine dividend growth rate.

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Bhargav Sugars Ltd.

Year Dividend Amount Change % Growth

1 26 – –
2 28 2.00 7.69
3 30 2.00 7.14
4 34 4.00 13.33
5 37 3.00 8.82
6 40 3.00 8.11
45.09

Dividend growth rate, i.e., 9% per year

Price of equity = Dividend yield 0.76 + Dividend growth rate 9% = 9.76 or

10%

Capital Asset Pricing Method (CAPM) is another popular approach to

estimate cost of equity capital. But it is a fact that while some analysts
accept the capital asset pricing method as an important approach to
common equity valuation; others suggest that it is not a practical method
when you consider how economy operates.

Under CAPM method, the required return for the common equity is
ascertained by the formula:
RRE = RFR + ß (ERM – RFR)
where,
RRE stands for required return on equity shares.
RFR stands for risk free rate of return.
ß is Beta coefficient which measures the historical volatility of the equity
stock under review with the general market index.
ERM is the normal return on the equity shares as measured by relevant
market capital index.

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To further understand the problem, let us assume that the expected return
in the market on the particular stock is 15%, the risk-free interest on
government bonds is 9% and ß of the said company is 0.8. In such
situation using CAPM formula, required rate on the equity works out to:

RRE = 9% + 0.8 (15 – 9) = 9 + 4.8 = 13.8%

Earlier, we had noted that CAPM methodology is not practical and this
stand is based after consideration of the following assumptions that
underlie the CAPM:
a. Investors are risk averse.
b. Returns on equity shares are normally distributed.
c. Investors have common expectations as far as returns from equity
investment are concerned.
d. Investors can borrow or lend freely at the risk-free interest rates.
e. Markets are perfect, there are no taxes, transaction expenses or
monopoly hold in the market.
If you study each of the above assumptions, you are bound to conclude
that all of them are not realistic enough to support CAPM.

Until now, we discussed valuation model and asset pricing model to

determine the required return on common stock or cost of capital. We
assumed that the equity holders’ expectations need to be fulfilled if we
want them to supply the business entity fresh funds for firm’s capital
investment for business growth. We must realize the fact that the business
entity has one more important and many times quite significant source of
ownership or equity capital in the form of retained earnings.

These accumulated earnings are the net sum of previous earnings less
distributed dividends in the past. The earnings are to be used to declare
further dividends and also for re-investment in the business entity.

Thus, one can assume that this is a free source for supply of funds. But
that is not the case, as there is an opportunity cost that needs to be
considered. The retained earnings can always be distributed to equity
holders of the business entity as dividends, and on their receipt, equity
holders are free to reinvest them for their further benefit.

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This new reinvestment must at least earn the stockholders in this business
entity same return as was available to them from their initial investment. It
is reasonable to restate that the cost of equity in the form of retained
earnings equals the required rate of return on firm’s stock and it is
determined as under:
CRE = D/SP + g
where,
CRE = Cost of Common Stock as Retained Earnings
D = Dividend per year
SP = Share price in the market
g = Constant growth rate in dividends

To repeat earlier example, ITC declared a dividend of Rs. 6.25 in the year
2015 on its common stock and market price of the stock was around Rs.
350. Thus, for ITC, the first factor dividend/price is 1.8% and if we assume
factor B to be 8%, the required rate of return using above equation is
9.8% or 10%.

Here, it is worth noting that when the firm’s shares are traded in the
market at higher values, the cost of capital gets reduced, the high market
value being an indicator of firm’s strong creditworthiness. This factor, thus,
is external to firm’s cost of capital. On the other hand, if the dividend
amount is higher, the cost of capital increases as higher dividend indicates
firm’s tendency to distribute retained earnings as dividends rather
employing them for re-investment. This dividend declaration is an internal
factor to cost of capital.

Before we conclude, we shall also consider the cost of equity which is to be

issued in the market for fresh equity capital. When we calculate the cost of
new, fresh capital, we need to take into account the cost of raising the
fresh capital – expenses for prospectus, underwriters, issue managers,
share broker agencies, etc. For retained earnings, we considered the
market price of the share. Now, we need to consider net share price which
will be: market share price – fresh capital raising expense per share. To
continue with the ITC example, the dividend of Rs. 6.25 will have now to
be divided by Rs. 335 assuming Rs. 15 to be the raising cost. The required
rate now turns out to be 1.87% + 8% = 9.87%.

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Video Link 1

Video Link 2

12.3 IDEAL CAPITAL STRUCTURE

We are now able to determine the cost of various elements that together
form a business entity’s capital structure. To arrive at optimal capital
structure for the firm, it is now necessary to assign weights to each
element of capital. How will you assign weights for debt or debenture,
preferred stock, and common equity? Debt being the cheapest, your first
choice naturally is debt which you would assign maximum weight. But debt
has to be used within limits, otherwise financial stability of the firm is
affected. Interest on debt is a continuous burden whether there are
supporting earnings or not. Naturally, you do not wish to over expose the
firm to debt and create fears of bankruptcy.

To understand the issue, let us take four different possible capital

structures for Shobha Developers Ltd., Pune. For simplicity’s sake,
preference stock is ignored and we focus on equity and debt alone.

Plan A Weights Cost after tax Weighted Cost

Debt 20% 6.5% 1.3%
Equity 80% 12.0% 9.6%
Total 10.9%
Plan B Weights Cost after tax Weighted Cost
Debt 40% 7.5% 3.0%
Equity 60% 12.5% 7.5%
Total 10.5%
Plan C Weights Cost after tax Weighted Cost
Debt 50% 8.0% 4.0%
Equity 50% 14.0% 7.0%
Total 11.0%

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Plan D Weights Cost after tax Weighted Cost

Debt 60% 9.0% 5.4%
Equity 40% 15.0% 6.0%
Total 11.4%

When you study the above table, you will note that up to 40% debt,
Shobha Developers are in a position to reduce weighted average capital
cost, but once the debt crosses 50%, the weighted average capital cost
starts increasing. That is the main reason why most businesses maintain
their debt/equity ratio to less than 50 thereby satisfying both the creditors
and investors.

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Self-training Exercise: 1
Machinery Manufacturer Corporation Ltd. has following capital structure:
Equity Capital Rs. 12 crores
Long-term debt Rs. 14 crores
Reserves Rs. 22 crores

Management is considering installing production capacity at the cost of Rs.

15 crores. As a CFO of MMC, you are of the opinion that instead of fresh
capital, new debt be issued to finance this expansion.

You are in the process of putting down your recommendation on paper for
submission to the Managing Director.

Which of the following statements will you include in your above

document? Mark x against the box provided below:

1. Bank rates are expected to go up in the next year.

2. Bank rates are expected to go down in the next year.
3. The returns from the additional capacity are expected to accrue in the
next two years.
4. The returns from the additional capacity are expected to accrue from
the fourth year.
5. The returns from the additional capacity will vary from year to year.
6. The returns from the additional capacity will grow at a steady rate.
7. While addressing the Chamber of Commerce on its completing 25 years,
the Finance Minister expressed likelihood of corporate tax rates going
up.
8. While addressing the Chamber of Commerce on its completing 25 years,
the Finance Minister expressed likelihood of corporate tax rates falling
by 5%.

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12.4 ENSURE YOUR CAPITAL STRUCTURE DECISION IS

ERROR-FREE

Here are some common mistakes financial planners commit. You should
ensure you do not fall prey to them.
1. Weighted Average Cost of Capital (WACC) is a purely academic
exercise: Cost of capital is an important element in cash flow analysis
along with project life and project cash flows. And like other two
elements, WACC can be determined with required precision for
investment decisions of a business entity.
2. Accounts payables and provisions form a part of capital: Capital is
provided by investors, accounts payables are not. Accounts payable
arise from typical operating relationship between the business entity on
one hand and its vendors and employees on the other. It is a fact that
current liabilities do affect project’s cash flows but not the WACC.
3. Present pre-tax rate of current debt is cost of debt: Present debt
reflects what happened in the past. WACC is needed for decisions on
future investments by the firm. What matters, therefore, is the rate on
debt instruments ruling in the market today. If the new project is to be
partly funded by debt, the firm has to pay interest at the rates prevalent
in the money markets.
4. Dividend rate reflects cost of equity: Dividend per share as a
percentage of its face value is valid indicator of firm’s cost of equity.
Dividend declared is a rate of return available (or offered by the firm) to
the investors. The cost of equity is the rate of return expected by the
investors given the risk they are exposed to at the time they agree for
fresh investment in the firm. It has nothing to do with dividends earned.
5. Retained earnings are undistributed dividends and hence cost
free: This common error occurs as financial planner has failed to
recognize existence of principle of opportunity costs. When retained
earnings are utilized to fund a project, they are no more available for
distribution of dividends. Instead of utilizing this source for funding the
investments, if the firm was to distribute them as dividends, the
shareholder can invest amounts received from dividends elsewhere and
earn income from this investment. The rate of return from this new

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investment is the opportunity cost of the retained earnings and has,

therefore, to be considered as such while working out WACC.
6. WACC is uniform to all projects to be undertaken by a firm: Each
project has its own risk profile. Naturally, a common (firm’s) WACC is
not applicable to all projects a firm wishes to undertake. But many
financial analysts argue that as investors are paid from the cash flows of
the firm and not from the cash flows of a particular project, use of one
WACC for all projects is justified. In reality, the return that investors
require from a project has to be the one that investors would obtain by
investing in any other project with the same risk profile. Each project
has its own cost of capital that is determined by its riskiness and debt
capacity. As a result, the WACC of a firm is the average of WACC of
each and every project undertaken by that firm.

12.5 FACTORS AFFECTING WACC

Weighted Average Cost of Capital results from several factors, some of

them from the economy and others based on investment or financial
policies of the business entity.

Factors from the Economy

• Interest rates: The ruling rates of interest determine the WACC. If the
rates in the market rise, there will be direct increase in the WACC. If the
interest rates fall, cost of capital will decrease. When we calculated cost
of capital by the popular Capital Asset Pricing Method (CAPM), we
adopted RFR which stood for risk-free interest rate.
• Risk premium: Market risk premium reflects the perceived riskiness of
equity stock. It also reflects investors’ aversion to risk. This risk premium
has direct effect on cost of equity and indirect substitution effect on debt.
• Income tax rates: Interest is chargeable against cash flows as an
expense. This provides tax benefit when we determine cost of debt.
Hence, we considered only after tax interest rates in our formulae for
determination of cost of capital. Any change in income tax rates declared
by the government thus has direct effect on cost of capital.

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Factors under Firm’s Control

• Risk factor: To estimate cost of capital, we start with the rates of return
required on the firm’s existing equity and debt sources of funds. This
permits us to gauge the firm’s risk appetite. If the new projects to be
undertaken are at the same risk level, the marginal cost of capital is not
likely to vary much. If not, then the new level of risk needs to be
considered while determining the weighted average cost of capital.
• Capital structure: Since post-tax cost of debt is lower, many new
projects may call for sourcing them from debt. The firm’s capital
structure policy reflects the degree of firm’s readiness to revise the debt-
equity ratio.
• Dividend Policy: As we noted earlier, if the firm’s dividend policy calls
for distribution of higher dividends, the cost of equity capital is likely to
be high. The conservative dividend policy on the other hand lowers
WACC.

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12.6 SUMMARY

A firm’s capital structure is the composition or ‘structure’ of its liabilities. A

typical capital structure pattern may be: (i) Equity Shares and Debentures
(i.e., Long-term debt including Bonds, etc.) or (ii) Equity Shares and
Preference Shares or (iii) Equity Shares, Preference Shares and Debentures
(i.e., Long-term debt including Bonds, etc.). Each source of long-term
finance has its own costs and returns and hence capital structure needs to
be composed in such a way that business entity’s value is maximized. The
capital structure implies the composition of funds raised from various
sources broadly classified as debt and equity. Optimum capital structure
has following four comprehensive objectives: (a) Value Maximization, (b)
Cost Minimization, (c) Increase in Share Price and (d) Investment
Opportunity.

To sustain and expand business, every entity needs funds. Hence, it is

necessary for the firm to determine the cost of these funds required. The
cost of debt is measured by the interest rate or yield earned by
bondholders. The current rate of interest can be determined by dividing the
annual interest income on an instrument divided by its ruling market price.
To arrive at cost of debt, this yield has to be adjusted for the tax effect, as
interest on debt is an expense to be reduced from taxable income.

The cost of preferred stock is similar to the cost of debt as earnings per
year are constant. As dividends are not expenses and are paid out of after
tax earnings, above adjustment for tax effect is not necessary while
determining cost of preference stock.

A business entity has two alternatives while determining cost of equity.

One is to find out cost of retained earnings which exists because net
earnings have not been distributed as dividends to equity stock holders. It
is the opportunity cost of retained earnings. Other, of course, is to find the
cost of issuing additional equity.

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 CAPITAL STRUCTURE – EQUITY VS. DEBT

One available approach to determine cost of common stock is based on

constant growth dividend valuation model. Under this approach, common
stock value is decided by two factors. The first is the dividend at the end of
the year divided by price of the stock in the market today. The second
factor is the constant growth rate in dividends. When you add these two,
you arrive at cost of equity capital. Capital Asset Pricing Method (CAPM) is
another popular approach to estimate cost of equity capital. Under CAPM,
the required return for the common equity is ascertained by reference to
risk-free rate of return (RFR). It also uses ß which is Beta coefficient that
measures the historical volatility of the equity stock under review with the
general market index. To arrive at cost of capital, we apply ß to the
difference between normal return on equity shares less RFR and add it to
the RFR.

We must realize the fact that the business entity has one more important
and many times quite significant source of ownership or equity capital in
the form of retained earnings. The cost of equity in the form of retained
earnings equals the required rate of return on firm’s stock and it is
determined by dividing the dividend per share earned at the end of the
year by its ruling market price and adding this rate to constant growth rate
in previous dividends.

We are now able to determine the cost of various elements that together
form a business entity’s capital structure. To arrive at optimal capital
structure for the firm, it is now necessary to assign weights to each
element of capital. Debt being the cheapest, your first choice naturally is
debt which you would assign maximum weight. But debt has to be used
within limits, otherwise financial stability of the firm is affected. Interest on
debt is a continuous burden whether there are supporting earnings or not.
With up to 40%, debt firms are normally in a position to reduce weighted
average capital cost, but once the debt crosses 50%, the weighted average
capital cost starts increasing.

While determining weighted average cost of capital, you must avoid these
common six errors: (1) Considering (WACC) as a purely academic exercise,
(2) Accounts payables and provisions form a part of capital, (3) Present
pre-tax rate of current debt is cost of debt, (4) Dividend rate reflects cost
of equity, (5) Retained earnings are undistributed dividends and hence cost
free and(6) WACC is uniform to all projects to be undertaken by a firm.

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There are three external factors that affect cost of capital: (a) Interest
rates prevailing in the market, (b) Risk premium in equity market and (c)
Income tax rates as announced by the central government. Balance three
factors internal to the business entity that affect WACC are: Risk appetite
of the firm (x), Capital structure preferred by the firm (y) and Firms
established dividend policy (z).

12.7 MULTIPLE CHOICE QUESTIONS

Mark (x) against the most reasonable alternative.

1. Jumbo Developers Ltd. recently launched Blue Ridge project in

Vadodara that provided return of 11%. This project was approved
earlier by the management unanimously as debt funds were available to
Jumbo at 8%. Next year, their business development manager, Ms.
Chaaya proposed more attractive Cool Himalayas project that assured
higher 13% returns. This was however not approved as their Finance
Director Bhargav, stated that the cost of issuing new equity was around
14.5%. If you were Finance Director, how would you have assisted for
correct decision?
(a) Confirmed Bhargav’s submission
(b) Rechecked that Bhargav had considered floatation cost
(c) Recalculated WACC considering both debt, retained earnings and
equity
(d) Asked Chaaya to recheck her numbers

2. Financial managers often make a simple error while determining the

cost of preference capital. Managers often __________.
(a) Do not consider market price of the preference share
(b) Consider after tax yield
(c) Ignore floating costs
(d) Any one of above

3. Temptation to increase deb- equity ratio has to be controlled otherwise

you can lead the firm to __________.
(a) Increase its WACC
(b) Decrease its WACC
(c) Loss of positive credit rating and perhaps bankruptcy
(d) Suboptimal capital structure

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4. Four management students Asha, Alaka, Anupama and Additi wrote

following statements in their weekly tests under the subject WACC. Can
you identify the one that is incorrect?
(a) Retained earnings are undistributed dividends but this source has
its cost
(b) Dividend rate does not reflect cost of equity
(c) Present pre-tax rate of current debt is cost of debt
(d) WACC is not uniform to all projects to be undertaken by a firm

5. Suresh, Ramesh and Harish all agreed that, while calculating cost of
debt, income tax rate plays a significant role to make debt an attractive
source. The relevant rate per Suresh was corporate tax rate, per
Ramesh it was the rate on capital gains and Harish insisted it was
personal income tax rate. Who was right among the group?
(a) Suresh
(b) Ramesh
(c) Harish
(d) All three

Answers: 1. (c), 2. (d), 3.(c), 4.(c), 5. (a).

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REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter

Summary

PPT

MCQ

Video Lecture

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 DIVIDEND POLICY AND DECISIONS

Chapter 13
Dividend Policy And Decisions

Objectives
After studying this chapter, you should be able to understand:
• Treatment of retained earnings as reserves or dividends
• Marginal Principle of Retained Earnings
• Shareholders’ preferences for dividends
• Dividend irrelevance theory of Miller and Modigliani
• Professor James E. Walter and Myron Gordon’s views on dividend
relevance
• Actual vs. expected dividends
• Internal and external factors that affect dividend decisions
• Stock dividends and stock splits

Structure:
13.1 Introduction
13.2 The Need for Dividends
13.3 Factors that Influence Dividend Decisions
13.4 Companies Act Provisions on Declaration of Dividends
13.5 Dividend Policy and Market Value of Equity Shares
13.6 Model Dividend Policy
13.7 Stock Dividends
13.8 Stock Splits
13.9 Summary
13.10 Multiple Choice Questions

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 DIVIDEND POLICY AND DECISIONS

13.1 INTRODUCTION

As young professionals, you strive to earn higher income and in the

process often skip meals and sometimes sleep as well. Your efforts allow
you to build savings for welfare of your family. But in proportion to the
efforts undertaken to earn income how many efforts you devote to manage
savings? Most of you are likely to keep mum. If a similar question was
asked to the corporate finance heads, they cannot remain silent as funds
handled by them do not belong to them but to the equity holders of the
company. Every CFO has, therefore, to decide how are the net earnings of
the company to be utilized? The one alternative is to retain them with the
company for reinvestment; the other one is distribute them to the share
owners as dividends. In most of the cases, they have to determine what
portion of the net earnings to be retained in the business and what portion
to be utilized for dividends.

13.1.1 Marginal Principle of Retained Earnings

Retained earnings of the company can either be used to reinvest in new

projects of the company that generate further revenue and assure
continuous growth or distributed to stock holders as dividends for the funds
provided by them to start the business. Ideally, the finance managers
should determine what rate of earnings the shareholders would receive
from the dividends distributed to them, if that rate is higher than the rate
of earnings from reinvestment in company’s future projects, then it is clear
that available funds can be distributed as dividends.

But if the rate of earnings on reinvestment in the company is higher than

what equity holders can earn from dividends in their hands, finance
managers have to decide what portion of retained earnings be distributed
as dividends so that enough funds are available for reinvestment for
further growth of the company. Each potential project to be financed by
internally generated funds must provide a higher rate of return than the
equity holder could achieve on his/her other investments.

When a company is incorporated, it starts with moderate sales and some

profit. At this stage, the rate at which sales volume grows is increasing
every year and earnings of each year are required for financing the
projects that are required to sustain this increase in the rate at which sales

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grow. Question of paying dividends in any form does not arise in this initial
stage.

If the company succeeds in finding a place for itself in the market, the
demand for its products or services creates growth in sales, earnings and
assets. Now, the firm has entered the growth stage. In this stage too, the
rate at which the sales and earnings rise keeps on increasing. Earnings
available are still required for reinvestment. But the firm can keep equity
holders satisfied by declaring bonus issue of equity. Thus, stock dividends
are possible but not cash dividends as retained earnings are fully required
for reinvestment alone. In the later part of this stage, the firm can consider
issue of low cash dividends to assure its equity holders that their decision
to invest in the said firm is bearing fruits.

After the growth and expansion stage is completed, maturity stage

commences, external funds (debt) are available at moderate rates. The
sales and earnings are growing at the same old or probably at decreasing
rate. Funds available from internal and external sources are able to meet
the need for firm’s investments. And now a larger part of retained earnings
can be utilized to declare regular cash dividends.

All along, we are assuming that dividends are to be paid out only if the
business entity cannot make better use of the available retained earnings.
The active base for issue of dividends is retained earnings and not the need
for dividends.

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13.1.2 Stockholders’ Preference

Ask the average Indian what he wants from his investments and the
answer would probably be, ‘stable returns’. This is why bank fixed deposits
and small savings schemes are so popular while stocks account for less
than 5% of total household wealth. Individuals stay away from stocks
because it is a volatile asset class. But take a closer look and you will find
that many companies have given steady income to investors to meet their
shareholders’ preference; they have consistently given back a significant
chunk of their net profits to shareholders in the form of dividends.

This stockholders’ preference is of two varieties. Some stockholders wish

highest return on their investment in the company by either reinvestment
of retained earnings or through payout of dividends to increase their
current returns whichever provides better results. They are in no hurry for
immediate funds. In such a situation, decisions arranged under 13.1.1 will
satisfy the stockholders.

However, this may not always be the case as other stockholders prefer
immediate returns in the form of dividends instead of longer term returns
through reinvestment of retained earnings. In this situation, decisions
under 13.1.1 do not fulfill stockholders’ preference. Then the management
cannot engage itself only in determining whether retained earnings or
dividends in hands of stockholders provide higher returns and decide when
to distribute dividends. It has to also consider stockholders’ preference.

13.2 THE NEED FOR DIVIDENDS

Shareholders are fully aware that theoretically potential returns from

reinvestment of retained earnings are bound to increase the value of their
equity in the company. But any event that is to occur in future carries a
certain degree of uncertainty. This accounts for the doubt in the mind of an
average shareholder about translation of future returns into dividends. As a
result, the typical equity holder offers premium on funds that are paid out
as dividends and discounts long-term returns from reinvestment of
retained earnings. Finance managers need to consider this factor in
addition to returns on retained earnings.

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Dividends paid by a company reflect its management’s judgment about

financial health of the company, its prospects and promising future. A
lower dividend payout suggests that the financial prospects of the company
are considered bright by its management and correspondingly higher
dividends announce optimistic future for the company. Share prices of such
companies paying more dividends always command higher and higher
prices in the stock market.

Here, the issue is not that shareholders can invest their funds for better
use than their company can. The real issue is what do shareholders desire?
And answer from all shareholders is some funds today rather than all (even
though more) tomorrow. As a result, most companies in India determine
reinvestment opportunities relative to required returns and then modify
resulting decision by their assessment of shareholders’ preference.

Companies with high business growth potential retain most of the retained
earnings for investment and declare modest dividends. Thus, high growth
companies enjoy a low payout ratio and those mature companies with
slower business growth potential have a high dividend payout ratio.

Consideration of shareholders need for dividends also compels the

management to consider stability in payments of dividends. Just like every
year, it considers returns from various opportunities available for
reinvestment, it must also consider the pattern of dividend payments over
a last few years. Maintenance of a record for steady dividend payments
creates psychological impact on investors of steady flow of (more)
dividends in future thereby creating greater value for its shares in the
stock markets.

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 DIVIDEND POLICY AND DECISIONS

Some financial analysts argue that investors are not concerned with a
company’s dividend policy since they can satisfy their need for current
funds as they can sell a portion of their portfolio of equities if they want
cash. This evidence is called the “dividend irrelevance theory,” and it
essentially indicates that an issuance of dividends should have little to no
impact on stock price. But each investor cannot be expected to sell a
portion of her shares in lieu of dividends as this is very complex alternative
to receipt of dividends direct into her bank account.

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13.3 FACTORS THAT INFLUENCE DIVIDEND DECISIONS

In addition to analysis of marginal returns on investments and shareholder

preferences, there are some other factors that management needs to
consider while arranging for dividend decisions.

13.3.1 Need for Informing Investors about Company’s Bright

Prospects

Dividends are used by companies for information signaling. Shareholders

are scared by uncertainties in economy and when they receive dividends
regularly, they are assured about the financial prospects of the company. A
high dividend payout ratio suggests that the future of the company as
judged by the management is promising and there is no need to look at
alternative investment opportunity.

Let us consider FMCG diversified conglomerate ITC. Its shares have yielded
an impressive 26% CAGR in the past ten years (2005-2015), while
maintaining a track record of generous dividend payouts, averaging more
than 50% of the net profit during this period. In the past 10 years, the
company has made a net profit of Rs. 44,925 crore. Of this, Rs. 25,350
crore has been given out as dividend to its shareholders.

13.3.2 Availability of Liquid Assets

A company with substantial net earnings has to consider its cash position
before a decision about dividends can be arranged. Retained earnings are
not fully reflected by liquid cash in the balance sheet. They are often
reflected by inventory and receivables which can be substantial, especially
when sales volumes are increasing. As sales and earnings expand rapidly
there is bound to be an inventory and receivables build-up. It restricts
generation of cash flow and it is uneconomic to liquidate these non-cash
assets for immediate satisfaction of shareholders.

Even if liquid funds are available today from which dividends can be paid
out, it is necessary for the CFO to look at the cash forecast for the next
year before any decision can be arranged. It is quite likely that a major
part of available liquid assets has already been earmarked for execution of
incomplete projects on hand.

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13.3.3 Access to the Financial Markets

However, a company with sound financial past record can have an easy
access to financial markets and it can arrange funds for dividends through
increasing its debt. Declaration of dividend this way ensures stability in
dividend payout which in turn has positive impact on the firm’s credit
standing. The healthy record of stabile dividends established by this
measure can also permit the company to issue fresh stock later and
liquidate the incremental debt caused by distribution of dividends. In other
words, if retained earnings are on the rise, funds can be raised through
debt to stabilize dividend payout.

13.3.4 Income Tax Considerations

Until 1997, dividend income of stockholders was added to their taxable

income. Shareholders in the higher tax bracket, at that time, were not in
favor of dividend payout. With no dividend obligations, a company could
utilize its retained earnings fully for reinvestment and increase in earnings
per share. This in turn results in higher market value for its shares. High
income tax payers, thus, had preference for scrips that offered potential to
generate capital gains achieved from increase in their value in the stock
market. The tax on capital gains was at much lower rate than tax on
income.

Today, the situation has changed. Shareholders do not have to pay any
income tax on dividend income. It is tax free. Companies, on the other
hand, are required to pay dividend distribution tax which is around 15%.
This dividend income exemption has prompted many companies to declare
higher dividends than before claim certain studies by different scholars.

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ONGC Dividend Policy

Dividends are declared at the Annual General Meeting of the shareholders

based on the recommendation by the Board. The Board may recommend
dividends, at its discretion, to be paid to our members. The Board may
also declare interim dividends. Generally, the factors that may be
considered by the Board before making any recommendations for the
dividend include, but are not limited to, future capital expenditure plans,
profits earned during the financial year, cost of raising funds from
alternate sources, cash flow position and applicable taxes including tax
on dividend, subject to the Government guidelines described below:

As per the guideline dated February 11, 1998 from the Government of
India, all profit-making PSUs which are essentially commercial
enterprises should declare the higher of a minimum dividend of 20% on
equity or a minimum dividend payout of 20% of post-tax profit. The
minimum dividend pay-out in respect of enterprises in the oil, petroleum,
chemical and other infrastructure sectors such as us should be 30% of
post-tax profits.

13.4 COMPANIES ACT PROVISIONS ON DECLARATION OF

DIVIDENDS

Dividend should be paid out of: (i) the profit of the company for the
financial year; or (ii) profits for the previous financial years which have not
been transferred to reserves; or (iii) out of both. It has to be ensured that
the board of directors has arranged to set off entire previous losses and
depreciation not provided in previous year or years. Company should pay
dividend to preference shareholders before dividend is paid to the equity
shareholders of the company.

Companies Act, 1956, had imposed a burden to transfer certain fixed

percentage of profit to reserve before declaration of dividend in any
financial year. This percentage had direct relation to the percentage of
dividend to be declared. However, Companies Act, 2013 introduced a
liberal provision in this regard and withdrew the fixed percentage of profits
to be transferred to reserves and instead allowed transfer such percentage
of profit to reserves of the company as company may consider appropriate.

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In any year in which the profits are inadequate or there are no profits, the
company may declare and pay dividend out of past year profit earned and
transferred to reserves subject to the provision of the Companies
(Declaration and Payment of Dividend) Rules, 2014. These rules stipulate
that for the purpose of declaration of dividend out of reserves, company
shall have to fulfill the following conditions:
a. The rate of dividend shall not exceed the average of three years
immediately preceding that year. (Above condition shall not apply to the
company which has not declared any dividend in each of the three years
immediately preceding that year.)
b. The total amount to be drawn from such accumulated profit shall not
exceed 1/10th of the sum of its paid-up share capital and free reserves
as appearing in the latest audited financial statement.
c. The amount so withdrawn shall first be utilized to set off the losses
incurred in the financial year in which dividend is declared before any
dividend in respect of equity shares is declared.
d. The balance of reserves after such withdrawal shall not fall below 15%
of its paid-up share capital as appearing in the latest audited financial
statement.
e. No company shall declare dividend unless previous losses and
depreciation, not provided in previous year or years, are set-off against
profit of the company of the current year.

The Act further states that after declaration of the dividend, the company
shall deposit amount of dividend (including interim dividend) in separate
account with a scheduled bank. Such amount must be deposited within five
days from the date of declaration of dividend. The dividend must be paid
within thirty days from the date of declaration of dividend. Dividend shall
be paid in cash, i.e., it shall not be paid in kind.

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13.5 DIVIDEND POLICY AND MARKET VALUE OF EQUITY

SHARES

One significant objective of corporate financial management is to maximize

the market value of firm’s equity stock. As a result, the CFO of the
corporation has to consider the effect of the firm’s dividend decisions on
market value of its ordinary shares. Unfortunately, financial analysts are
divided in determining this relationship. Some analysts belonging to perfect
market philosophy are of the opinion that a firm’s dividend policy has no
effect on the market value of its shares in the market. However, according
to other set of scholars, dividend decisions materially affect the
shareholders’ wealth and the valuation of the firm itself. These two
opinions are termed irrelevance concept of dividends and relevance
concept of dividends. First, we deal with irrelevance concept.

13.5.1 Market Price of Shares Depends on Earnings and Not on

Dividends

Two economists, Miller and Modigliani, have propagated that market value
of a company depends on its earning power and whether these earnings
are retained in the business for reinvestment or distributed to its
shareholders in the form of dividends has no relationship with firm’s
market value of shares.

The Modigliani-Miller theorem (of Franco Modigliani and Merton Miller) is a

theorem on capital structure, arguably forming the basis for modern
thinking on capital structure. The basic theorem states that under a certain
market price process (the classical random walk), in the absence of taxes,
bankruptcy costs, agency costs, and asymmetric information, and in an
efficient market, the value of a firm is unaffected by how that firm is
financed or how does it employ its retained earnings. Since the value of the
firm depends neither on its dividend policy nor its decision to raise capital
by issuing stock or selling debt, the Modigliani-Miller theorem is often
called the capital structure irrelevance principle. Modigliani and Miller
approach further states that the market value of a firm is affected by its
future growth prospect apart from the risk involved in the investment. The
theory stated that value of the firm is not dependent on the choice of
capital structure or financing decision of the firm. If a company has high
growth prospect, its market value is on the rise and hence its stock prices

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would be high. If investors do not see attractive growth prospects in a firm,

the market value of that firm would not be that great.
Assumptions of Modigliani and Miller Approach:
a. There are no taxes.
b. Transaction cost for buying and selling securities as well as bankruptcy
cost is nil.
c. There is symmetry of information. This means that an investor will have
access to same information that a corporate would and investors would
behave rationally.
d. The cost of borrowing is the same for investors as well as companies.
e. Debt financing does not affect companies EBIT (Earnings Before Income
Tax).
f. Modigliani and Miller approach indicates that value of a leveraged firm
(firm which has a mix of debt and equity) is the same as the value of an
unleveraged firm (firm which is wholly financed by equity) if the
operating profits and future prospects are the same. That is, if an
investor purchases shares of a leveraged firm, it would cost him the
same amount required to buy the shares of an unleveraged firm.

The key Modigliani-Miller theorem was developed in a world without taxes.

However, you know that when the interest on debt is tax deductible, and
ignoring other frictions, the value of the company increases in proportion
to the amount of debt used. And the source of additional value is due to
the amount of taxes saved by issuing debt instead of equity.

Critics argue that dividends are relevant because of the uncertainty

characterizing future, the imperfections in the capital market and the
existence of unavoidable taxes.

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13.5.2 Market Price of Shares Depends on Dividends

There are some economists who while studying a firm’s dividend policy
assume that its investment decisions are independent of dividend policy,
others argue that dividend and investment decisions are related. We shall
look at two models, one presented by James Walter and other by Myron
Gordon.

Walter’s Model

Professor James E. Walter argues that the choice of dividend policies

almost always affects the value of the enterprise. His model shows clearly
the importance of the relationship between the firm’s internal rate of return
(r) and its cost of capital (k) in determining the dividend policy that will
maximize the wealth of shareholders.

Walter’s model is based on the following six assumptions:

1. The firm finances all investment through retained earnings; that is debt
or new equity is not issued.
2. The firm’s internal rate of return (r) and its cost of capital (k) remain
constant.
3. All earnings are either distributed as dividend or reinvested internally for
business growth.
4. The values of the earnings per share (E), and the divided per share (D)
may be changed in the model to determine results, but any given values
of E and D are assumed to remain constant forever in determining a
given value.
5. The firm has a very long or infinite life.
6. There is no tax on corporate earnings or on dividend income.

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Walter’s formula to determine the market price per share (P) is as follows:
P = D/K + r(E – D)/K/K or

where,
P = Market price of share.
D = Dividend per share.
r = Internal rate of return.
E = Earnings per share.
K = Cost of capital.

The above equation clearly reveals that the market price per share is the
sum of the present value of two sources of income:
a. The present value of an infinite stream of constant dividends (D/K) and
b. The present value of the infinite stream of firm’s earnings [r (E – D)/K/
K].
You will now understand that as per Walter’s model:
a. When the rate of return is greater than the cost of capital, the price per
share increases and dividend payout ratio decreases.
b. When the rate of return is equal to the cost of capital, the price per
share remains constant and does not change with dividend payout
ratio.
c. When the rate of return is lesser than the cost of capital, the price per
share decreases and dividend payout ratio increases.
These implications lead us to conclude that:
(i) The optimal payout ratio for a growth firm is nil,
(ii) The optimal payout ratio for a normal firm is irrelevant; and
(iii) The optimal payout ratio for a declining firm is 100%.

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It is clear that these guidelines require us to follow a course of action that

is impractical. The model succeeds only to explain the effects of dividend
policy under different degrees of earnings. The model is quite useful to
show the effects of dividend policy on an all equity firm (firm that has no
debt on its balance sheet) under different assumptions about the rate of
return. However, the simplified nature of the model can lead to conclusions
which are not true in general, though true for Walter’s model under its
assumptions.

Video Link 1

Video Link 2

Gordon’s Model

Second very popular model explicitly relating the market value of the firm
to dividend policy is developed by Myron Gordon.
Gordon’s model is based on the following assumptions:
1. The firm is an all equity firm.
2. No external financing is available. Retained earnings represent the only
source of financing for the firm. Thus, like the Walter model, Gordon
model ties investment decision and dividend decision together.
3. The internal rate of return (r) of the firm on its investments is constant.
4. The appropriate discount rate (K) of the firm remains constant and is
greater than the growth rate.
5. The firm and its stream of earnings are perpetual.
6. The corporate taxes do not exist.
7. The retention ratio (b), once decided upon, is constant. Thus, the
growth rate (g) = br is constant forever.
8. K > br = g if this condition is not fulfilled, we cannot get a meaningful
value for the share.

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 DIVIDEND POLICY AND DECISIONS

According to Gordon’s dividend capitalization model, the market value of a

share (Po) is equal to the present value of an infinite stream of dividends
to be received by the share. Gordon uses the following equation to state
how the market price of a firm’s share is determined.

Video Link 1

Video Link 2

where,
(P0) = Price of the share at the end of year 0
(E1) = Earnings per share at the end of the year 1
B = The fraction of earnings the firm retains for investment
(1 – b) = The fraction of earnings the firm distributes as dividends
K = The rate of return required by the shareholders
R = The rate of return on investments arranged from retained
earnings

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Rational Expectations Model

The model is based on the premise that what matters is not the actual
dividend amount but the difference between what was expected to happen
and the actual event. This was enunciated by John F. Muth in his paper
entitled “Rational Expectations and the Theory of Price Movements.”

When we apply this theory to the relationship between dividends and price
of scrip on the markets, we arrive at the following conclusions.

If the company announces a dividend that equals the market expectations,

then there is no change likely to occur in the price of the share after the
dividend announcement. Here, it must be noted that absolute amount of
dividend is not material. It could be less than what was declared in the
earlier year. But since this (lower) dividend was expected by shareholders,
it was already built in share price ruling prior to dividend declaration.

However, if the dividend declared was higher than the market

expectations, investors start revising their estimates of firm’s future
earnings. This upward revision to future earnings initiates upward
movement in the firm’s share prices.

Dividend lower than what the market was expecting sets downward trend
in expected future earnings from the firm and drop in share prices. Here
again, the fact that the current year dividend is higher than previous year’s
dividend amount has no upward impact on the share prices. This is
explained by the fact that the market had discounted the dividend that was
higher than the one announced into the price ruling on the day of dividend
announcement.

Dividend Amount Share Price

Last
Expected this
Year This year
year

Rs. 10 Rs. 12 Rs. 15 Goes down

Rs. 10 Rs. 12 Rs. 12 Steady no change
Rs. 10 Rs. 12 Rs. 10 Goes up

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 DIVIDEND POLICY AND DECISIONS

Dividend declared in above three situations is the same, but because of the
changing market expectations prices move differently.

Let us conclude that per rational expectations theory, unexpected dividend

declarations convey messages about the firm’s future earnings that were
not built in the ruling market prices of shares earlier and, therefore, cause
changes in share prices.

Thus, on one hand, we have academicians who proclaim that share prices
are independent of dividend decisions and practical thinkers who prove that
dividends do influence market prices of shares.

Video Link 1

13.6 MODEL DIVIDEND POLICY

13.6.1 A Few Major Considerations

• Share values are influenced by business entity’s dividend decisions. The
CFO, therefore, has to devise the dividend policy that optimizes the price
of the stock on the stock exchange.
• The division of net earnings between reinvestment and dividends should
be such that potential investors are attracted to purchase shares and
thus sustain share prices at higher levels.
• Regardless of fluctuations in business entity’s earnings, its dividend
record needs to indicate continuity and stability.
• Dividend payout ratio has to be consistent and dividends should be
increased when there is a strong indication that earnings are healthy and
sustainable.
• Stockholders preferences have to be considered in devising the optimum
dividend policy and appropriate weightage needs to be provided to their
need for current dividend income.
• At the same time, if the business entity is on a growth path and funds
are required for business investments a residual dividend policy may be a
right dividend decision.

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13.6.2 Factors Affecting Dividend Policy

Before finalizing company’s dividend policy, it is necessary for the CFO to

consider various factors like the general state of economy, the state of the
capital market, legal and contractual requirements, existing corporate tax
structure, etc. You will observe that these are all external factors. In
addition, the CFO considers many internal factors like desire of the
shareholders, financial needs of the company, the quantum and nature of
the earnings, desire for control, liquidity position, etc. Let us now consider
each factor and examine how it affects the company’s dividend policy.

13.6.3 External Factors

1. State of Economy

As we examined earlier while considering dividend decision prudently the

CFO, in addition to earnings available, has to consider future flow of
earnings to maintain stability. The level of business activity and earnings
are significantly dependent on the general state of economy. Strong
positive economic indicators prompt the CFO to allocate a larger part of
earnings for dividend. On the other hand, bleak signals for economic
growth or a high degree of uncertainty compel the CFO to be on defensive
and preserve the earnings to be ready to face financial hurdles, if any.

If management is anticipating above average inflation, then it needs to

preserve the funds as they are necessary when the present assets are to
be replaced at higher prices. Existing funds available from depreciation can
take care of the original value of the asset to be replaced, but the balance
funds required to take care of increased price of the asset have to be
sourced from retained earnings. In such inflationary conditions, it is
prudent to restrict dividends.

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2. Capital Markets

Availability of funds also influences dividend decisions. If the conditions in

capital market are comfortable, funds are available when needed with ease
and at fair prices, the CFO is inclined to be generous in allotting surplus
earnings for dividends thereby earning confidence of investors.

On the other hand if the capital market is under pressure it is prudent for
the business entity to conserve its surplus funds to be ready to face any
possible liquidity challenges. In a tight capital market conditions, funds are
not freely available; and funds that are available carry a high interest
burden. Under such situation, by restricting the payout ratio, the CFO
preserves internal funds for use whenever required. These ploughed back
funds are there at economic rates compared to what debt funds command
in a tight capital market.

3. Legal Constraints

The Company Law earlier had imposed upon the management certain
percentages of the retained earnings that must be transferred to the
general reserve. The amounts to be transferred increased with the rise in
the rate of dividends. In 2013, these provisions were withdrawn and now it
is left to management to decide what part of earnings to transfer to
reserve and what part to utilize for dividend distribution.

However, if dividends are to be declared from previous year’s earnings, it

is mandatory that the provisions of the Companies (Declaration and
Payment of Dividend) Rules, 2014 are fully complied. These call for
maintenance of minimum reserve in relation to paid-up capital, providing
for accumulated depreciation or losses, if any. Please refer to 13.04 above.

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4. Corporate Tax Structure

Today, dividend earnings at the hand of shareholders are tax free. The
move is expected to attract investors into share market and thus
contribute to the growth of the organized sector. The company has to pay
dividend distribution tax. But in countries where such exemption on
dividend income does not exist, the CFO has to consider the shareholders’
preferences in restricting their tax burden. If shareholders are in the upper
income bracket, the dividends earned by them attract a high rate of
income tax. They prefer to see the price of their shares rising so that they
can cash on capital gains that attract lesser income tax rates. Lower
dividend policy can satisfy these shareholders as with low payout ratio the
price of equity receives healthy lift and opens an opportunity for capital
gains.

13.6.4 Internal Factors

1. Firm’s Need for Funds

Accrued earnings of a business entity are to be utilized for reinvestment to

ensure business growth and for dividend distribution to satisfy firm’s
investors. Obviously, the dividend policy has to weigh the need for funds
required for financing various projects that have to be implemented to
increase as well as sustain the business of the company.

In a situation where shareholders’ preference is for long-term gains instead

of current income and the company has many profitable projects on hand
with high rate of returns, the development of dividend policy is a straight
affair. Most of the net earnings have to be retained for reinvestment and
balance left to be used for dividend distribution to maintain stability.

Similarly, with a mature company, usually need of funds for reinvestment

is minimal as there are a few project opportunities that can yield
competitive rate of return. Here, if stockholders are keen to receive current
income in the form of dividends, most of the earnings can be used for
dividend distribution and balance left to finance few projects. Formulation
of dividend policy has no difficulty.

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But when internal funds are required for business growth and shareholders
also want dividends in the form of current income instead of capital gains
later, the CFO has unenviable task of balancing the two opposing demand
for fixed amount of funds. The net returns on funds with shareholders in
the form of dividends and return on the projects that can be executed by
investing retained earnings, have to be compared to arrive at a dividend
decision.

2. Business Nature

If the company is engaged in say manufacturing business and steady flow

of earnings is assured, a policy of stable and rising dividends is desirable.
But if the nature of the business is cyclical and future earnings are
variable, a conservative dividend policy suits the situation. Even in a
business boom, a large portion of net earnings has to be carried forward to
take care of ensuing slack phase. The conservative dividend policy also
suits the business units in their early stages of growth when opportunities
for profitable projects exist.

3. Availability of Funds

Companies with healthy credit standing and resulting easy access to capital
markets can, if they find it economical, fulfill opportunities for
remunerative projects through finance from capital market in the form of
debt. Here, the CFO has no compulsions to restrict dividend distribution.
On the other hand, if the company is small, new or otherwise risky or has
already having a high debt-equity ratio, the CFO may find using larger
retained earnings for projects on hand profitable than borrowing from
outside. This situation imposes limits on dividend distribution power of the
CFO.

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4. Maturity of the Business Unit

Normally, newer business units need a major part of earnings for growth
through expansion of activities. The rate at which they grow is on the
increase. Consequently, the number of opportunities for investment with
attractive rate of returns is greater. Naturally, the company will follow a
conservative dividend policy. As the company grows and reaches a stable
rate of growth, requirement for internal funds for investment is normal as
number of opportunities for investment at attractive rates are limited and
there is reasonable access to outside funds at affordable costs. The CFO at
this stage can think of declaring larger dividends. Since the company has
matured, a smaller part of earnings has to be earmarked for investment
and larger portion is available for dividend distribution.

5. Availability of Liquid Funds

We normally assume that highly profitable business units with larger

reserves on their balance sheets have adequate cash for distribution of
dividends. That may not be the case, always. This is more so when the unit
has to hold larger inventories due to longer business cycle (raw stocks at
manufacturing units, large work-in-progress, finished stocks in factories,
warehouses or at customer sites) or significant receivables to meet
competition.

Available cash is often required to meet debt obligations. Here, the CFO
has to balance the requirements of cash today and tomorrow with cash
required to maintain stable dividends. Adequate working capital to sustain
business takes priority over declaration of larger dividends. One of the
factors behind success of business units is their ability to retain adequate
working capital and maintaining large reserves. Liquidity requirements,
thus, play a major part in deciding how much dividend to be paid and
when.

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Dividend history of consumer conglomerate ITC Ltd. over 2008 to

2015
(Excludes 500% special dividend declared in 2011)

6. Ownership and Control

If the company has a small number of shareholders in high tax brackets,

there is hardly any need for regular dividends which add to the individual
income of the shareholders and compel them to more taxes. This
argument, however, is not applicable in India where dividend income is
tax-free as dividend distribution tax is paid by the company. Even in these
companies, management would like to postpone payment of dividend
distribution tax by delaying dividends as far as possible.

If a larger portion of net earnings are distributed as dividends, the

company may have to float additional equity to fund its expansion
programmes. This equity issue results in dilution of control of shareholders
in smaller companies. Hence, these companies would follow conservative
dividend policy with low payout ratio so that need for outside funds is
minimized.

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7. Debt Agreements

Companies with a high debt-equity ratio often are forced to enter into debt
agreements where lenders impose total restriction on distribution of
dividends or permit partial distribution. This restriction allows creditors to
ensure that liquidity of the borrower company is not at stake because of
use of net earnings to declare dividends. If the business entity has entered
in any such type of agreements, then the CFO has to review them before
she makes any announcement of dividends to shareholders.

8. Expansion Plans

Business firms often plan for expansion or automation of their facilities. If

these plans are not for immediate future, it is a sound policy to utilize the
available surplus funds towards above average dividends. This step
significantly improves the firm’s standing in the capital markets. As and
when the funds are required, the firm can enter the capital market
confidently reaping benefits of high credit standing generated by dividends
of the earlier years.

These are the major external and internal factors that play an important
role in the dividend distribution process.

13.7 STOCK DIVIDENDS

Until now, we confined our study of dividends that are distributed to equity
holders in cash. We, therefore, provided to importance to the fact whether
in addition to net earnings, the business entity also had cash reserves or
liquidity to enable it to declare dividends.

Companies have one more option to declare dividends in stocks or

popularly termed bonus issue. In this case, instead of cash, the firm issues
extra shares in a certain proportion, say one bonus share for every five
held. Here, there is no cash distribution, so firm’s liquidity is not affected.
Instead a part of the general reserves/ retained earnings of the company
gets transferred to equity.

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ABC Co. Ltd.

209, University Road,
Pune 411007.
Before stock dividends
Rs.
Common equity 100,000 shares of Rs. 10 each 1,000,000
General Reserves 400,000
Sundry Creditors 150,000
After issue of one share as stock dividend for five shares held
Rs.
Common equity 120,000 shares of Rs. 10 each 1,200,000
General Reserves 200,000
Sundry Creditors 150,000

Issue of stock dividends does not increase equity holders’ cash earnings
per se. But if the firm declares the same percentage of cash dividends next
year, their cash earnings are expected to increase by 20%. Further,
marketability of shares is widened as there are more shares floating in the
market than before. Shareholders have an option to sell additional shares
received and thus book capital gains.

It must be remembered here that before arranging for stock dividends, the
company must assure itself that its earnings are continuing to be robust. If
not, with the distributable surplus showing no growth, it may have to lower
dividend rate as the amount has to be distributed over wider capital (the
effect of bonus shares). This will have negative impact on its shareholders
and its image in the share market.

Creditors to the company welcome bonus issue as firm’s liquidity is in no

way affected by this form of dividend distribution. However, in the
following year if the company maintains the same percentage of dividends,
larger share (to the extent of bonus shares) of net earnings gets allotted
for dividends thereby reducing company’s liquidity.

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The Company Law provides for certain pre-conditions for issue of bonus
shares related to: (i) availability of sufficient distributable profits, (ii)
absence of partly paid shares, (iii) use of only free reserves or share
premium received in cash for capitalization, (iv) minimum residual reserve
percentage, etc.

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13.8 STOCK SPLITS

We observed that issue of stock dividend or bonus shares increase the

amount of paid-up capital and proportionately decreases the amount of
free reserves. In case of stock splits, more shares are issued by reducing
the par value of the shares, so that total equity amount and reserves
remain unchanged. Thus, if the company showed equity of Rs. 40,000,000
consisting of 4,000,000 shares of Rs. 10 each before the stock split; after
stock split, shareholders will have 8,000,000 shares (1:1 split) of Rs. 5
each. The share capital amount in the balance sheet has not changed.

Stock splits result in corresponding fall in the market price of shares

thereby increasing their marketability as they are available at more
affordable prices. With lower prices of shares more investors are likely to
consider investing in them. When the company wishes to secure fresh
equity funds from the markets, lower par value of shares (and
accompanying lower market prices) makes the job of seeking funds from
larger number of investors less difficult.

Stock splits also assist merger or acquisition of companies. Company A

wants to merge with company B and shareholders of company A are
offered one share of company B for every ten shares held by them in
company A. This one for ten ratio looks unattractive to shareholders of
company A. Hence, prior to the scheme of amalgamation is planned, the
company B announces a stock split of five shares at par value of Rs. 2 for 1
share of par value Rs. 10 held earlier. Now when merger scheme is
announced, the company B can offer its five shares (instead of two if stock
split was not there) to shareholders of company A against 10 shares held
by them in company A. The ratio 5 for 10 or 1 for every 2 shares now looks
quite attractive to shareholders of company A.

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ABC Co. Ltd.

209, University Road,
Pune 411007.
Before
Common equity 10,00,000
100,000 shares of
Rs. 10 each
General Reserves 4,00,000
Sundry Creditors 1,50,000 15,50,000
After issue of one share as stock dividend for five shares held
Common equity 12,00,000
120,000 shares of
Rs. 10 each
General Reserves 2,00,000
Sundry Creditors 50,000 15,50,000
After issue of five for one share stock split
Common equity 10,00,000
500,000 shares of 2
each
General Reserves 4,00,000
Sundry Creditors 1,50,000 15,50,000

Thus, you will observe that unlike stock dividend, the stock split does not
increase total equity value of shares held by a shareholder prior to offer of
stock split.

But there are few indirect advantages that can accrue to the shareholders.
To start with, let us assume that shares of the ABC Co. Ltd. were traded at
Rs. 3,500 on stock exchanges. After the split, the market share price drops
down to Rs. 700 (Rs. 3,500 ÷ 5). Many small investors who were not
willing to trade in ABC CO. Ltd. shares earlier because of its high market
price of Rs. 3,500 will now enter the market as the price has come down to
only Rs. 700 which is well within their reach. With more number of
investors for ABC in the market, the share price of ABC now can go up.

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However, this is hard to prove as there are several other factors that
influence share prices.

Companies normally do not prune down the dividends after the split by the
split ratio. If ABC had declared a dividend of Rs. 10 per share prior to split,
it will not bring down the dividend for the following year to Rs. 2 (Rs. 10 ÷
5). It will in all probability declare a dividend of at least Rs. 2.50. Thus,
shareholders are going to receive Rs. 12.50 (Rs. 2.50 × 5) against Rs.
10.00 they received per share last year.

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Video Link 2

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13.9 SUMMARY

Retained earnings of the company can either be used to reinvest in new

projects of the company that generate further revenue and assure
continuous growth or distributed to stock holders as dividends for the funds
provided by them to start the business. Ideally, the finance managers
should determine what rate of earnings the shareholders would receive
from the dividends distributed to them, if that rate is higher than the rate
of earnings from reinvestment in company’s future projects, then it is clear
that available funds can be distributed as dividends. This is termed
Marginal Principle of Retained Earnings. Here, we have tacitly assumed that
the active base for issue of dividends is retained earnings and not the need
for dividends.

However, when investors put their funds into company’s equity stock, they
expect to receive returns, usually more than what they would receive from
investment in term loans/deposits. Some want this return immediately and
at a reasonable fixed rate and balance wish long-term gains usually in the
form of appreciation the market value of their shares. Additionally, there is
a class of investors who want both above. Shareholders’ preference along
with the need for funds by the company together is considered by CFOs to
determine the part of the net earnings to be distributed as dividends.

Other factors that influence dividend decisions are the need for informing
investors about company’s bright prospects, availability of liquid assets,
access to the Financial Markets and Income Tax considerations.

The Companies Act 2013 allows CFOs to determine what proportion of net
earnings has to be retained by them as reserves with the company. Earlier,
these percentages were defined by the Act. The Act further states that,
after declaration of the dividend, the company shall deposit amount of
dividend (including interim dividend) in separate account with a scheduled
bank.

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Two economists, Miller and Modigliani, have propagated that market value
of a company depends on its earning power and whether these earnings
are retained in the business for reinvestment or distributed to its
shareholders in the form of dividends has no relationship with firm’s
market value of shares. On the other hand, Professor James E. Walter
argues that the choice of dividend policies almost always affects the value
of the enterprise. Second very popular model explicitly relating the market
value of the firm to dividend policy is developed by Myron Gordon.

The third school of thought on dividends is based on the premise that what
matters is not the actual dividend amount but the difference between what
was expected to happen and the actual event. This was enunciated by John
F. Muth in his paper entitled “Rational Expectations and the Theory of Price
Movements”.

External factors that affect company’s dividend policy include: (a) state of
economy, (b) capital markets, (c) legal constraints and (d) corporate tax
structure. While internal factors that determine dividend policy include: (a)
firm’s need for funds, (b) business nature, (c) availability of funds, (d)
maturity of business unit, (e) availability of liquid funds, (f) debt
agreements and (g) company’s’ expansion plans.

Dividends are sometimes also offered in the form stock dividends or stock
splits.

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13.10 MULTIPLE CHOICE QUESTIONS

Mark (x) against the most reasonable alternative.

1. Manda and Kunda, MBA students were discussing Marginal Principle of

Retained Earnings related to dividend policies of MNCs. They agreed
that the principle called for determining rate of returns if net earnings
are reinvested in in the business activity conducted by MNCs. But they
failed to recognize how this rate of return is used in the principle. What
is your advice to them?
(a) Compare this rate with what investors earn on term deposits
(b) Compare this rate with what investors earn on public provident fund
(c) Compare this rate with what investors would earn on their next
investment
(d) Compare this rate with the firm’s rate of return in the previous year

2. Whether to distribute larger part of net earnings as dividends now or

later mainly depends upon __________.
(a) Creditors’ terms in loan agreements
(b) Advice of the bankers to the equity issue
(c) Board of directors’ preferences
(d) Stockholders’ preferences

3. Availability of ___________ is one of the major considerations in

deciding the volume of net earnings to be distributed as dividends in a
particular year.
(a) Liquid assets
(b) Funds in the general reserve
(c) Credit manager’s approval
(d) Stock dividends

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4. If a company fails to earn net earnings/profits in a particular year, the

rules published under Companies Act, 2013 __________.
(a) Do not permit declaration of dividend in that year
(b) Permit declaration of dividends up to 50% of the previous year
(c) Permit declaration of dividends from reserves on complying with
a few stipulations
(d) Permit only stock dividends as cash is not involved

5. The rational expectations model of __________ is based on the premise

that what matters is not the actual dividend amount but the difference
between what was expected to happen and the actual event.
(a) John F. Muth
(b) Myron Gordon
(c) James E. Walter
(d) Modigliani-Miller

Answers: 1. (c), 2. (d), 3. (a), 4. (c), 5. (a).

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REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter

Summary

PPT

MCQ

Video Lecture - Part 1

Video Lecture - Part 2

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 FOREIGN EXCHANGE MARKET

Chapter 14
Foreign Exchange Market
Objectives
After studying this chapter, you should be able to understand:
• Transactions of Foreign Exchange Market
• Arbitrage and speculation in Foreign Exchange Market
• Fx Trading Spreads, Premium, Discount and exchange Arithmetic
• International Bond Financing
• Financial structure of subsidiaries of MNCs

Structure:
14.1 Introduction
14.2 Transactions of Foreign Exchange Market
14.3 Nature of foreign Exchange Spot Market
14.4 Arbitrage and speculation in Foreign Exchange Market
14.5 Foreign Exchange Trading Spreads
14.6 Exchange Arithmetic
14.7 Spread, Premium and discount
14.8 International Bond Financing
14.9 Determining Financial structure of Foreign Subsidiaries of MNCs
14.10 Summary
14.11 Multiple Choice Questions

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14.1 INTRODUCTION

Forex is derived from the term of the foreign exchange market and foreign
exchange market is introduction of buying and selling of currencies. Forex
needs a lot of buying of one currency in exchange for other currencies. This
offers unlimited possibilities of large profits from exchange market. The
major currencies traded are the U S dollar, Indian rupees. Japanese yen,
Pound sterling and the Euro. The change means that the currencies traded
in pairs and exchanged one against the other when they are traded. The
first currency currency pair is called the quote currency and second
currency is called as Base currency. The quote currency is at the
numerator while the base currency is at the denominator. The exchange
rate show how much we receive in exchange from dealer when selling
currency is the denominator. The exchange rate show how much we
receive in exchange from dealers when selling one unit of base currency. It
is market where foreign currencies are bought and sold. It broadly
comprises of:
Customer Market
It comprises of transactions between bank (authorized dealers) and their
customer. Such transactions are of two types, vis., Ready delivery and
Forward delivery.
Interbank Market:
It comprises of:
• Transactions between different bank in the same Center/country.
• Transactions between bank in a country with central banks of other
countries.
• Interbank foreign exchange dealings are of four types:
‣ Cash-same day delivery
‣ Tom-delivery on second successive working day
‣ Spot-delivery on second successive working day
‣ Forward-delivery beyond second successive working day

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14.2 TRANSACTION OF FOREIGN EXCHANGE MARKET

In foreign Exchange Market it is possible to lend and borrow foreign

currency, the market opened up the door to a wide range of arbitrage
transaction between countries and currencies. The new opportunities
increased in the international mobility of financial capital particularly as the
market operated in a legal vacuum. At that time, no national legislation
was able to control national banks’ transactions in foreign currency or non-
resident banks transactions in domestic currency. The market based at its
foreign exchange transactions on purely financial rationality which had no
connection with trading and foreign direct investment needs. Currencies
were henceforth fully-fledged financial assets and income part of
international asset management strategies. The fundamental question of
how foreign exchange transaction have contributed to exchange rate
stability or instability remains unanswered.

14.2.1 Spot Foreign Exchange Market

A Foreign exchange spot market is a market for trading one currency

against which the delivery takes place within two days of the execution of
the trade. It usually takes two days to transfer cash from one bank to the
other. The price is based on the ongoing exchange rate. i.e., the current
value of one country’s currency.The forex future market is minor derivative
of this market and it size is 1/100th of that of the foreign exchange spot
market.

14.3 NATURE OF FOREIGN EXCHANGE SPOT MARKETS

A currency’s spot rate expressed at its value relating to the Indian Rupees
i.e., the number of Indian Rupees needed to buy one unit of the other
currency. A foreign exchange spot market allows a company to buy or sell
a foreign currency according to its requirements. But even the daily
movement in spot exchange rate are characterized by several vagaries so
those operating in this market are speculators rather than trend followers.
For this reason, it exposes an entrepreneur’s cash management to number
of unpleasant alterations in foreign currencies. The spot rate of a currency
can be affected due to various reasons such as the current and future
expectations about the inflation rate, BOP (balance of payments) situation,
policies created by government and central bank and other economic
indicators of the currency.

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Reasons for the Trades to be settled on the Spot

Foreign exchange spot market is the most common from currency trade
because if the contracts are settled afterwards then the trades might ask
for compensating against the value that the money has gained over the
duration of delivery. So, these contracts are settled instantaneously sing
the electronic forex systems.

14.3.1 Forward Foreign Exchange Market

A forward FX contract is a deal to exchange currencies to buy or sell a

particular currency at an agreed date in the future at a rate a price agreed
now. This rate is called as the forward rate. Bank will provide forward FX
quote on more or less any currency pair. Forward value dates are
calculated out of spot value dates, which are in turn calculate out of the
transaction date. The spot vale dates are two business days after the
transaction date. Traditional FX forwards are available for maturities from
two days out to about two years. As such forward FX is the over-the-center
OTC equivalent of currency futures. Both contract types allow transactors
to take a view on the direction and extent of future spot FX rate,

These hedgers fall into three broad categories.

1. Corporate and retail clients with underlying business reason to use FX
are typical risk averse. They like the comfort of fixed future revenue
stream from international transactions.
2. International portfolio managers may also use forward FX for much the
same reason to secure the value of future investment returns (e.g.,
foreign currency denominated bond coupon payments)
3. Bank uses forward FX contract mainly for liquidity management. They
combine a forward FX trade with a spot FX trade to create a two-way
deal called an FX swap.

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14.3.2 Futures of Foreign Exchange Market

Foreign exchange future market refers to a type of financial derivative in

which two parties enter into a contract to buy/sell a particular currency at
a pre-determined price on a specific future date. A foreign exchange future
market provides an opportunity to hedge risk and speculate against the
exchange rate fluctuations.

• Evolution of Foreign Exchange Future Market.

Foreign exchange future markets basically replaced the nation of ‘par
value exchange rates’ which was then adopted by many other exchanges
in finical instruments like futures are nowadays also used in hedging
stock exchanges and interest rates.

• Foreign Exchange Future Market Gains over Traditional Futures

Foreign exchange future market, also popularly known as forex futures
market, constitutes only 1% of the foreign exchange future market is
same as the of traditional futures contract in the sense that both are
used to buy sell an asset (a specific amount) at an agreed price on a
particular future date. The two are however buy or sell and in case of a
foreign exchange future market none of the parties involved in buying or
selling any commodity other than currencies. Traditional futures are
traded on Centralized stock exchanges whereas the deal flow of foreign
exchange future market is available through many different exchanges in
the home and foreign country. But this does not imply that foreign
exchange future market is quoted in OTC (Over the Counter). They have
a designated ‘size per contract and are available in whole numbers.

Other Feature of a Foreign Exchange Future Market.

I. A foreign exchange future market is ‘market to market’ thus making it a
portfolio of forward contract that are adjusted daily for cash
settlements. This in fact mitigates the credit risk to every large extent.
II. These are carried out through the clearing house of the exchange. The
margin payments accrue to the exchange and the exchange ensures the
proper functioning of the contract.
III.A foreign exchange future market contract rarely results in a delivery. It
is used by parties, as it is a highly liquid way of hedging and speculating
and efficient transactions can be fixed up without delay.

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14.3.3 Options of Foreign Exchange Market

A currency option is a contract that gives the holder the right, but mot the
obligation to buy or sell a specified foreign currency during a specific time
period. It can be used to hedge a forex trading transaction and are a
favored method of reducing risk in companies that trades goods overseas.
There are two basic types of option. A call option gives the holder the right
to buy currency while a put option gives the holder the right to sell. The
worth of an option at expiry is equal to the value realized by the holder in
exercising the option. If the holder gains nothing, the option worth
nothing. The value at any other time of the contract duration is the
‘intrinsic value’ the value that can be realized if the holder exercises his
option. Intrinsic value is linked to the ‘strike price ‘the value specified by
the option contract. A call option has intrinsic value if the spot (current)
price is above the strike price. A put option has intrinsic value if the spot
price is below the strike price. If the option contract has intrinsic value it is
said to be in the money’, otherwise it is ‘out of the money or at the money
(par). Options would only be exercised if they are in the money. Options
are priced according to complex formulas that take into consideration both
the spot, the spot value and time value. Time value is calculated according
to expected market conditions including volatility and the difference in
interest rate between the two currencies. Currency options are used in
forex to minimize risk against unexpected move in the market. If we buy
an option, our losses are limited to the cost of the option. Those who sell
options are more vulnerable. They gain the premium but they are exposed
to unlimited loss if the market moves against them.

As a hedging tool, there are many different types of options available. They
are often used by companies that trade overseas to minimize the potential
loss due to fluctuation in the foreign exchange market. Forex trades have a
special type of option available know as a digital option. This option pays
specified amount at expiration if the criteria are met, otherwise it pauses
nothing. Forex traders who wish to use a digital option first decide which
direction the market is moving. They then decide on a payoff amount if the
market moves as expected within a certain time frame. With this
information the cost of the option is calculated. One assumes that one is
buying an asset: for instance, we can have a call option on oil, which
allows us to buy oil at a given price. One can consider this situation more
symmetrically in FX. People usually consider that in a fast-food restaurant,

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one buy hamburgers and pays in dollars, but one can instead say that the
restaurant buys dollars and pays in hamburgers.

There are number of subtleties that follows form this symmetry.

I. Ratio of Nationals
The ratio of the national in an FX option is the strike, not the current, spot
or forward. Notable, when constructing an option strategy from FX options,
one must carefully match the foreign currency nationals, else the foreign
currencies received and delivered do not offset and one is left with residual
risk.

II. Non-Linear Payoff

The payoff for a vanilla option is linear in the underlying when one
denominates the payout in given numeraire. In the case of an FX option on
a rate, one must be careful about which currency is underlying and which
is numeraire.

III. Change of Numeraire

The implied volatility of an FX option depends on the numeraire of the
purchaser, again because of the non-linearity of x®1/x.

14.3.4 Foreign Exchange Swaps

Foreign exchange swaps have appeared for some time in the intervention
toolkit of many central banks around the world, although their popularity
seems to be on the wane. This use partly reflected the limited depth of
domestic debt markets associated with limited fiscal deficits historically
incurred by the Swiss government. Formally, a foreign exchange (FX)
swaps a financial transaction whereby two parties exchange agreed-upon
amount of two currencies as a spot transaction, simultaneously agreeing to
unwed the exchange at future Data based on rule that reflects both
interest and principal payments

When the initiating agent is a central bank the motivation for undertaking
the swap is usually either to affect domestic liquidity or to manage foreign
exchange reserves.

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14.4 ARBITRAGE AND SPECULATION IN FOREIGN

EXCHANGE MARKET

It took advantage of the flaws inherent in the gaolable fiat monetary

system. These speculators that include international financial institutions
and fund managers, are very knowledgeable about financial markets,
economic cycles, etc.

They use this knowledge to “attack” currencies, etc. to reap huge profits.
The huge economic bubble that hovered over the East Asian countries,
created by the fiat money credit bubble, lured these speculators to attack
the currencies of these countries by shorting them. Collective action of
speculators would amount to an attack on the currency. While the central
bank may counter such attacks to keep exchange rate within reasonable
levels, a continues attack can be difficult for the central bank to match.

While speculators can take on huge leveraged positions, the central bank
would need large number of foreign reserves to counter this, Inability to
match the speculators would cause the exchange rate to lunge as
happened to the Asian currencies. While one may argue that it is ethically
not right for speculators to attack a currency. It is the current global
monetary system that allowed them to do so. When an exchange rate
moves due to speculative attacks or otherwise. It breaks the equilibrium
among currencies. This makes it possible for further profiteering called
arbitrage profits. Arbitrage is like finding money on the ground.

By attacking the currency as such, the traders make two types of profits:
1. Speculative profit and
2. Arbitrage profits

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14.4.1 Speculative Profit

Speculative profit comes from the speculating that a currency would
appreciate or depreciate (either due to economic factors or the speculative
attacks themselves or even both). If the speculation is correct, then the
traders would make profits, however, if their speculation turns out to be
wrong, they will then make losses, there is another profit to be made the
arbitrage profit.

14.4.2 Arbitrage Profit

Arbitrage profit is made from the mispricing or disequilibrium among the
exchange rates. In our example, this disequilibrium happened when the
ringgit exchange rate moved. Arbitrage profits are realized at a point in
time unlike speculative profit that require a span of time.
In the following example, the arbitrage profit made as below.
Step 1: Borrow money and exchange it into RM3 million (at the new
prevailing exchange rate of RM3.80 per unit.
Step 2: Exchange the RM3.8 million into other (at the exchange rate of
RM1.50 per unit)
Step 3: Exchange the money into 1.5833 million (at the exchange rate of
1.60 per unit)
Step 4: Return bank the loan.
Types of Arbitrages
a. Arbitraging between Banks: All banks in a market do not necessarily
have identical quotes for a given per of currencies at a given point of
time. Hence, it may be possible for an active market player to do
arbitraging and make some gain.
b. Inverse Quotes and Two-Point Arbitrage: Two-point arbitrage
means buying a currency in one market and selling it at a higher price
in another market. It is also known as space arbitrage.
c. Cross-Rate and Three-Point Arbitrage three arbitrage, three
currencies are involved. Start with currency a, sell it for currency B, sell
currency B for currency C and finally sell Currency C bank for Currency
An ending up with more amount of currency.

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14.5 FOREIGN EXCHANGE TRADING SPREADS

In order understand the foreign exchange trading spread, we need to know

what it is. A foreign exchange trading spread is the difference between the
ask price (the price we buy at) and the bid price (the price we sell at) that
is quoted in the pips. The pips are the smallest unit of difference between
the two currencies in the quote. Example if the quote between EUR/USD at
a given moment is 1.2222/4, then the foreign exchange trading spread
equals 2 pips, the difference between the 2 and the 4. If the quote is
1.22225/4, then the foreign exchange trading spread is going to equal 1.5
pips. The foreign exchange trading spread is how brokers make their
money. Wider foreign exchange trading spreads will result in a higher
asking price and lower bid price. The result of this is that will pay more
when we buy and get less when we sell, making it more difficult to realize
a profit. Brokers generally do not earn the full spread, especially when they
hedge client positions. The spread helps to compensate the brokerage for
the risk it assumes from the time it starts a client trade to when the
broker’s net exposure is hedge (which could possibly be at a different
price). Foreign exchange trading spread affect at return on trading storage
in a big way. As a trade, the sole interest is buying higher and having to
sell low and selling high (like futures and commodities trading). Wider
foreign exchange trading spreads means buying higher an having to sell
lower. A half-pip lower spread does not necessarily sound like much, but it
can easily mean the difference between a profitable trading strategy and
one that is not. The tighter the foreign exchange trading spread is the
better things are going to be for us. But tight foreign exchange trading
spreads are only meaningful when they are parried up with good
execution. A good example of this is when the screen shows a tight foreign
exchange trading spread, but our trad is filled a few pips in the wrong
direction or is mysteriously rejected. When this occurs repeatedly. It
means that the broker is showing tight foreign exchange stop hunting are
foreign exchange trading strategies that some brokers us to get rid of the
promise of tight spreads. Foreign exchange trading spreads show always
be considered in conjunction with depth of book. Oddly enough, when it
comes to economies of scale, forex does not even act like most other
markets. On the inter-bank market, for example: the larger the ticket size,
the larger the foreign exchange trading spread is. In many cases, the tight
spread that is offered applies only to a capped trade sizes that do not
works for most the common foreign exchange trading strategies.

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Video Link 1

14.6 EXCHANGE ARITHMETIC

In bank, when we take of foreign exchange, we refer to the general

mechanism by which a bank convert currency of one country into that
another. Foreign Trade gives rise to foreign Exchange. Foreign Trade is
transacted either in the currency of the exporter’s country or that of the
imports country or that of tried country like Pound, Sterling, U.S Dollars
etc. acceptable to both the exporter and the importer. In Foreign trade, the
export suppliers the goods and the importer have to make payment of the
price of those good. The important however will make payment in his
nation’s currency and the exporter will require payment in his country’s
currency. This, therefore, involves conversion of currencies and transfer
found from one country to another. Foreign exchange is thus the
concomitant to Trade. It is the general mechanism by which the settlement
of debt arising out of the operations of international trade, services and
finance is affected. This requires the conversion of the currency of one
country into its equivalent in the currency of another country. Foreign
exchange rate computations involve several calculations which can be best
understood by example.

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14.7 SPREAD, PREMIUM AND DISCOUNT

The forex spread is the difference between the value of the buy and sell
rate of currency pair. This spread is normally employed to cover the
expenses which the broker agents, the FX brokers and the market and the
market come across. The truth is regardless of what market we deal with
there would continually be fees that the agents and the brokerage would
have to pay for and of course the fees would have come from the forex
traders. It might genuinely appear unfair if one is providing the service the
other would be the one to pay for the fees. It simply just looks proper that
the ones using the service would be the ones to pay extra fees. The fees in
the stock market are usually not obtained from a “spread” conversely there
exists a fee that a trade needs to pay for every stock and share that he/
she buys. In the import market there would always be delivery costs, labor
costs and very much more. This spread is achieved by looking at just how
much would take to successfully enter a trade with the currencies involved.
In some currency pairs the charges might be a tad greater compared to
other pairs. The spread is usually the same in most brokerages, but we will
see some FX broker who have bigger spreads of the fact that they have to
cover a lot of core changes that we do not have to worry ourselves with.
Only one forex trader would not be able to cover all the expenses that the
market would experience: the good thing is there are far more than a
million investors out there. If we were to multiply that by one forex trader
would not be able to cover all the expenses that the market would
experience; the good thing is that, there are far more than a million
investors out there. If we were to multiply that by one of the lowest
spreads in forex than that would imply at the ever least 3 million.

Amongst the Fastest Growing Forms of One-Line Stocks trading today is

Binary Options.

One of the fastest growing forms of online stocks trading today is binary
options. It is a trading vehicle wherein traders are expected to bid whether
a particular asset will go up or down within a specified length of wherein
traders are expected to bid whether a particular asses will go up or down
within a specified length of time.
Option Fair Review: Easy Method to Trade Binary Option on the Internet

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Choosing between the various online brokers out there for binary options
can be challenging. To help with making a good choice, examine a few
important categories and factors that take make or break an online broker.

The Actual Disadvantages of Forex Trade Fundamental Assessment

Fundamental analysis has its advantages but where there are advantages
there are sure to be disadvantages to be found just around the corner.
Besides, there is no such thing as a sure thing right?
Why we should trade forex investment in the first place: a forex technical
analysis trader understands
There are a lot of reasons why people trade forex: the most common
reason would be the possibly high earning that we can earn, while for
others they just like the thrill of the market.
Premium and Discount
Futures prices at any given time are often different than their underlying
commodity spot prices (the difference is sometimes referred as basis)
For Example, gold futures prices are virtually always above the cash (spot)
price of gold. The reason is that gold prices are volatile and are assumed to
go up over time when we buy gold contracts pay a little (or a lot) extra to
lock in our price for the delivery down the road.

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14.8 INTERNATIONAL BOND FINANCING

A company needs funds to expand into new markets, while governments

need money for everything from infrastructure to social programs. The
problem large organization run into is that they typically need far more
money than the average bank can provide. They solution is to raise money
by issuing bond (or other debt instruments) to a public market. Thousands
of investors then each lend a portion of the capital needed. Really, a bond
is nothing more than a loan for which we are the lender. The organization
that sells a bond is known as the issuer. The issuer a bond must pay the
investor something extra for the privilege of using his or her money. This
“extra” comes in the form of interest payments, which are made at a
predetermined rate and schedule. The interest rate is often referred to as
the coupon. The date on which the issuer has to repay the amount
borrowed (known as face value) is called the maturity date. Bonds are
known as fixed- Income securities because we know the exact amount of
cash we will get back if we hold the security until maturity.

14.8.1 Debt Versus. Equity

Bond are debt, whereas stocks are equity. This is the important distinction
between the two securities. By purchasing equity (stock) an investor
becomes an owner in a corporation. Ownership comes with voting rights
and the right to share in any future profits. By purchasing debt (bonds)
investor become a creditor to the corporation (or government). The
primary advantage of being a creditor is that we have higher claim on
assets than shareholder do: that is in the case of bankruptcy, a bondholder
will get paid before a shareholder, However, the bondholder does not share
in the profits if a company does well, he or she is entitled only to the
principal plus interest. To sum up there is generally less risk in owning
binds than owning stocks.

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14.8.2 Problems of Bonds

It is an investing axiom that stock returns more than bonds. Bonds are
appropriate any time we cannot tolerate the short-term volatility of the
stock market. There are two situations where this may be true:

1. Retirement: The easiest example to think of is individual living off a

fixed income. A retiree simply cannot afford to lose his / her principal,
as income for it is required to pay the bills.

2. Shorter Time Horizons: It is true that stock market provides the

opportunity for higher growth, which is why his / her retirement fund is
mostly in stocks, but executive cannot afford to take the chance of
losing the money going towards his / her education. Because Money is
needed for specific purpose in the relatively near future, fixed income
securities are likely the best investment.

These two examples make clear cut that they don’t represents all
investors. Most personal financial advisors advocate maintaining the
diversified portfolio and changing the weighting of asset classes throughout
our life.

For example, in our 20’s and 30’s a majority of wealth should be in

equities. In our 40’s and 50’s the percentage shifts out of stocks to bonds
until retirement, when majority of our investments should be in the form of
fixed income.

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14.8.3 Characteristics:

Bonds have number of characteristics of which we need to be aware. All of

these factors play a role in determining the value of the bond and the
extent to which it fits in to our portfolio.

• Face value / Par Value:

The face value (also known as par value or Principal) is the amount of
money a holder will get back once bond matures. A newly issued bonds
usually sells at par value. Corporate bond has normally had par value of
Rs. 47,000 but this amount can be much greater for the government
bonds. What confuses many people is that the par value is not a price of
the bond. A bond price fluctuates throughout its life in response to number
of variables. When bond trades at price above the face value, it is said to
be selling at premium. When a bond sells below the face value, it is said to
be selling at discount.

• Coupon (The interest rate):

The coupon is the amount the bondholder will receive as Interest payment.
It is called as coupon, because sometimes there are physical coupons on
the bond that we tear off and redeem for interest. However, this was more
common in the past. Nowadays, records are more likely to be kept
electronically. Most bond pay interest every 6 months, but it is possible for
them to pay monthly, quarterly or annually. The coupon is expressed as
percentage of the par value. If bond pays coupon of 10% and its par value
is Rs. 47000, then it will pay Rs. 4700 of interest a year. A rate that says
as fixed percentage of the part value like this is fixed rate bond. Another
possibility is an adjustable interest payment, known as floating rate bond.
In this case the interest rate is tied to market rates through and index,
such as the rate on Treasury bills.

We might think investors will pay more for high coupon than for low
coupon. All things being equal, a lower coupon means that the price of the
bond will fluctuate more.

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• Maturity:

There is the date in the future on which investor’s principal will be repaid.
Maturities maturity date can range from as little as one day to as long as
30 years (though the term of 100 years has been issued). A bond that
matures in one year is much more predictable and thus less risky than the
bond that matures in 20 years.

Therefore, in general, the longer the term maturity, the higher the interest
rate. Also, all things being equal, a longer-term bond will fluctuate more
than a shorter-term bond.

• Issuer:

The issuer of Bond is crucial factor to consider, as issuer stability is our

main assurance of getting paid back. For Example, the Indian Government
is far more secure than any corporation. Its default Risk (the chance of
debt being not paid back) is extremely small, so small that Indian
government securities are known as risk free assets. The reason behind
this is that a government will always be able to bring in the future revenue
through taxation. A company on other hand, must continue to make
profits, which is far from the guaranteed. This added risk means corporate
bond must offer a higher yield in order to entice investors this is the risk /
returns trade off in action. The bond rating system helps investors
determine a company’s credit risk. Think of a bond rating as the report
card for company’s credit rating. Blue Chip Firms, which are safer
investments, have a high rating, while risky companies have a low rating.
The table below illustrates the different bond rating scales from the major
rating agencies.

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Bond Rating
Grade Risk
Moody’s S& P / Fitch
Aaa AAA Investment Highest Quality
Aa AA Investment High Quality
A A Investment Strong
Baa BBB Investment Medium Grade
Ba, B BB, B Junk Speculative
Caa/Ca/C CCC/CC/C Junk Highly Speculative
C D Junk In default

Notice that, if the company falls below certain credit rating, its grade
changes from investment quality to Junk status. Junk bonds are aptly
named: They are the debt of companies in some sort of financial difficulty,
because they are so risky, they have to offer much higher yields than any
other debt. This brings up an important point, not all the bonds are
inherently safer than stocks. Certain Types of the bond can be just risky, if
not riskier than stocks.

14.8.4 Different Types of Bonds:

• Government Bonds:
In general, Fixed income securities are classified according to the length of
time before maturity. There are 3 main categories:
1. Bills: Debt securities maturing in less than one year.
2. Notes: Debt securities maturing in 1 to 10 years.
3. Bonds: Debt securities maturing in more than 10 years

Markable securities from the Indian Government known collectively as

treasuries follow this guideline and are issued as treasury bonds, treasury
notes and Treasury bills (T-Bills). Technically speaking, T – Bills are not
bonds because of their short maturities. The debts of many developing
countries, however, does carries substantial risk. Like companies, countries
can default in payments.

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• Municipal Bonds:

Municipal Bonds, known as “Munis”, are the next progression in terms of

Risk. Cities do not go bankrupt, but it can happen. The major advantage to
munis is that the returns are free from federal tax. Furthermore, local
government will sometime make their debt non-taxable for residents, thus
making some municipal bonds completely tax free. Because of these tax
savings, the yield on munis is usually lower than that of taxable bonds.
Depending on the personal situation municipal bonds can be great
investment on an after-tax basis.

• Corporate Bonds:

A company can issue corporate bonds just as it can issue stocks. Large
corporation have lot of Flexibility as to how much debt they can issue: the
limit is whatever the market will bear. Generally, a short-term corporate
bond is less than 5 years, intermediate is 5 to 12 years, and long term is
over 12 years. Corporate bonds are characterized by higher yields because
there is higher risk of company defaulting than government. The upside is
that they can also be the most rewarding fixed income investments
because of the risk the investor must take on. The company’s credit quality
is very important: the higher the quality, the lower the interest rates the
investor receives.

Other variations on corporate bonds include convertible bonds, which the

holder can convert into stocks, and callable bonds, which allow the
company to redeem an issue prior to maturity.

• Zero-Coupon Bonds:

This is type of bond that makes no coupon payments but instead is issued
at considerable discount to par value. For example, let’s say a zero-coupon
bond with and Rs. 47,000 par value and 10 years to maturity is trading at
Rs. 3000, we would be paying Rs. 3000 today for bond that will worth
Rs.47,000 in 10 years.

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In the end we can say.

‣ Buying a bond means we are lending out our money
‣ Bonds are also called Fixed-income Securities because cash flow from
them is fixed.
‣ Stocks are equity, bonds are debt.
‣ The key reason to purchase bonds is to diversify our portfolio.
‣ The issuer of bonds are Government and Corporations.
‣ Bond is characterized by its face value, coupon rate, maturity and issuer.
‣ Yield is rate of return we get on the bond
‣ When price goes up, yield goes down and vice versa.
‣ When interest rate rise, the price bond in the market falls and vice versa.
‣ Bills, Notes, and bonds are all fixed income securities classified by
maturities.
‣ Government bonds are safest bonds, followed by municipal bonds and
then corporate bonds
‣ Bonds are not Risk free, It is always possible especially in case of
corporate bonds for the borrower to default on the debt payment.
‣ High risk / high yield bonds are known as Junk bonds.
‣ We can purchase most bonds through a brokerage or bank brokers will
not charge a commission to buy bonds but will mark up the price instead.

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• Euro Bond and Foreign Bonds:

International bonds can be euro bonds and foreign bonds. The distinction
depends on whether borrower is domestic or foreign resident or whether
issuer is dominated in the domestic or foreign currency. A euro bond issue
is underwritten by an international syndicate of banks and other financial
institutions and placed in the countries other than the country in whose
currency the issue is denominated. A foreign bond is underwritten by
syndicate consisting of members from a single country, sold primarily
within that country and denominated in its currency. The issuer or
borrower is however in foreign. Even if borrower is not particularly
interested in currency of the issue, the funds raised can be swapped for the
currency. The euro bond market, which is the extension of the offshore or
the external financial markets, has emerged because of some of the same
factors that have to the emergence of the euro currency market or market
for the short -term euro currency funds. These includes.
(i) The absence of regulatory interference
(ii) Less Stringent disclosure requirement and
(iii) Favourable tax status, as interest income is not subject to income and
withholding tax.
Main steps involved in bond issuance:
1. Securitization
2. Bond Issuance
3. Trading of debt certificate.

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1. Securitization:

Asset Securitization is the essence of Islamic bond issue, as bond must

assume the role of AL-mal or property to qualify as an object of the sale.
An object of the sale in the Islamic law of contract must be property of the
value. When a bond certificate is supported by an asset as evidenced via
securitization process, it is transformed into an object of the value and
therefore qualifies to become an object of the trade whereby it can be
purchased and sold in the both the primary and secondary market.
Investors then will have right to sell these bonds. In the bay al-inah asset
securitization, the financier purchases an asset from the issuer and sell it
back to the same party at a credit price. This buy back agreement will
ensure that the issuer will receive the money in cash while financier will be
paid as prefixed or contracted amount in future date. Debt payment will be
made by installment through bonds issues. The difference between the
cash and mark up price will represent the profit due to the financier.

2. Bond Issuance:

This usually takes place in primary market where in settling the debt, the
issuing company will sale debt, issuing company will sale debt certificate or
bonds to investors. As mentioned above, debt certificates issued issues are
valid only when it is supported by an asset. In other words, the bonds
must be securitized.

3. Trading of Dept Certificate:

For Liquidity purposes, bond trading in the secondary market is crucial.

However, almost all Islamic bonds today were brought for long term
investment. The lack of secondary market however should not imply that
trading issues is no longer significant. This calls the need to explain the
Islamic view of bond trading in the secondary market.

Video Link 1

Video Link 2

Video Link 3

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14.9 DETERMINING FINANCIAL STRUCTURE OF FOREIGN

SUBSIDIARIES OF MNCS

In the past many multinational corporations (MNCs) sought to treat all

their foreign subsidiaries in the same way. Nowadays, many MNCs know
that individual subsidiaries might have individual tasks to fulfill and might
therefore take on different roles. However as will be shown, most studies
which provides evidence of the differentiation of subsidiary roles are
primarily concerned with Asia based or European MNCs and not with
Japanese MNCs and introduces one role a foreign subsidiary can have the
role of centre of competence.

14.9.1 Strategic Relationship:

The strategic relationship to MNCs emphasizes that the central concern of

management is the development and implementation of the MNCs
strategy. Control and coordination requirements emanate from the firm’s
strategy. Consequently, early proponents of the perspectives examined the
fit between MNC strategy and structure (e.g., bureaucratic controls). The
current strategic perspective stresses that MNCs need to develop
competitive advantage by being responsive to different strategic
requirement such as product and market diversity and economic efficiency.
Thus, today’s MNCs pursue a wide verity of strategies. These range from
global strategies in which firm uses a standardized approach in each
national market. As a result, subsidiary is no longer regarded as simply a
pipeline from headquarter to specific market. Instead, the focus is more on
differential ability of each subsidiary to contribute to MNCs worldwide
competitive strategy. This focus on competitive advantage indicates that
strategies as well as control mechanism serve to link the MNC
headquarters with its subsidiaries. The next section reviews the literature
which emphasizes this strategic linkage.

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14.9.2 Strategic Subsidiary Role:

During the past few years, a relatively small body of literature has
examined the strategic functions of foreign subsidiaries within MNCs. Most
of the studies use 2 factors to depict the subsidiary’s situation. However, a
summary of all of the factors depicted in suggest that choice of subsidiary
role within MNC is based on at least 3 situational factors: it’s degree of
integration with headquarters; the subsidiary’s own competencies / skill;
and the characteristics of the local environment. Each study differs in both
the number and type of subsidiary roles observed. These differences seem
to be due to the fact that most of the studies have either; been conducted
independently and have not had the benefit of building on each other;
focused on a different set of situational factors; or been limited to
subsidiaries operating in just one local environment. Therefore, a concise
classification of generic subsidiary strategies is developed below.

14.9.3 Generic Strategies for MNC Subsidiaries:

The event of the past decade reveals that subsidiaries perform different
functions for their MNCs, yet there appears to be no clear set of rules to
guide future practice. Thus, a classification of model of generic subsidiary
strategies is proposed to clarify those strategies which are applicable to a
wide variety of organisations, industries, and nations. Such a classification
should reduce the number of variables a strategist need consider by
providing general model of the situation and indicating broad guidelines for
action under varying circumstances (e.g., a contingency model).
Furthermore, by drawing on tabular data, omitted common factors and the
roles identified in research, partial validation of proposed classification is
provided.

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The starting point for the development of the model was identify a small
but powerful set of critical factors or dimensions which defines the situation
in which the subsidiary is likely operates, thus defining its strategic
context. Since the present classification adopts the strategic orientation of
MNCs – subsidiary literature depicted in and the relevant strategic
management literature. The utility of the strategic management concepts
for managing MNC subsidiaries. Both stream of literature suggest that one
needs to consider 3 critical factors in developing organizational strategies.
The MNC -subsidiary literature indicates the need to consider the following
determining the strategic functions of the MNC Subsidiaries; the degree of
integration of subsidiary activities with the rest of the MNC; the
configuration of subsidiaries resources and skills; and the characteristics of
the subsidiary’s local environment. Alternatively, strategic management
theory indicates that setting the strategic directions for any firm involves a
consideration of the firm’s existing strategy, it’s internal skills and
resources and the external opportunities and threats in the firm’s
environment.

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14.10 SUMMARY:

Forex is derived from the term of the foreign exchange market and foreign
exchange market introduction is buying and selling of currencies. Forex
needs a lot of buying of one currency in exchange for other currencies. This
offers unlimited possibilities of large profits from exchange market. The
major currencies traded are the U S dollar, India rupees. Japanese yen,
proud sterling and the euro. The change means that the currencies traded
in pairs and exchanged one against the other when traded. The first
currency is in the currency pair called the quote currency and second is
said to be base currency. The quote currency is the numerator while the
base currency is the denominator. The exchange rate show how much we
receive in exchange dealer when selling currency is the denominator. The
exchange rate show how much we receive in exchange dealers when
selling one unit of base currency. It is market where foreign currencies are
bought and sold. The foreign exchange market is mechanism, by which
person of the firm transfers purchasing power from one country to another
country, obtains or provides credit for international trade transactions, and
minimizes exposure to foreign exchange risk. Foreign exchange transaction
is an agreement between a buyer and seller that a given amount of one
currency is to be delivered at a specified rate for some other currency.

A foreign exchange rate is the price of the foreign currency. A foreign

exchange quotation or quote is a statement of willingness to buy or sell at
an announced rate.

The foreign exchange market consists of two tiers: the interbank or

wholesale market and the client or the retail market.

Transactions are effectuated either on the spot basis or on forward or Swap

basis. A pot transaction is for an almost immediate value date while the
forward transaction is for value date somewhere in the future.

A cross rate is an exchange rate between two currencies, calculated from

their common relationship with a third currency.

While speculators can take on huge leveraged positions, the central bank
would need large number of foreign reserves to counter this, Inability to
match the speculators would cause the exchange rate to lunge as
happened to the Asian currencies.

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Arbitrage profit is made from the mispricing or disequilibrium among the

exchange rates. In our example, this disequilibrium happened when the
ringgit exchange rate moved. Arbitrage profits are realized at a point in
time unlike speculative profit that require a span of time

In order understand the foreign exchange trading spread, one need to

know what it is. A foreign exchange trading spread is the difference
between the ask price (the price we buy at) and the bid price (the price we
sell at) that is quoted in the pips. The pips are the smallest unit of
difference between the two currencies in the quote.

A company needs funds to expand into new markets, while governments

need money for everything from infrastructure to social programs. The
problem large organization run into is that they typically need far more
money than the average bank can provide. They solution is to raise money
by issuing bound (or other debt instruments) to a public market.

Bond are debt, whereas stocks are equity. This is the important distinction
between the two securities. By purchasing equity (stock) an investor
becomes an owner in a corporation. Ownership comes with voting rights
and the right to share in any future profits. By purchasing debt (bonds)
investor become a creditor to the corporation (or government).

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14.11 MULTIPLE CHOICE QUESTIONS:

1. The exchange rate is ---------------------------

(a) The price of one currency relative to gold
(b) The exchange is the value of money over time
(c) The price of one currency relative to another
(d) None of these

2. Exchange rates are determined in --------------------------------

(a) The money markets
(b) The foreign exchange markets
(c) The stock markets
(d) None of these

3. The immediate (two days) exchange of one currency for another is a

---------------------------
(a) Spot transaction
(b) Money transaction
(c) Exchange transaction
(d) Transfer transaction

4. In an agreement to exchange dollars for euros in three months at a

price of USD 0.90 per euro, the price is the ------------------------
(a) Spot exchange rate
(b) Money exchange rate
(c) Forward Exchange rate
(d) TOM exchange rate

5. The currency used to buy imported goods is ------------------

(a) The currency of third country
(b) The buyers home currency
(c) The sellers home currency
(d) Currency of invoice

6. Which of the following exchange rate policies uses a target exchange

rate, but allows the target to change?
(a) Fixed exchange rate
(b) Flexible exchange rate
(c) Crawling peg
(d) None of these

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7. When the value of one currency falls relative to another currency, the
exchange rate for the first currency has---------------------
(a) Revalued
(b) Depreciated
(c) Appreciated
(d) Devalued

8. Arbitrageurs in foreign Exchange market; ----------------------

(a) Make their profits through the spread between bid and offer rates
of exchange
(b) Attempt to make profits by outguessing the market
(c) Take advantage of small inconsistencies that develop between
market
(d) By undertaking large deals

9. It is very difficult to interpret news in the foreign exchange market

because -------------------
(a) It is difficult to know which news is relevant to future exchange
rate
(b) It is difficult to know whether the news has been obtained legally
(c) Very little information is publicly available
(d) Correct source of information

10. Which of the following example is of foreign exchange?

(a) Exchange of cash issued by a foreign central bank
(b) Exchange of claims denominated in other currency
(c) Exchange bank deposit
(d) All of the above

Answers: 1. (c), 2. (b), 3. (a), 4.(c), 5. (c), 6. (c), 7. (b) 8. (c), 9. (a),
10. (d)

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REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter

Summary

PPT

MCQ

Video Lecture - Part 1

Video Lecture - Part 2

Video Lecture - Part 3

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Chapter 15
Short Term Financial Market

Objectives
After studying this chapter, you should be able to understand:
• Understanding Eurodollars
• Explanation about Euro currency
• Understanding Euro Notes and Multinational Banking market efficiency
• The efficiency of money markets and foreign exchange markets

Structure:
15.1 Introduction
15.2 Euro Dollars
15.3 Euro Currencies
15.4 Euro Notes and Multinational Banking Market efficiency
15.5 Efficiency of money markets
15.6 Summary
15.7 Multiple choice questions

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15.1 INTRODUCTION

Long term speculations and enhancing decisions gives rise to opportunity

cash flow which, when discounted by a proper cost of capital, determine
the market value of company. However, such a long-term decision will only
result in expected benefits for the company, if attention is paid to short
term decisions regarding the current assets and liabilities. Current assets
and Liabilities, i.e., assets and liabilities with maturity of less than one year
need to be cautiously managed. Net working capital is the term given to
the difference between current assets and current liabilities: in
advancement assets may include inventories of raw materials, work-in-
progress and finished goods, trade receivables, short term investment and
cash, while the progress liabilities may include trade payables, overdrafts,
and short-term loans. The level of current assets is a key factor in a
company’s liquidity position. A company must have or be able to generate
enough cash to meet its short term need if it is to go on with in business.
Therefore, functional capital management is key factor in the company’s
long-term success: without the “Oil” of working capital, the engine of non-
current possessions will not function. The superior the extent to which
current assets exceed current liabilities, the more solvent or liquid the
company is likely to be, depending on the nature of current assets. Short
term sources of financial take account of overdraft, short term bank loan
and trade credit. An overdraft is concurrence by a bank to allow a company
to borrow up to a certain limit without the need for further discussion.

The company will borrow as much or as little as requirements up to

overdraft limit and the bank will charge daily interest at variable rate on
the debt exceptional. The bank may also have need of security or collateral
as protection against the risk of non-payment by company. An overdraft is
flexible source of financial in that company only uses it when the need
arises. However, an overdraft is in principle repayable on demand, even
though a collected works is likely in practice to give warning of its intention
to withdraw agreed overdraft facilities. A short-term loan is an axed
amount of debt financial borrowed by company from Bank, with repayment
to be made in a near future, for example after one year. The company
pays interest on the loan at either predetermined or floating (variable) rate
at regular interval for example quarterly. A short-term bank loan is less
bendable than the overdraft, since the full amount of loan must be
borrowed over the loan period and the company takes on commitment to
pay interest on this amount, whereas, with an overdraft interest is only

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paid on the amount borrowed, not on the agreed overdraft limit. As with an
overdraft, however, protection may be required as condition of short-term
loan being granted. Trade credit is an agreement to take payment for the
goods and armed forces at later date than that on which the goods and
services are supplied to the consuming company. It is ordinary to find one,
two- or even three-months credit being offered on commercial transactions
and trade credit is major source of short-term finance for most companies.
Short term source of finance is usually cheaper and more flexible than long
term ones. Short term interest rate is usually lower than long term
interest rates, for example, and an overdraft is more flexible than a long-
term loan on which company is committed to pay fixed amount of
importance every year. However, short term sources of finance are riskier
than long term sources from borrowers’ point of view in that they may not
be renewed or may be renewed on less favorable terms. Another source of
risk for the short-term borrower is that interest rate is more volatile in the
short term than in the long term and this risk is compounded if floating
rate short term debt is used. A company must clearly balance portability
and risk in reaching a decision on how the funding of current and non-
current assets is divided between long term and short-term source of
funds.

15.2 EURODOLLARS

Eurodollars are time deposits denominated in U.S. dollars at banks outside

the United States, and thus are not under the jurisdiction of the Federal
Reserve. Consequently, such deposits are subject to much less regulation
than similar deposits within the U.S. The term was originally coined for
U.S. dollars in European banks, but it expanded over the years to its
present definition. A U.S. dollar-denominated deposit in Tokyo or Beijing
would be likewise deemed a Eurodollar deposit (sometimes an Asia dollar).
There is no connection with the euro currency or the eurozone. The
offshore locations of Eurodollar make it exposed to potential country risk
and economic risk.

More generally, the euro- prefix can be used to indicate any currency held
in a country where it is not the official currency, or eurocurrency: for
example, Euro yen or even Euro euro.

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Gradually, after World War II, the quantity of U.S. dollars outside the
United States increased significantly, as a result of both the Marshall Plan
and imports into the U.S., which had become the largest consumer market
after World War II.

As a result, large amounts of U.S. dollars were in the custody of foreign

banks outside the United States. Some foreign countries, including the
Soviet Union, also had deposits in U.S. dollars in American banks, granted
by certificates. Various accounts are given of the creation or booking of the
first Eurodollar, but most trace back to Communist governments keeping
dollar deposits abroad.

In one version, the first booking traces back to Communist China, which, in
1949, managed to move almost all of its U.S. dollars to the Soviet-owned
Banque Commerciale pour l'Europe du Nord in Paris before the United
States froze the remaining assets during the Korean War.

In another version, the first booking traces back to the Soviet Union during
the Cold War period, especially after the invasion of Hungary in 1956, as
the Soviet Union feared that its deposits in North American banks would be
frozen as a retaliation. It decided to move some of its holdings to the
Moscow Narodny Bank, a Soviet-owned bank with a British charter. The
British bank would then deposit that money in the U.S. banks. There would
be no chance of confiscating that money, because it belonged to the British
bank and not directly to the Soviets. On 28 February 1957, the sum of
$800,000 was transferred, creating the first Eurodollars. Initially dubbed
"Eurobank dollars" after the bank's telex address, they eventually became
known as "Eurodollars" as such deposits were at first held mostly by
European banks and financial institutions. A major role was played by City
of London banks, such as Midland Bank, now HSBC, and their offshore
holding companies.

In the mid-1950s, Eurodollar trading and its development into a dominant

world currency began when the Soviet Union wanted better interest rates
on their Eurodollars and convinced an Italian banking cartel to give them
more interest than could have been earned if the dollars were deposited in
the U.S. The Italian bankers then had to find customers ready to borrow
the Soviet dollars and pay above the U.S. legal interest-rate caps for their
use, and were able to do so; thus, Eurodollars began to be used
increasingly in global finance.

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Eurodollars can have a higher interest rate attached to them because they
are out of reach from the Federal Reserve. U.S. banks hold an account at
the Fed and can, in theory, receive unlimited liquidity from the Fed if
necessary. These required reserves and Fed backing make U.S. dollar
deposits in U.S. banks inherently less risky, and Eurodollar deposits slightly
more risky, which requires a slightly higher interest rate.

By the end of 1970, 385 billion Eurodollars were booked offshore. These
deposits were lent on as U.S. dollar loans to businesses in other countries
where interest rates on loans were perhaps much higher in the local
currency, and where the businesses were exporting to the US and being
paid in dollars, thereby avoiding foreign exchange risk on their loans.

Several factors led Eurodollars to overtake certificates of deposit (CDs)

issued by U.S. banks as the primary private short-term money market
instruments by the 1980s, including:
• The successive commercial deficits of the United States
• The U.S. Federal Reserve's ceiling on domestic deposits during the high
inflation of the 1970s
• Eurodollar deposits were a cheaper source of funds because they were
free of reserve requirements and deposit insurance assessments

Since the Eurodollar market is not run by any government agency its
growth is hard to estimate. However, the Eurodollar market is by a wide
margin the largest source of global finance. In 1997, nearly 90% of all
international loans were made this way.

In December 1985 the Eurodollar market was estimated by J.P. Morgan

Guaranty bank to have a net size of 1.668 trillion. In 2016, the Eurodollar
market size was estimated at around 13.833 trillion.

Video Link 1

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15.3 EURO CURRENCIES

euro, monetary unit and currency of the European Union (EU). It was
introduced as a non cash monetary unit in 1999, and currency notes and
coins appeared in participating countries on January 1, 2002. After
February 28, 2002, the euro became the sole currency of 12 EU member
states, and their national currencies ceased to be legal tender. Other states
subsequently adopted the currency. The euro is represented by the symbol
€.

The euro’s origins lay in the Maastricht Treaty (1991), an agreement

among the then 12 member countries of the European Community (now
the European Union) United Kingdom, France, Germany, Italy, Ireland,
Belgium, Denmark, Netherland , Spain Portugal, Greece and Luxemburg
that included the creation of an economic and monetary union (EMU). The
treaty called for a common unit of exchange, the euro, and set strict
criteria for conversion to the euro and participation in the EMU. These
requirements included annual budget deficits not exceeding 3 percent of
gross domestic product (GDP), public debt under 60 percent of GDP,
exchange rate stability, inflation rates within 1.5 percent of the three
lowest inflation rates in the EU, and long-term inflation rates within 2
percent. Although several states had public debt ratios exceeding 60
percent—the rates topped 120 percent in Italy and Belgium—the European
Commission (the executive branch of the EU) recommended their entry
into the EMU, citing the significant steps each country had taken to reduce
its debt ratio.

Supporters of the euro argued that a single European currency would boost
trade by eliminating foreign exchange fluctuations and reducing prices.
Although there were concerns regarding a single currency, including
worries about counterfeiting and loss of national sovereignty and national
identity, 11 countries (Austria, Belgium, Finland, France, Germany, Ireland,
Italy, Luxembourg, the Netherlands, Portugal, and Spain) formally joined
the EMU in 1998. Britain and Sweden delayed joining, though some
businesses in Britain decided to accept payment in euros. Voters in
Denmark narrowly rejected the euro in a September 2000 referendum.
Greece initially failed to meet the economic requirements but was admitted
in January 2001 after overhauling its economy.

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In 2007 Slovenia became the first former communist country to adopt the
euro. Having demonstrated fiscal stability since joining the EU in 2004,
both Malta and the Greek Cypriot sector of Cyprus adopted the euro in
2008. Other countries that adopted the currency include Slovakia (2009),
Estonia (2011), Latvia (2014), and Lithuania (2015). (The euro is also the
official currency in several areas outside the EU, including Andorra,
Montenegro, Kosovo, and San Marino.) The 19 participating EU countries
are known as the euro area, euroland, or the euro zone.

In 1998 the European Central Bank (ECB) was established to manage the
new currency. Based in Frankfurt, Germany, the ECB is an independent
and neutral body headed by an appointed president who is approved by all
member countries to serve an eight-year term. The euro was launched on
January 1, 1999, replacing the precursor ecu at a 1:1 value. Until the
circulation of currency notes and coins in 2002, the euro was used only by
financial markets and certain businesses. Many experts predicted that the
euro could eventually rival the U.S. dollar as an international currency.

Unlike most of the national currencies that they replaced, euro banknotes
do not display famous national figures. The seven colourful bills, designed
by the Austrian artist Robert Kalina and ranging in denomination from €5
to €500, symbolize the unity of Europe and feature a map of Europe, the
EU’s flag, and arches, bridges, gateways, and windows. The eight euro
coins range in denominations from one cent to two euros. The coins
feature one side with a common design; the reverse sides’ designs differ in
each of the individual participating countries.

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15.4 EURO NOTES AND MULTINATIONAL BANKING

MARKET EFFICIENCY

• Euro banknotes from the first series (The Ages and Styles of
Europe) (2002–2013)

Banknotes of the euro, the currency of the euro area and institutions, have
been in circulation since the first series (also called ES1) was issued in
2002. They are issued by the national central banks of the Euro system or
the European Central Bank. In 1999 the euro was introduced virtually, and
in 2002 notes and coins began to circulate. The euro rapidly took over from
the former national currencies and slowly expanded around the European
Union.

Denominations of the notes range from €5 to €500 and, unlike euro coins,
the design is identical across the whole of the Eurozone, although they are
issued and printed in various member states. The euro banknotes are pure
cotton fibre, which improves their durability as well as giving the
banknotes a distinctive feel. They measure from 120 by 62 millimetres (4.7
in × 2.4 in) to 160 by 82 millimetres (6.3 in × 3.2 in) and have a variety of
colour schemes. The euro notes contain many complex security features
such as watermarks, invisible ink characteristics, holograms, optically
variable inks and microprinting that document their authenticity. While
euro coins have a national side indicating the country of issue (although
not necessarily of minting), euro notes lack this. Instead, this information
is shown by the first character of each note's serial number.

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According to European Central Bank estimates, in March 2021, there were

about 26.494 billion banknotes in circulation around the Eurozone, with a
total value of about €1.448 trillion. On 8 November 2012, the European
Central Bank announced that the first series of notes would be replaced by
the Europa series (also called ES2), starting with the 5 euro note on 2 May
2013.

Estimates suggest that the average life of a euro banknote is about three
years before it is replaced due to wear, but individual lifespans vary
depending on denomination, from less than a year for €5 banknote to over
30 years for €500 banknote. High denomination banknotes (€100, €200,
€500) last longer as they are less frequently used. The Europa series of the
lower denominations €5 and €10 is designed to last longer than the
previous one due to additional coating.

• Euro Coins:

There are eight euro coin denominations, ranging from one cent to two
euros[1] (the euro is divided into a hundred cents). The coins first came
into use in 1999. They have a common reverse, portraying a map of
Europe, but each country in the eurozone has its own design on the
obverse, which means that each coin has a variety of different designs in
circulation at once. Four European microstates that are not members of the
European Union (Andorra, Monaco, San Marino, and the Vatican City) use
the euro as their currency and also have the right to mint coins with their
own designs on the obverse side.

The coins, and various commemorative coins, are minted at numerous

national mints across the European Union to strict national quotas. Obverse
designs are chosen nationally, while the reverse and the currency as a
whole is managed by the European Central Bank (ECB).

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• Multinational Banking Market Efficiency:

Multinational banks have been emerged fast, especially within EU. The size
and global interconnectedness of their behavior has raised serious concern
on their potential systemic effects. They have been considered among the
main culprits of the present financial crisis. Many of the financial
institutions that had to be bailed out supported with public funds in 2008
and 2009 in Europe and in the US were multinational banking,
extraordinary supervisory mechanism and prudential ratios for these banks
are at the core of the most modification proposals of regulations and
supervision of financial markets. However, these concerns often rest on
superficial consideration of the role and activities of multinational banks.

Over the last two decades, several important changes occurred in the
European banking industry, leading to increased competition and pressure
on bank profitability.

On the whole, the findings of this work highlight that if bank managers
want to protect their performance, they will have to improve cost
management efficiency.

In a very difficult economic and financial environment, the challenges of

banks in a bank-oriented system are enormous and include low-interest
rates, intense pricing competition for commercial and mortgage loans and
higher operating costs, particularly related to regulatory compliance,
technology, and health care. For this reason, the use of economies of scale
is important, and the management decisions and specific factors of each
bank, are determining factors for bank performance and efficiency

This work points out the factors that lead to a bank being classified as
efficient change, which confirms the importance of the economic
environment in a way that could affect the bank performances, aside from
the bank level features.

The new European regulation has been important, but the fact that in a
universe of 564 DMUs (94 banks used in the value-based DEA method
observed in six consecutive years) only 20 have been considered efficient
shows that there is still a long way to go.

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The main limitation of this study is related to the number of banks listed by
country. So, for future research it would be interesting to analyze other
markets and integrate institutional and ownership factors, with very
different characteristics in civil law and common law countries; to compare
the determinants of efficiency in the bull and bear periods also considering
different external factors such cultural and market sentiment factors.

The results obtained could help managers, investors or governments to

know how to improve the efficiency of their banking sector, which is the
engine of the economy for civil law countries .

15.5 EFFICIENCY OF MONEY MARKET

Trading rules based on the foundation that historical data is information

rich about the future bearing of assets prices, defies the time honoured
academic position of the efficient market hypothesis. However one of the
empirical challenge with test of efficient market hypothesis relates to
ambivalence that researchers have in rejecting the null hypothesis and
having employed a

• What Is Market Efficiency?

Market efficiency refers to the degree to which market prices reflect all
available, relevant information. If markets are efficient, then all
information is already incorporated into prices, and so there is no way to
"beat" the market because there are no undervalued or overvalued
securities available.

The term was taken from a paper written in 1970 by economist Eugene
Fama, however Fama himself acknowledges that the term is a bit
misleading because no one has a clear definition of how to perfectly define
or precisely measure this thing called market efficiency. Despite such
limitations, the term is used in referring to what Fama is best known for,
the efficient market hypothesis (EMH).

The EMH states that an investor can't outperform the market, and that
market anomalies should not exist because they will immediately be
arbitraged away. Fama later won the Nobel Prize for his efforts. Investors
who agree with this theory tend to buy index funds that track overall
market performance and are proponents of passive portfolio management.

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At its core, market efficiency is the ability of markets to incorporate

information that provides the maximum amount of opportunities to
purchasers and sellers of securities to effect transactions without
increasing transaction costs.

• Market Efficiency Theory

There are three degrees of market efficiency. The weak form of market
efficiency is that past price movements are not useful for predicting future
prices. If all available, relevant information is incorporated into current
prices, then any information relevant information that can be gleaned from
past prices is already incorporated into current prices. Therefore future
price changes can only be the result of new information becoming
available.

Based on this form of the hypothesis, such investing strategies such as

momentum or any technical-analysis based rules used for trading or
investing decisions should not be expected to persistently achieve above
normal market returns. Within this form of the hypothesis there remains
the possibility that excess returns might be possible using fundamental
analysis. This point of view has been widely taught in academic finance
studies for decades, though this point of view is no long held so
dogmatically.

The semi-strong form of market efficiency assumes that stocks adjust

quickly to absorb new public information so that an investor cannot benefit
over and above the market by trading on that new information. This
implies that neither technical analysis nor fundamental analysis would be
reliable strategies to achieve superior returns, because any information
gained through fundamental analysis will already be available and thus
already incorporated into current prices. Only private information
unavailable to the market at large will be useful to gain an advantage in
trading, and only to those who possess the information before the rest of
the market does.

The strong form of market efficiency says that market prices reflect all
information both public and private, building on and incorporating the weak
form and the semi-strong form. Given the assumption that stock prices
reflect all information (public as well as private), no investor, including a

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corporate insider, would be able to profit above the average investor even
if he were privy to new insider information.

• Differing Beliefs of an Efficient Market

Investors and academics have a wide range of viewpoints on the actual

efficiency of the market, as reflected in the strong, semi-strong, and weak
versions of the EMH. Believers in strong form efficiency agree with Fama
and often consist of passive index investors. Practitioners of the weak
version of the EMH believe active trading can generate abnormal profits
through arbitrage, while semi-strong believers fall somewhere in the
middle.

For example, at the other end of the spectrum from Fama and his followers
are the value investors, who believe stocks can become undervalued, or
priced below what they are worth. Successful value investors make their
money by purchasing stocks when they are undervalued and selling them
when their price rises to meet or exceed their intrinsic worth.

People who do not believe in an efficient market point to the fact that
active traders exist. If there are no opportunities to earn profits that beat
the market, then there should be no incentive to become an active trader.
Further, the fees charged by active managers are seen as proof the EMH is
not correct because it stipulates that an efficient market has low
transaction costs.

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• An Example of an Efficient Market

While there are investors who believe in both sides of the EMH, there is
real-world proof that wider dissemination of financial information affects
securities prices and makes a market more efficient.

For example, the passing of the Sarbanes-Oxley Act of 2002, which

required greater financial transparency for publicly traded companies, saw
a decline in equity market volatility after a company released a quarterly
report. It was found that financial statements were deemed to be more
credible, thus making the information more reliable and generating more
confidence in the stated price of a security. There are fewer surprises, so
the reactions to earnings reports are smaller. This change in volatility
pattern shows that the passing of the Sarbanes-Oxley Act and its
information requirements made the market more efficient. This can be
considered a confirmation of the EMH in that increasing the quality and
reliability of financial statements is a way of lowering transaction costs.

Other examples of efficiency arise when perceived market anomalies

become widely known and then subsequently disappear. For instance, it
was once the case that when a stock was added to an index such as the
S&P 500 for the first time, there would be a large boost to that share's
price simply because it became part of the index and not because of any
new change in the company's fundamentals. This index effect anomaly
became widely reported and known, and has since largely disappeared as a
result. This means that as information increases, markets become more
efficient and anomalies are reduced.

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15.6 SUMMARY:

Long term speculations and enhancing decisions gives rise to opportunity

cash flow which, when discounted by a proper cost of capital, determine
the market value of company. However, such a long-term decision will only
result in expected benefits for the company if attention is paid to short
term decisions regarding the current assets and liabilities. Current assets
and Liabilities, i.e., assets and liabilities with maturity of less than one year
need to be cautiously managed.

Short-term sources of finance are riskier than long term sources from
borrowers’ point of view in that they may not be renewed or may be
renewed on less favorable terms. Another source of risk for the short-term
borrower is that interest rate is more volatile in the short term than in the
long term and this risk is compounded if floating rate short term debt is
used. A company must clearly balance portability and risk in reaching a
decision on how the funding of current and non-current assets is divided
between long term and short-term source of funds.

Eurodollars are time deposits denominated in U.S. dollars at banks outside

the United States, and thus are not under the jurisdiction of the Federal
Reserve. Consequently, such deposits are subject to much less regulation
than similar deposits within the U.S. The term was originally coined for
U.S. dollars in European banks, but it expanded over the years to its
present definition. A U.S. dollar-denominated deposit in Tokyo or Beijing
would be likewise deemed a Eurodollar deposit (sometimes an Asia dollar).
There is no connection with the euro currency or the eurozone. The
offshore locations of Eurodollar make it exposed to potential country risk
and economic risk.

Euro, monetary unit and currency of the European Union (EU). It was
introduced as a noncash monetary unit in 1999, and currency notes and
coins appeared in participating countries on January 1, 2002. After
February 28, 2002, the euro became the sole currency of 12 EU member
states, and their national currencies ceased to be legal tender. Other states
subsequently adopted the currency. The euro is represented by the symbol
€.

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 SHORT TERM FINANCIAL MARKET

Banknotes of the euro, the currency of the euro area and institutions, have
been in circulation since the first series (also called ES1) was issued in
2002. They are issued by the national central banks of the Euro system or
the European Central Bank. In 1999 the euro was introduced virtually, and
in 2002 notes and coins began to circulate. The euro rapidly took over from
the former national currencies and slowly expanded around the European
Union.

There are eight euro coin denominations, ranging from one cent to two
euros (the euro is divided into a hundred cents). The coins first came into
use in 1999. They have a common reverse, portraying a map of Europe,
but each country in the eurozone has its own design on the obverse, which
means that each coin has a variety of different designs in circulation at
once.

Market efficiency refers to how well current prices reflect all available,
relevant information about the actual value of the underlying assets.

A truly efficient market eliminates the possibility of beating the market,

because any information available to any trader is already incorporated
into the market price.

As the quality and amount of information increases, the market becomes

more efficient reducing opportunities for arbitrage and above market
returns.

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15.7 MULTIPLE CHOICE QUESTIONS

1. Money Market Securities are---------------

(a) Short Term
(b) Low Risk
(c) Very Liquid
(d) All the above Options

2. Money Market Instruments ----------------------

(a) Are usually sold in large denomination
(b) Have low default risk
(c) Matures in one year or less
(d) All the above options

3. The most influential participants in US Money market ------------------

(a) Is the Federal Reserve
(b) Is the US Treasury department
(c) Are the largest Money centre banks
(d) Are the investment banks that underwrite securities

4. Eurodollars are time deposits denominated in U.S. dollars at banks

-------------------- and thus are not under the jurisdiction of the Federal
Reserve.
(a) Within the United States
(b) Outside the United States
(c) In European Union
(d) Across the world

5. If markets are efficient, then all information is already incorporated into

prices, and so there is no way to "beat" the market because
-------------------
(a) there are no undervalued securities available.
(b) there are no overvalued securities available.
(c) there are no undervalued or overvalued securities available.
(d) there are no securities available.

Answers: 1. (d), 2. (d), 3. (a), 4. (b), 5. (c).

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REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter

Summary

PPT

MCQ

Video Lecture

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Chapter 16
Long Term Financial Market

Objectives
After studying this chapter, you should be able to understand:
• Equity and Bond investment
• Equity and bond financing
• Understand Eurobonds and Foreign Bonds
• Understand Multi currency bonds
• Bank financing

Structure:
16.1 Introduction
16.2 Equity and Bond investments
16.3 Equity and Bond Financing
16.4 Eurobonds and Foreign Bonds
16.5 Multi-currency Bonds
16.6 Bank Financing
16.7 Summary
16.8 Multiple choice questions

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16.1 INTRODUCTION

Financing is a very important part of every business. Firms often need

financing to pay for their assets, equipment, and other important items.
Financing can be either long-term or short-term. As is obvious, long-term
financing is more expensive as compared to short-term financing.

There are different vehicles through which long-term and short-term

financing is made available.

The common sources of financing are capital that is generated by the firm
itself and sometimes, it is capital from external funders, which is usually
obtained after issuance of new debt and equity.

A firm’s management is responsible for matching the long-term or short-

term financing mix. This mix is applicable to the assets that are to be
financed as closely as possible, regarding timing and cash flows.

• Long-Term Financing

Long-term financing is usually needed for acquiring new equipment, R&D,

cash flow enhancement, and company expansion. Some of the major
methods for long-term financing are discussed below.

• Equity Financing

Equity financing includes preferred stocks and common stocks. This

method is less risky in respect to cash flow commitments. However, equity
financing often results in dissolution of share ownership and it also
decreases earnings.

The cost associated with equity is generally higher than the cost associated
with debt, which is again a deductible expense. Therefore, equity financing
can also result in an enhanced hurdle rate that may cancel any reduction in
the cash flow risk.

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• Corporate Bond

A corporate bond is a special kind of bond issued by any corporation to

collect money effectively in an aim to expand its business. This tern is
usually used for long-term debt instruments that generally have a maturity
date after one year after their issue date at the minimum.

Some corporate bonds may have an associated call option that permits the
issuer to redeem it before it reaches the maturity. All other types of bonds
that are known as convertible bonds that offer investors the option to
convert the bond to equity.

• Capital Notes

Capital notes are a type of convertible security that are exercisable into
shares. They are one type of equity vehicle. Capital notes resemble
warrants, except the fact that they usually don’t have the expiry date or an
exercise price. That is why the entire consideration the company aims to
receive, for the future issuance of the shares, is generally paid at the time
of issuance of capital notes.

Many times, capital notes are issued with a debt-for-equity swap

restructuring. Instead of offering the shares (that replace debt) in the
present, the company provides its creditors with convertible securities –
the capital notes – and hence the dilution occurs later.

• Types of Financial Market Structure:

The types of financial market structure that emerged are on 4 basic Forms
as under:
I. Auction market conducted through brokers
II. Over the counter (OTC) Market conducted through dealers
III.Organised exchanges such as, stock exchanges, which combine auction
and OTC market features. Specially organised exchanges permit buyers
and sellers to trade with each other in the centralizes location, like an
auction. However securities are traded on the floor of the exchange with
the help of specialist traders who combine broker and dealer functions.
The specialist broker trades but also stand ready to buy and sell the
stock from personal inventories if buy and sell orders do not match

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IV.Intermediation Financial Markets conducted through financial

intermediaries.

Financial Markets taking first 3 forms are generally referred to as securities

market. Some financial markets combine features from more than one of
these categories, so the categories constitute only rough guidelines.

Over the counter markets:

An over-the-counter market has no centralised mechanism or facility for

trading. Instead, the market is a public market consisting of number of
dealers spread across the region, a country or indeed the world who make
the market in some type of assets. That is the dealer themselves post bid
and ask the price for this asset and then stand ready to buy or sell units of
this asset with anyone who chooses to trade at these posted prices. The
dealers provide customers more flexibility in trading than brokers because
dealers can offset imbalances in the demand and supply of asset by trading
out of their own accounts.

Intermediation Financial Markets:

In intermediation financial market in which financial intermediaries help

transfer funds from saver to borrowers by issuing certain types of financial
assets to savers and receiving other types of financial Assets from
Borrowers. The Financial assets issued to savers are claims against the
financial intermediaries, whereas the financial assets received from
borrowers are the claims against the borrowers, hence assets of the
financial intermediaries.

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16.2 EQUITY AND BOND INVESTMENTS

The quest for profits is what drives all investments – every investor seeks
to deploy his funds profitably and gain high returns on his investment. To
this end, investors may choose to invest their funds in one or more of the
many different investment avenues (investment classes). Bonds, equity,
cash equivalents, real estate, gold (and silver), other commodities, etc. are
some of the common investment avenues available to investors.

Among the different investment avenues, bonds, equity, and cash

equivalents are considered to be the three main investment avenues (the
three traditional investment classes). All other investment avenues are
considered alternative investment classes. Typically, the three main
investment classes may offer various advantages (to investors) vis-à-vis
the alternative investment classes. As a result, many investors prefer
investing in the three main investment classes rather than in the
alternative investment classes.

Let us quickly understand the different advantages of investing in the three

main investment classes vis-à-vis investment in the alternative investment
classes. One of the biggest advantages of investing in the main investment
classes (especially for small investors) is that, often, investment in these
classes may be started with relatively smaller sums of money. For
example, investment in real estate may often require a large one-time
payment by the investor (as real estate properties may be quite
expensive). In contrast, it is generally possible for investors to buy just a
small number of cheap shares or cheap bonds in one transaction. Thus,
investors may invest in these assets with a relatively smaller amount of
funds.

Secondly, the three investment classes may often offer far greater number
of investment options than the number of options available in some of the
alternative investment classes. For example, the equity market may
include stocks of several thousand companies. Equity investors can choose
to invest in one or more of these thousands of companies. In contrast,
some commodity markets may only include a few hundred (or even fewer)
investment options. Other alternative investment classes may similarly
offer limited options to investors.

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Further, the main investment classes typically offer greater liquidity and
transparency to investors vis-à-vis alternative investment classes. Bonds,
equity, and some cash equivalents are typically traded on well-organised
and regulated markets. As these investment classes are very popular with
investors, these markets see a very large number of transactions daily.
Thus, generally, investors in these asset classes are able to sell off their
assets and recover their money quickly. In contrast, for example, if the
owner of a piece of real estate wants to sell the property and recover his
money, he may need to wait for several months to get a buyer.

Similarly, the markets that deal with the three main investment classes
typically update the prices (on the basis of the different transactions in that
market) of various instruments (financial assets) very frequently
(generally, many times per second). These markets also display the
current prices constantly. Thus, investors can easily (and accurately) find
out the prevalent price of any asset traded in these markets. This enables
investors to make well-informed investment decisions. In contrast, if we
take a look at the real estate market, it may not always be possible to
know the exact price at which the last trade in a particular area was
finalized. Thus, an investor in real estate may find it difficult to know the
exact market value of his holdings. Correspondingly, at times, such an
investor may end up selling his piece of property for a price lower than its
market value (thereby losing potential profits).

These then are the major advantages that the main investment classes
offer to investors (vis-à-vis the alternative investment classes). As a result
of these advantages, as discussed above, many investors prefer to invest
their money in the three main investment classes rather than in the
alternative investment classes. Let us now look at bond investments and
equity investments and identify which of the two is more suitable for you.

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Understanding Bond and Equity Investments

As we have seen, both bonds and equity are counted among the three
main investment classes. However, there are significant differences
between these two investment avenues. Let us, therefore, understand
these two investment classes thoroughly. We start with bonds.

Bonds are instruments of lending, i.e. purchasing a bond is equivalent to

lending money to the issuer of the bond. Thus, the purchaser of a bond
essentially becomes a lender to the issuer of the bond (who effectively
becomes the borrower). In lieu of the funds borrowed, the borrower (issuer
of the bond) pays periodic interest to the lender (purchaser of the bond) –
thus, bonds may serve as fixed income instruments. Typically, each bond
also has a period of maturity (effectively, the term of the loan). Upon
completion of the period of maturity, the borrower returns the original sum
(the principal) to the lender. Do note that bonds may be issued by the
union government (central or federal government), local government
bodies, corporate entities, etc.

Bonds are highly flexible – different bonds may have very different terms
and conditions. Thus, bonds offer a lot of variety – and hence, appeal to
many different categories of investors. For example, the period of maturity
of different bonds may vary widely. The period of maturity of many
common bonds may be as short as 2 to 3 years. Other bonds may have
much longer periods of maturity – in fact, many common bonds have
periods of maturity of up to 30 years. Generally, bonds with longer periods
of maturity offer higher rates of return than bonds with shorter periods of
maturity.

Bonds are generally seen as relatively secure (safe) investments – for

example, bonds are typically considered safer than equity. Government
bonds are seen as nearly risk free instruments. Therefore, the rate of
return offered by government bonds is often considered risk free return –
this return may be used as a benchmark to assess returns offered by other
financial instruments.

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As bonds are considered safer investments than equity, the rate of return
offered by bonds is typically expected to be lower than the rate of return
offered by equity. However, some bonds (high yield bonds) may offer very
high rate of return. Some bonds (for example, junk bonds) may yield rates
of return as high as 50% per year or higher. Such bonds typically carry
very high risk of default.

Some bonds may be sold in designated markets before the completion of

their period of maturity. Such bonds offer a lot of liquidity to bond
investors – these investors can sell such bonds in these markets at any
point of time and recover their money. Selling a bond can also provide an
additional source of gains (profit). If the purchaser of a bond sells it at a
price higher than his purchase price, then he makes a profit on the sale.
(Conversely, if the purchaser of a bond sells it at a price lower than his
purchase price, then he may make a loss on the sale.) These are some of
the salient features of bonds. Let us now understand equity.

As we have seen, a bond is a lending instrument. In contrast, equity is an

instrument of ownership. When you purchase the shares of a company,
you have essentially purchased a part of the company – you have become
a part owner of the company. Equity investments can offer two sources of
income. First of all, the price of a share may go up. If an equity investor
sells his shares at a price higher than the price at which he purchased
them, then he makes a profit.

Secondly, profitable companies often pay dividends to shareholders. A

dividend is that part of the profits (or cash reserves) of a company which is
paid out to the shareholders. Some companies may issue regular dividends
to their shareholders. In such cases, the dividend may serve as a source of
regular income (fixed income).

Equity is generally seen as a high-risk, high-return investment. Typically,

equity investments are seen as riskier than investments in bonds or
investments in cash equivalents. Correspondingly, it is expected that
equity would generate higher rates of return than investments in bonds or
in cash equivalents. As a result, experts often suggest that most investors
should allocate at least some part of their portfolio to equity so that at
least that part of their portfolio can be expected to generate higher
returns.

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Experts also advise that equity investors should have a relatively long
investment horizon (at least 5 years long and ideally, 10 years or longer)
in order to maximize their chances of getting good returns on their
investments. In the short term, market fluctuations may pull down the
prices of even good stocks. But over the long term, it is expected that good
stocks will perform well and will generate good returns.

Bonds vs Equity – Identifying Your Ideal Investment

Now, you have understood the important features of bonds and equity, you
are ready to identify which of these would be the ideal investment for you.
In order to do this, you must start by identifying your investment
objectives. As we have seen, bonds and equity are different kinds of
investments. Accordingly, bond investment and equity investment may
appeal to investors with different investment objectives.

Suppose an investor has a relatively shorter investment horizon (let’s say

shorter than 5 years). As we have seen, equity investments are ideal for
investors with longer investment horizon. On the other hand, different
bonds have different periods of maturity. Hence, investors with widely
differing investment horizons may be able to find bonds whose period of
maturity matches their investment horizon. Thus, investors with shorter
investment horizon may invest in short term bonds (with periods of
maturity of about 2 to 3 years). This would be especially useful for
investors who are somewhat risk averse and want safer investment options
(since bonds are relatively secure investments).

Some investors may have a short investment horizon and may be willing to
take on more risk. Such investors may target some high growth stocks –
for example, shares of companies in rapidly growing industries. Such
stocks may be expected to generate decent returns even in the short term,
though they would be considered high-risk investments.

Investors with a longer investment horizon may choose to invest in long

term bonds if they are relatively risk averse and want safer investment
options. On the other hand, if they are willing to take on more risk, they
may invest in equity. In this case (i.e. over the long term), it is expected
that equity would yield higher returns than bonds.

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Another option available to investors is to invest in a balanced portfolio.

This ensures that a part of the portfolio is invested in safe, highly liquid
cash equivalents, a part is invested in low-risk bonds and a part is invested
in high-risk, high-return equity. For investors who have a long investment
horizon and who are able to bear some risk, experts often advise investing
10% of the portfolio in cash equivalents, 20% in bonds, and 70% in equity.
Similarly, for investors with a shorter investment horizon and lesser risk
tolerance, experts often advise investing 40% of the portfolio in cash
equivalents, 50% in bonds and 10% in equity. Thus, once you identify your
investment objectives, you can design the ideal portfolio that matches your
investment objectives.

You have now understood the important features of bond investment and
equity investment. You have also understood how to design your own
portfolio. Thus, you are now empowered to make smart investment
decisions and invest your way to prosperity and success.

Equity bond is a method of linking your investment to the stock market but
without the risk of losing any money when stock markets go down. They
are sometime referred to Structured products. Bonds are taken out for a
particular length of time, such as 3,4 or years, during which time
withdrawals may or may not be allowed. The returns are based on the
performance of defend investment index the relevant index is made clear
in the relevant index is made clear in the advertising for the bond. This is
usually a percentage of the growth achieved over the relevant period and
is paid in the form on interest. If the index falls during the period, you will
receive back your original investment only.

16.2.1 Investment Strategy

The equity and bond fund invests all of its assets in shares of the state
Firm Equity Fund and the state firm bond fund. Generally, the equity and
bond fund attempts to maintain approximately 60% of its net assets in
shares of the state Farm Equity Fund and approximately 40% of its net
assets in shares of the state Farms Bond Fund. The equity and bond fund
never invests more than 75% of its net assets in either underlying fund.
Though the equity and bond fund is not an asset allocation or market
timing mutual fund. It does, from time to time, adjust the amount of its
assets invested in each underling fund as economic, market and financial
conditions warrant.

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• Investor Profile

Invest in the equity and bond fund if you are seeking long-term growth
potential, some current income, and/or the convenience of a balance
portfolio of stocks and bonds in a single investment. You may not want to
invest in the equity and bond fund if you have a short term investment
horizon, want the greater growth potential of an investment entirely in
equity securities, or are unwilling to accept share price fluctuations.

• Equity Investments.

Equity refers to ownership, Stock shares represent ownership in a

company, so stocks are the equity in an investment portfolio. The equity
portion of a portfolio should provide long-term growth of value, plus the
possibility of income from stock dividends. Stocks listed on the exchanges
decline in value. During positive stock market periods, the returns to
investors can be very attractive, with the overall market increasing by 20%
or 30% or more per year.

• Fixed Income

The fixed-income portion of an investment portfolio is usually filled by bond

investments. These investments pay a fixed rate value of bonds can rise
and fall with changes in interest rate, but the fluctuations will, in most
market conditions, be less volatile than the stock market. Investment
bonds include government, foreign, municipal and corporate bond.

• Investment Choices

An investor can use several different types of investments to make up the

equity portion of an investment portfolio. Besides individual stocks, one
could use stock mutual funds or stock exchange-traded funds, or ETFs. All
of these investments would be categorized as equity.; Investing in bonds
can also be accomplished using mutual funds or ETFs. Whether a fund is
equity or income depends on the type of securities a fund hold. Some
funds, often referred to as lifestyle or target retirement funds, are balance
portfolio of both stocks and bonds in a single mutual fund.

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• Asset Allocation

The Securities and Exchanges commission states the assets allocation

percentages between the different types of investments should be based
on the personal situation. Important factors are the investment period of
time frame, risk tolerance and comfort with the different investment
available. The different asset type’s equity and bonds will move up and
down in value, often on different cycles. A portfolio balance between the
two types of investment classes, plus a portion in cash, will have more
stable value and growth over time than investing all of your money in just
one asset type.

16.3 EQUITY AND BOND FINANCING

A company’s equity is the value of its assets less liabilities. In the stock
market, an investor who purchases shares of a company is entitled a
portion of its equity, when a firm sell a portion of its equity, either as an
initial public offering (IPO) or a secondary offering. It is saying, in effect,
we are going to use your money to finance our venture. In return, we are
giving you ownership in our company and the potential to share in our
profits-in the for of dividends or a higher valuation on the stock.” What and
investor get is a piece of ownership in the company and the possibility of a
higher stock price, plus dividends. But remember. There’s no guarantee
the company will succeed No matter what company an investor decides to
invest in. there are several reasons why shareholders can lose some or all
of their money. Let’s say you own shares of ABC Company. If ABC loses
money and reports a net loss the price of its shares can go down, as
investors sell the company’s stock. This potential for price movement is
referred to as market risk. However, it is not uncommon for some money-
losing companies to have incredibly high stock prices. In certain cases,
investors sell the companies that are losing money now may have some
value that will be realized or unlocked in the future. Getting back to ABC,
what if the company goes completed out of business? You could easily lose
all the money you have invested. As a shareholder of ABC’s common stock,
if the company goes bankrupt. You are not considered a creditor of the
company and therefore not entitled to any of ABC’s remaining assets.

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16.3.1 Debt Financing

Debt financing effectively put the company in debt to the investor. A

company pursing this type of capital will usually issue bonds. As we all
know, a bond is like an IOU and pays a specific interest rate to the holder.
Until the bond is sold or “called” by the issuer. In purchasing a bond, the
investor is promised of a should of payments over the lifetime of the bond.
When the bond matures, the investor receives back his or her original
investment. When a company issues a bond, it is saying to investors, “we
are going to use our money to finance our venture and in return we
promise to pay you fixed interest rate for the use of your money. We also
promise to give you your money back once the bond matures. “So, what’s
the risk of owning a bond? Well, for one thing, interest rate rise, If you
purchases a corporate bond with a coupon rate of 7 and a half % and soon
thereafter the interest rate rise could rise, you are stuck with a bond
yielding a lower interest rate. The cost Should not companies always
choose equity since they do not have to guarantee to pay it back. Since
equity investors know they have no guaranteed return, they topically
demand a higher rate than debt markets. Of course, “demand “is a strong
word since they have no way of being sure of receiving more money down
the road. But companies that fail the reward their shareholder will have a
hard time attracting more shareholders, and an even harder time of raising
additional amounts of capital in the future.

What does this mean as an Investor?

From an investor’s standpoint, the key difference between stocks and

bonds is the potential for price appreciation. While stocks are inherently
riskier investments, they offer potentially better investment performance
than bonds, which are generally considered more conservative investment.
So why would anyone want to invest in the equity market? Should not you
stay sway if the value of the investment can go down? Both stocks and
bonds carry risks; each with it is won flavor. The market risk associated
with individual stocks can make returns volatilities. But inflation and
interest rate risk factors can erode the “sure thing “returns associated with
bonds, making even the guaranteed return unappealing.

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16.3.2 Advantage of Bonds Common Stock Financing

When a business wants to finance new project, it has two basic options. It
can finance the project through the issue of debt, but this creates a liability
in the form of interest payments, or it can finance the project through new
equity-this is done by issuing new shares of stock. The proper balance of
debt and equity is unique to each individual company, although some
theories claim that the optimal capital structure is 100% debt.

Company Control

Owners of a company are often hesitant to give up or dilute their

controlling stake in that company. Essentially that is what occurs when
common stock financing is used. Having multiple shareholders means it will
be harder for the primary owner to dictate the direction of the company as
well as the governing board. If a decision needs to be made regarding a
project, or even a fairly routine decision needs to be made regarding a
project, or even a fairly routine decision needs to be made, the new
investor would want input into the situation. Their position would carry the
weight of their percentage ownership in the company. Bonds, on the other
hand, do not give the purchaser a stake in the company. The only
obligation a corporation has to the purchaser if a bond is to make timely
coupon payments and to repay the principal at the bound maturity.

Tax Shield

The theory claiming that the optimal capital structure for any company is
100% debt relies completely on the fact that debt provides a tax shield.
Interest paid on loans and bonds can be deducted from earnings before
taxes are taken out. That means that the amount of money saved through
debt financing is equal to the interest payment on debt multiplied by the
corporate tax rate. Consequently, this tax shield will also reduce the real
cost of the loan to the company by the tax rate. Common stockholders are
paid through dividends. Dividends are paid from earnings after taxes are
paid due to this, common stock financing does not provide any sort of tax
shield.

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Financial Planning

When debt is issued, an agreement is signed. The company can

incorporate the effect of the new debt into their forecasts and number. This
means that financial projections will be more accurate. Budgets can also be
developed more accurately, making it easier for management to set goals
and maximize worker productivity. Developed more accurately, making it
easier for management to set goals and maximize worker productivity. At
time, companies with a solid Track record can gain a loan at a lower cost
than issuing new equity and paying dividends. Budding credit through a
good track record of repaying debt cab be especially helpful cost reduction
if a large issue of debt is anticipated in the future. Common stockholders
can be compensated in a variety of fashions, depending on the financial
health of a company. This makes it much more difficult to predict the
future effects of common stock on a corporation.

Paperwork

Issuing equity is a lengthy process. It requires application and approval

from the government just to offer the new common stock. After the stock
is issued. Reports need to be compiled and sent out to the stockholders at
least on an annual basis. Whit debt, the only interaction is the selling of
the bonds, the coupon payment, and the payment at maturity.

Rewards on Growth

For a high growth company, debt is usually the better option. The amount
lost through payments on debt will usually be much less than the loss
suffered through unrealized gains in equity that has been sold off. In other
word, a company that held full ownership will not realize as much of the
profit from the growth of a company as a company that held full ownership
and financed their projects with bonds.

Video Link 1

Video Link 2

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16.4 EUROBONDS AND FOREIGN BONDS

The two segments of the international bond market are: foreign bonds and
Eurobonds. A foreign bond is a bond issued in a domestic market for a
foreign borrower. Foreign bonds tend to be more regulated than Eurobonds
and are usually issued by a domestic group of banks. A debt security
issued by a borrower form outside the country, in which currency the bond
is denominated and in which the bond is sold. A bond denominated in U.S
dollars that is issued in the United

States by the government of Canada is foreign bond. A foreign bond allows

an investor a measure of international diversification without subjection to
the risk of changes in relative currency values. A Eurobond issue is one
denominated in a particular currency but sold to investors in national
capital markets other than the country which issues the denominating
currency.

A Eurobond is a bond denominated in a currency other than that of the

country of issue (for example, Proctor and Gamble issuing a U.S dollar
denominated bond in Germany. Eurobonds. Also have the advantages of
limited regulation and record keeping and no ta withholding requirements,
which further lower the interest rate required by investors. Eurobonds
make up over 80% of the international bond market. The two major
reasons for this stem from the fact that the U.S dollar is the currency most
frequently sought in international bond financing. First Eurodollar bonds
can be brought to market more quickly than Yankee bonds because they
are not offered to U.S investors an thus do not have to meet the strict SEC
registration requirements. Second, Eurobonds are typically bearer bond
that provide anonymity to the owner and thus allow a means for evading
taxes on the interest received. Because of this feature, investors are
generally willing to accept a lower yield on Eurodollar bonds in comparison
to registered Yankee bonds of comparable terms, where ownership is
recorded. For borrowers the lower yield means a lower cost of debt service.

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The Major types of international bond instrument and their

distinguishing characteristic are a follow:

• Straight Fixed Rate Bond: This Bond issue has designated maturity
date at which the principal of bond issue is promised to be repaid. During
the life of the bond, fixed coupon payments that are some percentage
rates of the face value are paid as interest to the bond holder. This is the
major international bond type. Straight fixed rate Eurobonds are typically
bearer bonds and pay coupon interest annually.

• Floating Rate Notes (FRN): These are typically medium-term bonds

with their coupon payments indexed to some reference rate. Common
reference rates are either 3 months or 6 months UD Dollar LIBOR
Coupon payments on FRN are usually quarterly or semi-annual and in
accordance with reference rates.

• Convertible Bonds: Issue of these bonds allows investors to exchange

the bond for a predetermined number of equity shares of the issuer. The
Floor value of the convertible bonds is its straight fixed rate bond value.
Convertibles usually sell at premium above the larger of their straight
debt value and their conversion value. Additionally, investors are usually
willing to accept a lower coupon rate of interest that the comparable
straight fixed coupon bond rate because they find the calls future
attractive.

• Bond with Equity: These are the warrants, can be viewed as a straight
fixed rate bonds with addition of call options (or warrants) features. The
Warrants entitles the bond holders to purchase a certain number of
equity shares in the issuer at pre stated price over the pre-determined
period.

• Zero coupon bonds: Zero coupon bonds are sold at discount from the
face value and do not pay any coupon interest over their life. At maturity
the investors receive the full-face value. Another form of zero-coupon
bond is stripped bonds.

• A stripped Bonds: It is the zero-coupon bond results from stripping the

coupon and principal from the coupon bond. The result is a series of
zero-coupon bond represented by the individual coupon and principal
payments.

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• A dual currency bonds: It is straight fixed rate bond which is issued in

one currency and pays coupon interest in that same currency. At
maturity, the principal is repaid in a second currency. Coupon interest is
frequently at higher rate than comparable straight fixed rate bond. The
amount of the dollar principal repayment at maturity is set at inception;
frequently, the amount allows for some appreciation in exchange rate of
the stronger currency. From investors perspective, dual currency bond
includes a long-term forward contract.

16.4.1 International Bond issue to market

A borrower desiring to raise the funds by issuing Eurobonds to the

investing public will contact an investment banker and ask it to serve as
lead manager of underwriting syndicate th at will bring the bond to market.
The lead manager will usually invite other banks to form a managing group
to help negotiate terms with borrowers, ascertain the market condition,
and manage the issuance. The managing group, along with other banks,
will serve as underwrites for the issue, i.e., they will commit their own
capital to buy the issue from the borrower at discount from the issue price.
Most of the underwriters, along with other banks, will be part of selling
group that sells the bonds to the investing public. The various members of
the underwriting syndicate receive a portion of the spread (usually it
ranges from 2% to 2.5% of the issue size), depending up on the numbers
and type of functions they perform. The lead managers receive the full
spread, and the bank serving as only a member of the selling group
receives a smaller portion.

16.4.2 Characteristics of Foreign Bonds:

There are 3 characteristics of foreign bonds:
1. The bond is either issued by foreign entity (such as government,
municipality, or corporation)
2. The bond is traded on foreign market, and
3. The bond is denominated in foreign currency

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The foreign bonds are subject to currency risk, when you hold the bond, it
is denominated in foreign currency. As bond takes specified time to
mature, there is no guarantee of return of the bond given the currency
exchange fluctuations.” by “due to currency exchange fluctuation”. A
Eurobond is a bond issued and traded in the country other than the one in
which its currency is denominated. A Eurobond does not necessarily have
to originate or end up in the Europe although the most debt instruments of
this type are issued by non-European entities to European investors.
Meaning an entity can place a bond on German exchange denominated in
American dollars. Another difference is the composition of underwriting
syndicate. Eurobonds are underwritten by an international syndicate and is
not subject to rules and regulations of any country. Foreign bonds,
however, are underwritten in the country of currency denomination, and
are therefore subject to the regulations of that country.

16.4.3 Foreign bonds represent an-Un enforceable claim

The primary risk of foreign bond is that it is an unenforceable claim. An

investor that owns a bond of a company in his or her home country has
specific legal recourse in the event of default. Foreign bond, however,
offers no such protection. An extremist political movement (e.g., Iran in
1970) could come to the power and seize or deny all the foreign assets and
claims. Country may become engaged in military conflict and prohibits its
currency from leaving its border. After world War II, for example, investors
holding bonds in a great Britain were paid interest in pounds yet were
unable to convert those pounds in to dollars; the money could only be re-
invested in pound denominated investments or spent within the borders of
Britain or her colonies.

16.4.4 Invest in Foreign Securities:

Investing in foreign securities can reduce the overall portfolio risk and at
some time modestly increase the potential for return. The us Stock market
still remains the largest in the world; however, foreign markets now
account for approximately 50% of the global stock market capitalization.
Consequently, it is becoming more important to diversify portfolios
globally, taking advantage of growth rates in different regions and
countries. Proper international diversification can help the balance out your
returns by reducing or avoiding the losses when the US markets are under
performing.

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Video Link 1

Video Link 2

16.5 MULTI-CURRENCY BONDS

A multicurrency bond is a bond Denominated in more than one currency

(for example, Toyota issuing a bond promising interest payment in YEN
and repayment of principal in US Dollars). Bond provide legal entities with
means for financing investments and found in variety of forms.
Multicurrency bonds differ from plain vanilla bonds in that the currency of
interest coupon is different from currency of the repayment amount. The
information regarding processing of foreign exchange facts is available in
the business content documentation for IFRS, as well as in the other
available SAP documents. Multicurrency bonds are normally set up with a
fixed or variable interest rate (floater) and have fixed maturity terms. An
exception to this is perpetual or perpetual bonds, for which no end of the
term has been agreed up on. Business content does not take perpetuals in
to account. Bond sums usually repaid at the end of the maturity term.
However, multicurrency bonds with installment repayment are also
possible. The latter, however, currently cannot be mapped by bank
analyzer.
Different variants of the interest structure can be found in bond market.
The following list presents only those products that are mapped in business
content; it is not intended to be the complete list:
• Fixed interest Bonds (fixed interest for complete term)
• Floating Rate note (FRN): generally variable interest plus mark-up)
• Reverse Floater (fixed interest minus variable interest)
• Step-up / down (interest rate vary over term, and are from start,
however fixed per coupon)
• Zero bonds ( Bond without current interest calculation (zero coupon
bonds) that are issued at an exchange rate clearly below 100%) The
difference with respect to 100% corresponds to the discounted interest
payments through the end of maturity term for zero bonds.

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• Multicurrency Bond Assets:

A purchased multicurrency bond is financial assets portfolio that is
reported either in the trading position (trading securities=FfT, DFV) or
assets portfolio (investment securities=AfS, HtM) depending up on the
assignment. The holding category is assigned according to the general
object model of bank analyzer in the form of separate securities position
account.
• Multicurrency Bond Issue:
• Issues are reported on the balance sheet in the item “debt securities in
issue” and are amortized cost. They are always managed in the holding
category “other liabilities”

16.5.1 Recognition and valuation according to IFRS:

Holding Criteria:
Held to maturity: For business content, the holding category HTM is not
considered for multicurrency bonds. It is off course in theory possible for
multi-currency bonds as well; in practice, however this is seldom form
banks. A multicurrency bond might be categorized as HTM for example, in
the case of an insurance company that holds such securities until maturity,
as premium reserve fund, for example.
The reclassification business transaction is therefore also irrelevant, since
position can only be reclassified from/ to HTM position.
Available for sale:
Position of the category available for sale (AfS) are to be recognized at the
time of acquisition; transaction cost are calculated at acquisition cost in
business content.
The fair value is also calculated in the key date valuation; the amortization
is determined in the first step (result=amortized cost). In second step, the
unrealized result are determined on the basis of the fair value in the object
currency. The result from the fair value calculations are posted as a part of
the capital to a revaluation reserve (revaluation surplus) without affecting
net income. In the third step, unrealized profit or loss in foreign currency is
calculated.

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Held for trading:

Position in the category held for trading (HfT) are used for short term
realisation of profit. These positions are also managed at fair value in the
balance sheet. Amortization is determined at the first step in the key date
valuation (result=amortized cost). In the second step, unrealized results
are determined on the basis of the fair value in the object currency. In the
third step, the unrealized profit or loss in foreign currency is calculated.
The valuation results are posted directly in the profit and loss statement.
All positions that are from short sales (short position) and that have to be
accounted for as trading liabilities must be assigned to holding category
HfT. This fact must be taken into account when delivering the business
transaction.
Valuation Model
The following key table is relevant to the valuation of multicurrency bonds:
Category Carrying value Notes
AfS Fair value Fair value=(Book Value)
HfT Fair value
DFV Fair value Fair value=(Book Value)
OLI Amortized cost Fair value

Amortized cost:

The Amortized cost is calculated using the valuation model cash flow disc
based on effective interest rate.

Fair Value:

The fair value is calculated (if market prices are available) using the
valuation model mark to market: if no market prices are available, then
the valuation model cash flow disc is used.

Discounting is performed with the swap curve without any spread curve
and without using the financial instrument – dependent spread.

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Short position can be valued using “mark – to-market” valuation only, they
can not be valued using “mark to model “valuation.

16.5.2 Multi currency Strategy geared for high return:

Have you heard of “currency sandwich” strategy? Investors in the know

have been using this “distortion” in the world’s currency market to make
some high returns for decades. This strategy is not for the faint of heart,
but for those that can risk big losses for the substantial rewards. In simple
terms the currency sandwich is a strategy where one borrows a low
interest currency and then investing the loan in multiple currency with
higher return than the cost of the loan. This difference in interest has
returned many investors profit in the double to triple digits in range,
however, this strategy is highly speculative and is not without risk. The
cost of the repaying the loan together with interest will go up should the
exchange rate on the loan currency goes up, thus the net profit will
decline. As long as interest differential is larger than the possible negative
development in the price and exchange rate, a potential gain on the
investment is made.

16.6 BANK FINANCING

The Indian Banking system has remarkably successful in some respects.

Its immense size and enormous penetration in rural areas is exemplary
among developing countries, as its solid reputation for stability among the
depositors. The penetration in rural areas has been associated with
reduction in poverty and a diversification of agriculture. However, in recent
years it has been widely viewed as being both expensive and inept. In
particular, it has been argued that most banks are overstated, that large
fraction of their assets are nonperforming (NPA) and those they under-
lend, in the sense of not putting through efforts into their primary task of
financing industry. A wide range of remedies has been suggested ranging
from strengthening the legal system to punish the defaulters, to abolish
the targeted lending programs (so called Priority sector lending) to
privatization of entire banking system.

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16.6.1 Parallel Loans

A parallel loan involves exchange of firms between firms in different

countries, with exchange reserved at later date. A parallel loan refers to a
loan which involves an exchange of currencies between four parties, with a
promise to re exchange the currencies at pre-determined exchange rate on
a specified future date. Typically, the parties consist of two pairs of
affiliated companies. Parallel loans are commonly arranged by two
multinational parent companies in two different countries.

Back-to-back loans:
Back-to-back loan involves an exchange of currencies between two parties,
with a promise to re-exchange the currencies at specified rate on the
specified future date. Back-to-back loan involves two companies domiciled
in two different countries. For Example, IBM borrows money in US Dollars
and lend the borrowed funds to Olivetti in Italy, which in turn borrows fund
in Italy and lend those funds to IBM in United States. By this simple
arrangement, each firm has access to capital markets in foreign country
and makes use of their comparative advantage of borrowing in different
capital markets.

Video Link 1

16.6.2 Drawbacks of parallel and back-to-back loans:

The difficulty in finding counterparties with matching needs. Firm must find
the firms with mirror image financing needs. Financing requirement
includes principals, types of interest payments, frequency of interest
payments and the length of loan period. The search cost for finding such
counterparty is quite considerable. One is still obligated to comply with the
loan terms even when the other defaults. In the above example, IBM is still
liable for the loan even if Olivetti defaults. To avoid default risk, a separate
agreement defining the right of offset must be drafted. The loan is carried
on the accounting books of both the firms. This limits additional borrowings
and hence limits the leverage of these firms.

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Swaps on the other hand overcome the above drawbacks by.

• Making it easier to find counter parties via swap brokers
• Defining an offset agreement as a part of the swap
• Principal amounts in a swap do not appear on accounting books. These
off-book transactions help banks to avoid increases in capital
requirements under applicable regulations.

16.6.3 Swap banks

Financial institutions which assist in completion of swaps are called swap

banks. The swap banks make profits from the bid-ask spread it imposes on
swap coupon. A swap broker is a swap bank who acts strictly as agent
without taking any financial position in the swap transaction, i.e., mealy
match’s counter parties and does not assume any risk of swap. A swap
dealer is a swap bank who transacts for its own account to help complete
the swap. In this capacity, the swap dealer assumes a position in the swap
and thus assumes certain risks.

16.6.4 Types of SWAPS

Following are the types of SWAPS.
Plain Vanilla Swaps:
It is simplest kind of swaps. Here two counter parties agree to make
payments to each other based on some underlying assets. These payments
include interest payment, commission, and other service payments. The
swap agreement contains specifications of the assets to be exchanged, the
rate of interest applicable to each, the timetable by which the payments
are to be made and other provisions. The two parties may or may not
exchange the underline assets, which are called notional principals, in
order to distinguish them from physical exchanges in the cash market.
Interest rate Swaps:
The interest rate swaps is a swap in which counter parties exchange cash
flow of a floating rate for cash flows of fixed rate or vice versa. No notional
principal changes hands, but it is reference amount against which interest
is calculated. Interest rate swap can be international or domestic. The most
common motive for interest rate swap is:

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• Changes in financial markets may cause interest rate change.

• Borrowers may have different credit rating in different countries.
• Borrowers have different preferences for the debt service payment
schedule.
Interest rate swaps are normally arranged by an international bank which
serves as a swap broker or a swap dealer. Through interest rate swaps,
borrower obtains a lower cost of the debt service payment and lender
obtains a service guarantee.
Currency Swaps:
A currency swap is a swap in which one party provides a certain principal in
one currency to its counterparty in exchange for equivalent amount in a
different currency. For example, a US firm wants to exchange it’s dollars
for Indian Rupee, while an Indian firm wants to exchange a rupee to US
Dollars. Given these two needs the two may engage in a swap deal.
Currency swap is like parallel loans, but swaps are better due to:
• Ease of finding counterparty
• The right to offset the loan payment
• Off book transaction

Video Link 1

Video Link 2

Swaptions, caps, Floor, and collars

A swaption is an option to enter plain vanilla swaps. A call swaption gives

the holder the right to receive fixed interest payments. A put swaption
gives the holder right to make fixed interest payment. Call swaption are
attractive when interest rate is expected to fall. Put swaption are attractive
when interest rates are expected to rise. Banks and investment firms
usually acts as a dealer rather than broker. An interest rate cap sets the
maximum rate of interest on floating rate interest payments; an interest
rate floor set the minimum rate of interest on floating rate interest
payments; an interest rate floor sets the minimum rate of interest on
floating rate interest payment, and an interest rate collar combines a cap

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with a floor. A buyer of these instruments pays one time premium, which is
a small percentage of national capital.

Motivation for swaps:

There are three basic motivations for swaps. First, companies use swaps to
provide protection against the future changes in exchange rates. Second,
companies use swaps to eliminate interest rate risk arising from the normal
commercial operations. Third, Companies use swaps to reduce the
financing cost.

Closing thoughts:

Swap market has emerged largely because financial swap escapes many of
the limitations inherent in currency futures and option markets. Swaps are
custom tailored to the need of two parties; swap agreements are more
likely to meet the specific needs of counterparties than currency futures
and options. Swaps market is done via financial institutions and offers
privacy when compared to foreign exchange market. Lastly swaps are not
as highly regulated as options and future markets.

16.6.5 Credit swaps:

A credit swap involves the exchange of currencies between bank and firm
rather than two firms. It is alternate method of obtaining debt capital for
foreign subsidiary without sending the funds abroad. Credit default swaps
are utilised to control one’s exposure to credit risk. A credit default swap is
like an insurance contract because it provides protection against the
specific credit events. In a typical credit default swap, one party sales the
credit risk, usually associated with corporate bond or underlying credit
assets to the counterparty. The buyer pays the periodic fees or premium,
normally expressed in basis points on the notional amount, to the seller. In
turn seller pays default payment upon default, i.e., defined credit related
event of the underlying corporate entities thus protecting the buyer from a
financial loss.

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Credit default swap are often founded on ISDA Master agreement which
defines the protection and obligation of the parties. However, if any default
does not occur during the term of swap, then the buyer continues to pay
the premium till maturity. Traditionally, there is no exchange money when
the two parties enter into contract. The payments are done only during the
term of contract. The premium paid by the buyer to the seller is most often
called “spread”. It is expressed in term of basis points per annum of the
notional value of the contract and typically paid quarterly for corporate
credit default swap or even semiannually. The notional value of the
contract implies the total face value of the underlying Assets. It is
important to note that these spreads are not the same as the yield spread
of corporate bond or government bonds. The maturity period of typical
credit default swap varies from one year to ten years, with five years being
the most common time frame. There are no limits on the size of the credit
default swap contract, though the most contracts fall between Rs. 500
million and Rs. 100 million. The underlying corporate entity may be
autonomous corporate entities, state governments, financial institutions
and other investment or sub-investment grade corporations.

Once the specified credit related event, like the insolvency of an underlying
corporate entity, occurs a” credit event notice” is delivered either by buyer
or seller. Usually, the settlement condition for the default payment of credit
default swap is established at the time of writing the relevant credit default
sap. In case the credit related event is triggered; cash settlement or
physical settlement is settled upon. Physical settlement: in a physical
settlement, the seller takes delivery (or buy’s) the defaulted bonds or loan
from the buyer at the par value. Physical settlement takes place within 30
days after the credit event. Cash Settlement: Cash settlement is payment
equal to difference between the market value of the bond (or the final
value of the underlying credit assets for the initial notional amount) and
the par value of the bond.

The main difference between physical settlement and cash settlement is

that in a physical settlement the seller has a remedy to the underlying
corporate entity as well as the chance to take part in the workout
procedure as the holder of the defaulted underlying credit asset.

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The common credit events of credit default swaps are:

• Bankruptcy: The underlying corporate entity becomes insolvent or is
unable to repay the debt.
• Failure to pay: The underlying corporate entity is unable to make the
outstanding interest payment or principal payment.
• Debt Restructuring: The underlying corporate entity negotiates
changes in term of the debt obligations.

Video Link 1

Video Link 2

16.6.6 Parallel Loan Versus Credit Swaps:

A parallel loan involves two companies, where as credit swap involves one
company. In both companies or banks are located in two different
countries. Both type of financing avoids money flow between the countries.
Parallel loans are more difficult to arrange than credit swap because the
parties must find each other. In case of credit swap all that is needed is
that the parent or its subsidiary approaches a bank.

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16.7 SUMMARY

Financing is a very important part of every business. Firms often need

financing to pay for their assets, equipment, and other important items.
Financing can be either long-term or short-term. As is obvious, long-term
financing is more expensive as compared to short-term financing.

There are different vehicles through which long-term and short-term

financing is made available. This chapter deals with the major vehicles of
both types of financing.

The common sources of financing are capital that is generated by the firm
itself and sometimes, it is capital from external funders, which is usually
obtained after issuance of new debt and equity.

Among the different investment avenues, bonds, equity, and cash

equivalents are the three main investment avenues (the three traditional
investment classes). All other investment avenues are considered
alternative investment classes. Typically, the three main investment
classes may offer various advantages (to investors) vis-à-vis the
alternative investment classes. As a result, many investors prefer investing
in the three main investment classes rather than in the alternative
investment classes

A company’s equity is the value of its assets less liabilities. In the stock
market, an investor who purchases shares of a company is entitled to a
portion of its equity, when a firm sell a portion of its equity, either as an
initial public offering (IPO) or a secondary offering. It is saying, in effect,
they are going to use your money to finance our venture. In return, they
are giving you ownership in our company and the potential to share in our
profits-in the form of dividends or a higher valuation on the stock.” What
an investor get is a piece of ownership in the company and the possibility
of a higher stock price, plus dividends. But remember, there’s no
guarantee the company will succeed. No matter what company an investor
decides to invest in. there are several reasons why shareholders can lose
some or all of their money.

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The two segments of the international bond market are: foreign bonds and
Eurobonds. A foreign bond is a bond issued in a domestic market for a
foreign borrower. Foreign bonds tend to be more regulated than Eurobonds
and are usually issued by a domestic group of banks. A debt security
issued by a borrower from outside the country, in which currency the bond
is denominated and in which the bond is sold. A bond denominated in U.S
dollars that is issued in the United

States by the government of Canada is foreign bond. A foreign bond allows

an investor a measure of international diversification without subjection to
the risk of changes in relative currency values. A Eurobond issue is one
denominated in a particular currency but sold to investors in national
capital markets other than the country which issues the denominating
currency.

The Indian Banking system has remarkably successful in some respects.

Its immense size and enormous penetration in rural areas is exemplary
among developing countries, as its solid reputation for stability among the
depositors. The penetration in rural areas has been associated with
reduction in poverty and a diversification of agriculture. However, in recent
years it has been widely viewed as being both expensive and inept

A parallel loan involves exchange of firms between firms in different

countries, with exchange reserved at later date. A parallel loan refers to a
loan which involves an exchange of currencies between four parties, with a
promise to re exchange the currencies at pre-determined exchange rate on
a specified future date. Typically, the parties consist of two pairs of
affiliated companies. Parallel loans are commonly arranged by two
multinational parent companies in two different countries.

Back-to-back loan involves an exchange of currencies between two parties,

with a promise to re-exchange the currencies at specified rate on the
specified future date. Back-to-back loan involves two companies domiciled
in two different countries.

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16.8 MULTIPLE CHOICE QUESTIONS:

1. Most of the bonds are----------------------

(a) Floating rate securities
(b) Interest -bearing obligations of governments or corporations
(c) Giving bondholders a voice in the affairs of corporation
(d) Money market securities

2. Which of the following is the capital market securities?

(a) Eurodollars
(b) Treasury Bills
(c) Federal Agency bonds
(d) Federal funds

3. To curb insider trading, SEBI has stipulated that, those investors who
have more than 5% stake in any company, has to inform the company
within -------------days, if their stake is altered by more than 2%.
(a) 10
(b) 8
(c) 5
(d) 4

4. Goods and service tax (GST) is implemented with effect from

---------------
(a) 1st April 2009
(b) 1st April 2010
(c) 1st April 2011
(d) None of the above

5. The oil crisis caused US Oil companies overseas profits to shoot up,
producing a jump in ----------- that could mislead policy makers
(a) GDP
(b) GNP
(c) Investment
(d) Interest rates

Answers: 1. (b), 2. (c), 3. (d), 4. (b), 5. (c).

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REFERENCE MATERIAL
Click on the links below to view additional reference material for this
chapter

Summary

PPT

MCQ

Video Lecture - Part 1

Video Lecture - Part 2

Video Lecture - Part 3

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