Financial Management means planning, organizing, directing and controlling the

financial activities such as procurement and utilization of funds of the enterprise.

It means applying general management principles to financial resources of the
enterprise.
Business finance refers to money and credit employed in business.
It involves procurement and utilization of funds so that business firms may be able
to carry out their operations effectively and efficiently. Business finance includes all
types of funds used in business.
SCOPE/ ELEMENTS
1. Investment decisions includes investment in fixed assets (called as capital
budgeting). Investment in current assets are also a part of investment decisions
called as working capital decisions.
2. Financial decisions – They relate to the raising of finance from various resources
which will depend upon decision on type of source, period of financing, cost of
financing and the returns thereby.
3. Dividend decision – The finance manager has to take decision with regards to the
net profit distribution. Net profits are generally divided into two:
(i) Dividend for shareholders - Dividend and the rate of it has to be decided.
(ii) Retained profits - Amount of retained profits has to be finalized which will
depend upon expansion and diversification plans of the enterprise.
OBJECTIVES OF FINANCIAL MANAGEMENT The financial management is generally
concerned with procurement, allocation and control of financial resources of a
concern. The objectives can be
1. To ensure regular and adequate supply of funds to the concern.
2. To ensure adequate returns to the shareholders this will depend upon the earning
capacity, market price of the share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.
4. To ensure safety on investment, i.e, funds should be invested in safe ventures so
that adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair composition of
capital so that a balance is maintained between debt and equity capital.
FUNCTIONS OF FINANCIAL MANAGEMENT
1. Estimation of capital requirements: A finance manager has to make estimation
with regards to capital requirements of the company. This will depend upon
expected costs and profits and future programmes and policies of a concern.
Estimations have to be made in an adequate manner which increases earning
capacity of enterprise.
2. Determination of capital composition: Once the estimation has been made, the
capital structure has to be decided. This involves short- term and long- term debt
equity analysis. This will depend upon the proportion of equity capital a company is
possessing and additional funds which have to be raised 3.Choice of sources of
funds: For additional funds to be procured, a company has many choices like
a) Issue of shares and debentures
b) Loans to be taken from banks and financial institutions
c) Public deposits to be drawn like in form of bonds. Choice of factor will depend on
relative merits and demerits of each source and period of financing.
3. Investment of funds: The finance manager has to decide to allocate funds into
profitable ventures so that there is safety on investment and regular returns is
possible.
4. Disposal of surplus: The net profits decision has to be made by the finance
manager. This can be done in two ways:
a) Dividend declaration – It includes identifying the rate of dividends and other
benefits like bonus. \
b) Retained profits – The volume has to be decided which will depend upon
expansional, innovate, diversification plans of the company.
5. Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and
salaries, payment of electricity and water bills, payment to creditors, meeting
current liabilities, maintenance of enough stock, purchase of raw materials, etc.
6. Financial controls: The finance manager has not only to plan, procure and utilize
the funds but he also has to exercise control over finances. This can be done through
many techniques like ratio analysis, financial forecasting, cost and profit control, etc.
UNIT 2: FINANCIAL STATEMENT & ITS TYPES
Financial Statements represent a formal record of the financial activities of an
entity. These are written reports that quantify the financial strength, performance
and liquidity of a company. Financial Statements reflect the financial effects of
business transactions and events on the entity. Financial statements are written
records that convey the financial activities and conditions of a business or entity and
consist of four major components. Financial statements are meant to present the
financial information of the entity in question as clearly and concisely as possible for
both the entity and for readers. Financial statements for businesses usually include
income statements, balance sheets, statements of retained earnings and cash flows
but may also require additional detailed disclosures depending on the relevant
accounting framework. Financial statements are often audited by government
agencies, accountants, firms, etc. to ensure accuracy and for tax, financing or
investing purposes.
4 TYPES OF FINANCIAL STATEMENTS
1. Statement of Financial Position Statement of Financial Position, also known as the
Balance Sheet, presents the financial position of an entity at a given date. It is
comprised of the following three elements: Assets: Something a business owns or
controls (e.g. cash, inventory, plant and machinery, etc) Liabilities: Something a
business owes to someone (e.g. creditors, bank loans, etc) Equity: What the business
owes to its owners. This represents the amount of capital that remains in the
business after its assets are used to pay off its outstanding liabilities. Equity therefore
represents the difference between the assets and liabilities.
2. Income Statement Income Statement, also known as the Profit and Loss
Statement, reports the company’s financial performance in terms of net profit or
loss over a specified period. Income Statement is composed of the following two
elements: Income: What the business has earned over a period (e.g. sales revenue,
dividend income, etc) Expense: The cost incurred by the business over a period (e.g.
salaries and wages, depreciation, rental charges, etc) Net profit or loss is arrived by
deducting expenses from income.
3. Cash Flow Statement Cash Flow Statement, presents the movement in cash and
bank balances over a period. The movement in cash flows is classified into the
following segments: Operating Activities: Represents the cash flow from primary
activities of a business. Investing Activities: Represents cash flow from the purchase
and sale of assets other than inventories (e.g. purchase of a factory plant) Financing
Activities: Represents cash flow generated or spent on raising and repaying share
capital and debt together with the payments of interest and dividends.
4. Statement of Changes in Equity Statement of Changes in Equity, also known as the
Statement of Retained Earnings, details the movement in owners’ equity over a
period. The movement in owners’ equity is derived from the following components:
Net Profit or loss during the period as reported in the income statement Share
capital issued or repaid during the period Dividend payments Gains or losses
recognized directly in equity (e.g. revaluation surpluses) Effects of a change in
accounting policy or correction of accounting error.

UNIT 2.1: TECHNIQUES OF FINANCIAL ANALYSIS Financial Analysis is defined as

being the process of identifying financial strength and weakness of a business by
establishing relationship between the elements of balance sheet and income
statement. The information pertaining to the financial statements is of great
importance through which interpretation and analysis is made. It is through the
process of financial analysis that the key performance indicators, such as, liquidity
solvency, profitability as well as the efficiency of operations of a business entity may
be ascertained, while short term and long-term prospects of a business may be
evaluated. Thus, identifying the weakness, the intent is to arrive at
recommendations as well as forecasts for the future of a business entity. Financial
analysis focuses on the financial statements, as they are a disclosure of a financial
performance of a business entity. “A Financial Statement is an organized collection
of data according to logical and consistent accounting procedures. Its purpose is to
convey an understanding of some financial aspects of a business firm. It may show
assets position at a moment of time as in the case of balance sheet, or may reveal a
series of activities over a given period of times, as in the case of an income
statement.” Since there is recurring need to evaluate the past performance, present
financial position, the position of liquidity and to assist in forecasting the future
prospects of the organization, various financial statements are to be examined in
order that the forecast on the earnings may be made and the progress of the
company be ascertained. The financial statements are: Income statement, balance
sheet, statement of earnings, statement of changes in financial position and the
cash flow statement. The income statement, having been termed as profit and loss
account is the most useful financial statement to enlighten what has happened to
the business between the specified time intervals while showing, revenues,
expenses gains and losses. Balance sheet is a statement which shows the financial
position of a business at certain point of time. The distinction between income
statement and the balance sheet is that the former is for a period and the latter
indicates the financial position on a particular date. However, on the basis of
financial statements, the objective of financial analysis is to draw information to
facilitate decision making, to evaluate the strength and the weakness of a business,
to determine the earning capacity, to provide insights on liquidity, solvency and
profitability and to decide the future prospects of a business entity. There are
various types of financial analysis: External analysis: The external analysis is done on
the basis of published financial statements by those who do not have access to the
accounting information, such as, stock holders, banks, creditors, and the general
public. Internal Analysis: This type of analysis is done by finance and accounting
department. The objective of such analysis is to provide the information to the top
management, while assisting in the decision-making process. Short term Analysis: It
is concerned with the working capital analysis. It involves the analysis of both
current assets and current liabilities, so that the cash position (liquidity) may be
determined. Horizontal Analysis: The comparative financial statements are an
example of horizontal analysis, as it involves analysis of financial statements for a
number of years. Horizontal analysis is also regarded as Dynamic Analysis.
11/8/24UNIT 2.1 Techniques of Financial Analysis
Vertical Analysis: it is performed when financial ratios are to be calculated for one
year only. It is also called as static analysis. An assortment of techniques is
employed in analyzing financial statements.
They are: Comparative Financial Statements, statement of changes in working
capital, common size balance sheets and income statements, trend analysis and
ratio analysis.
Comparative Financial Statements: It is an important method of analysis which is
used to make comparison between two financial statements. Being a technique of
horizontal analysis and applicable to both financial statements, income statement
and balance sheet, it provides meaningful information when compared to the
similar data of prior periods. The comparative statement of income statements
enables to review the operational performance and to draw conclusions, whereas
the balance sheets, presenting a change in the financial position during the period,
show the effects of operations on the assets and liabilities. Thus, the absolute
change from one period to another may be determined.
Statement of Changes in Working Capital: The objective of this analysis is to extract
the information relating to working capital. The amount of net working capital is
determined by deducting the total of current liabilities from the total of current
assets. The statement of changes in working capital provides the information in
relation to working capital between two financial periods.
Common Size Statements: The figures of financial statements are converted to
percentages. It is performed by taking the total balance sheet as 100. The balance
sheet items are expressed as the ratio of each asset to total assets and the ratio of
each liability to total liabilities. Thus, it shows the relation of each component to the
whole – Hence, the name common size.
Trend Analysis: It is an important tool of horizontal analysis. Under this analysis,
ratios of different items of the financial statements for various periods are
calculated and the comparison is made accordingly. The analysis over the prior
year’s indicates the trend or direction. Trend analysis is a useful tool to know
whether the financial health of a business entity is improving in the course of time
or it is deteriorating.
Ratio Analysis: The most popular way to analyse the financial statements is
computing ratios. It is an important and widely used tool of analysis of financial
statements. While developing a meaningful relationship between the individual
items or group of items of balance sheets and income statements, it highlights the
key performance indicators, such as, liquidity, solvency and profitability of a
business entity. The tool of ratio analysis performs in a way that it makes the
process of comprehension of financial statements simpler, at the same time, it
reveals a lot about the changes in the financial condition of a business entity. It
must be noted that Financial analysis is a continuous process being applicable to
every business to evaluate its past performance and current financial position. It is
useful in various situations to provide managers the information that is needed for
critical decisions. The process of financial analysis provides the information about
the ability of a business entity to earn income while sustaining both short term and
long-term growth.

UNIT 2.2: LIMITATIONS OF FINANCIAL ANALYSIS

Although analysis of financial statement is essential to obtain relevant information
for making several decisions and formulating corporate plans and policies, it should
be carefully performed as it suffers from a number of the following limitations.

1. Mislead the user

The accuracy of financial information largely depends on how accurately financial
statements are prepared. If their preparation is wrong, the information obtained
from their analysis will also be wrong which may mislead the user in making
decisions.

2. Not useful for planning

Since financial statements are prepared by using historical financial data, therefore,
the information derived from such statements may not be effective in corporate
planning, if the previous situation does not prevail.

3. Qualitative aspects
Then financial statement analysis provides only quantitative information about the
company’s financial affairs. However, it fails to provide qualitative information such
as management labour relation, customer’s satisfaction, and management’s skills
and so on which are also equally important for decision making.

4. Comparison not possible

The financial statements are based on historical data. Therefore, comparative
analysis of financial statements of different years cannot be done as inflation distorts
the view presented by the statements of different years.

5. Wrong judgement
The skills used in the analysis without adequate knowledge of the subject matter
may lead to negative direction. Similarly, biased attitude of the analyst may also lead
to wrong judgement and conclusion.
The limitations mentioned above about financial statement analysis make it clear
that the analysis is a means to an end and not an end to itself. The users and analysts
must understand the limitations before analyzing the financial statements of the
company.

RATIO ANALYSIS
Ratio analysis involves the construction of ratios using specific elements from the
financial statements in ways that help identify the strengths and weaknesses of the
firm. Ratios help measure the relative performance of different financial measures
that characterize the firm’s financial health. We could just look at the dollar value
of each financial measure and draw conclusions about performance; however,
using ratios often provides a standardized measure which is easier to interpret.

CLASSIFICATION OF RATIOS

1. Liquidity Ratios: These ratios measure the ability of a company to meet its
current obligations, and indicate the short-term financial stability of the company.
The parties interested in the liquid ratio would be employees, bankers and short-
term creditors.

2. Profitability Ratios: These measure the overall effectiveness in terms of returns

generated, with profits being related to sales and adequacy of such profits as to
sales or investment. The profitability ratios are important to internal management,
to bankers, to investors and to the owners.

3. Leverage Ratios: These measure the extent to which the company has been
financed through borrowing (debt financing whether short or long-term). Those
interested would be bankers, owners and investors.

4. Activity Ratios: These measure the extent to which the company has been
financed through borrowing (debt financing whether short or long-term). Those
interested would be bankers, owners and investors.

5. Solvency Ratios: These ratios would give a picture of the company so that an
early forewarning is available for remedial action in time.

6. Financial Ratios: These enable quick spotting of over or under-capitalization of a

business, so that a proper, balance is achieved between owner’s funds, borrowed
funds and shareholder’s funds.

MEANING OF RATIO ANALYSIS

Ratio analysis is an important technique of making financial analysis. Under this

method, financial statements are analysed by calculating various financial ratios by
taking the relevant data contained in the financial statements (income statement
and balance sheet).
Comparing the ratios calculated with the past ratios of the same firm or with the
ratios of other firms or with the ratios of the industry to which the firm belongs
and interpreting the ratios calculated.

ADVANTAGES/ USES AND LIMITATIONS OF RATIO ANALYSIS

Advantages/ Uses
Ratio analysis is a useful tool for users of financial statements. It has following
advantages:

1) It simplifies the financial statements.

2) It helps in comparing companies of different size with each other.
3) It helps in trend analysis which involves comparing a single company over a
period.
4) It highlights important information in a simpler form quickly. A user can judge a
company’s financial position and profitability by just looking at few ratios instead
of reading the whole financial statements

Limitations
Despite advantages, ratio analysis has some disadvantages. Some key demerits of
financial ratio analysis are:

1) Different companies operate in different industries, each having different

environmental conditions such as regulation, market structure, etc. Such factors
are so significant that a comparison of two companies from different industries
might be misleading.
2) Financial accounting information is affected by estimates and assumptions.
Accounting standards allow different accounting policies, which impairs
comparability and hence ratio analysis is less useful in such situations.
3) Ratio analysis explains relationships between past information while users are
more concerned about current and future information.
4) There may be window dressing of financial statements by the management of
the company which may lead to misleading information. Many times comparison
of ratios over time is meaningless because of inflation.

IMPORTANCE/ ADVANTAGES OF RATIO ANALYSIS

Ratio analysis is an important tool for analysing a company’s financial statements

(Income statement and Balance sheet). The following are the important advantages
of the accounting ratios:

1. Analysing the Financial Statements:

Ratio analysis is an important technique of financial statement analysis. Accounting
ratios are useful for understanding the financial position of the company. Different
users such as investors, management, bankers and creditors use the ratio to
analyse the financial situation of the company for their decision-making purpose.
2. Judging the efficiency of the company:
Accounting ratios are important for judging the company’s efficiency in terms of its
operations and management. They help judge how well the company has been
able to utilize its assets and earn profits.

3. Locating the weakness of the company:

Accounting ratios can also be used in locating weakness of the company’s
operations even though its overall performance may be quite good. Management
can then pay attention to the weakness and take remedial measures to overcome
them.

4. Formulating Plans:
Although accounting ratios are used to analyse the company’s past financial
performance, they can also be used to establish future trends of its financial
performance. As a result, they help formulate the company’s future plans.

5. Comparing the performance of the company:

It is essential for a company to know how well it is performing over years or as
compared to the other firms of the similar nature. Besides, it is also important to
know how well its different divisions are performing among themselves in different
years. Ratio analysis facilitates such comparison.

LIMITATIONS OF FINANCIAL RATIOS

There are some important limitations of financial ratios that analysts should be
conscious of: Many large firms operate different divisions in different industries.
For these companies it is difficult to find a meaningful set of industry average
ratios.

Inflation may have badly distorted a company’s balance sheet. In this case, profits
will also be affected. Thus, a ratio analysis of one company over time or a
comparative analysis of companies of different ages must be interpreted with
judgement.

Seasonal factors can also distort ratio analysis. Understanding seasonal factors that
affect a business can reduce the chance of misinterpretation. For example, a
retailer’s inventory may be high in the summer in preparation for back-to-school
season. As a result, the company’s accounts payable will be high and its ROA low.

Different accounting practices distort comparisons even within the same company
(leasing versus buying equipment, LIFO versus FIFO, etc.)

It is difficult to generalize about whether a ratio is good or not. A high cash ratio in
a historically classified growth company may be interpreted as a good sign, but
could also be seen as a sign that the company is no longer a growth company and
should command lower valuations.
 LIMITATIONS OF RATIO ANALYSIS

Ratio analysis, without a doubt, is amongst the most powerful tools of financial
analysis. Any investor, who wants to be more efficient at their job, must devote
more time towards understanding ratios and ratio analysis. However, this does not
mean that it is free of limitations. Like all techniques, financial ratios have their
limitations too. Understanding the limitations will help investors understand the
possible shortcomings with ratios and avoid them. Here are the shortcomings:

1) Misleading Financial Statements

The first ad foremost threat to ratio analysis is deliberate misleading statements
issued by the management. The management of most companies is aware that
investors look at certain numbers like sales, earnings, cash flow etc. very seriously.
Other numbers on the financial statements do not get such attention. They
therefore manipulate the numbers within the legal framework to make important
metrics looks good. This is a common practice among publicly listed companies and
is called “Window Dressing”. Investors need to be aware of such window dressing
and must be careful in calculating and interpreting ratios based on these numbers.

2) Incomparability
Comparison is the crux of ratio analysis. Once ratios have been calculated, they
need to be compared with other companies or over time. However, many times
companies have accounting policies that do not match with each other. This makes
it impossible to have any meaningful ratio analysis. Regulators all over the world
are striving to make financial statements standardized. However, in many cases,
companies can still choose accounting policies which will make their statements
incomparable.

3) Qualitative Factors
Comparison over time is another important technique used in ratio analysis. It is
called horizontal analysis. However, many times comparison over time is
meaningless because of inflation. Two companies may be using the same machine
with the same efficiency but one will have a better ratio because it bought the
machine earlier at a low price. Also, since the machine was purchased earlier, it
may be closer to impairment. But the ratio does not reflect this.

4) Subjective Interpretation
Financial ratios are established “thumb of rules” about the way a business should
operate. However, some of these rules of thumb have become obsolete. Therefore,
when companies come with a new kind of business model, ratios show that the
company is not a good investment. In reality the company is just “unconventional”.
Many may even call these companies innovative. Ratio analysis of such companies
does not provide meaningful information. Investors must look further to make
their decisions

UNIT 4 :
FUNDS FLOW ANALYSIS
 Meaning:

Funds flow refers to change in fund. Increase of funds of any transaction is a source
and decrease of funds in any transaction is application or uses of funds. Fund being
working capital funds flow refers to the flow of working capital between two points
of time. It involves information relating to the various
changes undergone in working capital during a given period i.e. between the two
balance sheet dates.

Every change in working capital is associated with a flow of funds i.e. either
an inflow or an outflow of funds. Thus, funds flow involves information relating
to the inflows and outflows of funds that resulted in a change in working
capital between the two points of time.

Funds flow statement is a statement which shows the sources from which
funds were obtained and the uses to which they have been put during a
particular period. It speaks about the changes in financial items of balance
sheets prepared at two different dates. Therefore, the funds flow analysis studies
the movement of funds (inflows and outflows of funds) during a given
period, generally a year. Thus it exhibits the movements of funds in both the
directions – inside and outside the business. In other words, the term ‘flow’ in the
context of funds flow analysis indicates the transfer of cash or cash equivalent from
asset to equity or from one equity to equity or from one asset to another asset.

Significance of funds flow:

1.
It helps shareholders, creditors and others to evaluate the uses of funds by the
enterprise.
2.
3.
It assists in analysis of past t rends and thus aid future expansion decisions.
4.
5.
It helps finance managers in identification of problems, enabling detailed analysis
and immediate action.
6.

Uses of Funds Flow Statement:

1. It guides the management in deciding about the dividend and retention policies.
2. It enables planning for long-term purposes.
3. It facilitates proper allocation of resources and funds.
4. It indicates the sources from which the company has obtained its funds.
5. It helps in ascertaining the factors resulting in changes in the working capital
position of an enterprise.
Advantages of Funds Flow Statement:

Funds flow statement is prepared to show changes in the assets, liabilities and
equity between two balance sheet dates, it is also called statement of sources and
uses of funds. The advantages of preparing funds flow statement are:

1. Funds flow statement reveals the net result of operations done by the company
during the year.
2. In addition to the balance sheet, it serves as an additional reference for many
interested parties like creditors, suppliers, government etc. to look into financial
position of the company.
3. It shows how the funds were raised from various sources and also how those
funds were put to use in the business, therefore it is a great tool for management
when it wants to know about where and from funds were raised and also how
those funds got utilized into the business.
4. It reveals the causes for the changes in liabilities and assets between the two
balance sheet dates therefore providing a detailed analysis of the balance sheet of
the company.
5. Funds flow statement helps the management in deciding its future course of
plans and also it acts as a control tool for the management.
6. Funds flow statement should not be looked alone rather it should be used along
with balance sheet in order judge the financial position of the company in a better
way.

Limitations of Funds Flow Statement:

1. Though funds flow statement has many advantages it has also

some disadvantages or limitations. The major limitations of funds flow statement
are:
2. Funds flow statement has to be used along with balance sheet and profit and
loss account, it cannot be used alone.
3. It does not reveal the cash position of the company, and that is why company
has to prepare cash flow statement in addition to funds flow statement.
4. Funds flow statement merely rearranges the data which is there in the books of
account and therefore it lacks originality. In simple words it presents the data in
the financial statements in systematic way and
therefore many companies tend to avoid preparing funds flow statements.
5. Funds flow statement is basically historic in nature, that is it indicates what
happened in the past and it does not communicate anything about the future, only
estimates can be made based on the past data and
therefore it cannot be used the management for taking decision related to future.

Cash flow analysis

The cash flow statement is useful to managers, lenders, and investors because it
translates the earnings reported on the income statement—which are subject
to reporting regulations and accounting decisions— into a simple summary of
how much cash the company has generated during the period in question.

A typical cash flow statement is divided into three parts: cash from operations
(from daily business activities like collecting payments from customers or
making payments to suppliers and employees); cash from investment activities
(the purchase or sale of assets); and cash from financing activities (the issuing
of stock or borrowing of funds). The final total shows the net increase or
decrease in cash for the period.

Cash flow statements facilitate decision making by providing a basis

for judgments concerning the profitability, financial condition, and
financial management of a company. While historical cash flow statements
facilitate the systematic evaluation of past cash flows, projected (or pro forma)
cash
flow statements provide insights regarding future cash flows. Projected cash
flow statements are typically developed using historical cash flow data modified
for anticipated changes in price, volume, interest rates, and so on.

Purpose/Objectives of Cash Flow Statement:

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 with the expenses
associated with generating those revenues. The cash flow statement includes
only inflow s and outflow s 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 to name a few . The cash flow statement is a cash basis report on three
types of financial activities: operating activities, investing activities, and
financing activities. Non-cash activities are usually reported in footnotes.

The different objectives of cash flow statement are:

1. to provide information on a firm's liquidity and solvency and its ability

to change cash flow s in future circumstances
2. to provide additional information for evaluating changes in
assets, liabilities and equity
3. to improve the comparability of different firms' operating performance
by eliminating the effects of different accounting methods
4. to indicate the amount, timing and probability of future cash flows The
cash flow statement has been adopted as a standard financial statement
because it eliminates allocations, which might be derived from different
accounting methods, such as various time frames for depreciating
fixed assets.
Cash flow activities:
The cash flow statement is partitioned into three segments. They are:
1. Cash flow resulting from operating activities
2. Cash flow resulting from investing activities
3. Cash flow resulting from financing activities.

The money coming into the business is called cash inflow, and money
going out from the business is called cash outflow .

i. Operating activities

Operating activities include the production, sales and delivery of

the company's product as w ell as collecting payment from its customers.
This could include purchasing raw materials, building inventory,
advertising, and shipping the product.
Measuring the cash inflows and outflows caused by core
business operations, the operations component of cash flow reflects how
much cash is generated from a company's products or services.
Generally, changes made in cash, accounts receivable, depreciation,
inventory and accounts
payable are reflected in cash from operations.

Cash flow is calculated by making certain adjustments to net income

by adding or subtracting differences in revenue, expenses and
credit transactions (appearing on the balance sheet and income
statement) resulting from transactions that occur from one period to the
next. These adjustments are made because non-cash items are calculated
into net income (income statement) and total assets and liabilities
(balance sheet). So, because not all transactions involve actual cash
items, many items have
to be re-evaluated w hen calculating cash flow from operations.

For example, depreciation is not really a cash expense; it is an

amount that is deducted from the total value of an asset that has
previously been accounted for. That is why it is added back into net sales
for calculating cash flow . The only time income from an asset is
accounted for in CFS calculations is w hen the asset is sold.

Changes in accounts receivable on the balance sheet from one

accounting period to the next must also be reflected in cash flow . If
accounts receivable decreases, this implies that more cash has entered
the company from
customers paying off their credit accounts - the amount by which AR
has decreased is then added to net sales. If accounts receivable increase
from one accounting period to the next, the amount of the increase must
be deducted from net sales because, although the amounts represented
in AR are revenue, they are not cash.
An increase in inventory, on the other hand, signals that a company
has spent more money to purchase more raw materials. If the inventory
was paid with cash, the increase in the value of inventory is deducted
from net sales. A decrease in inventory would be added to net sales. If
inventory was
purchased on credit, an increase in accounts payable would occur on
the balance sheet, and the amount of the increase from one year to the
other would be added to net sales.

The same logic holds true for taxes payable, salaries payable and
prepaid insurance. If something has been paid off, then the difference in
the value owed from one year to the next has to be subtracted from net
income. If there is an amount that is still ow ed, then any differences w
ill have to be
added to net earnings.

Operating cash flows include:

1. Receipts from the sale of goods or services
2. Receipts for the sale of loans, debt or equity instruments in a
trading portfolio
3. Interest received on loans
4. Dividends received on equity securities
5. Payments to suppliers for goods and services
6. Payments to employees or on behalf of employees
7. Interest payments (alternatively, this can be reported under
financing activities)
8. Buying Merchandise

Items which are added back to [or subtracted from, as appropriate] the
net income figure (which is found on the Income Statement) to arrive at
cash flows from operations generally include:

1. Depreciation (loss of tangible asset value over time)

2. Deferred tax
3. Amortization (loss of intangible asset value over time)
4. Any gains or losses associated with the sale of a non-current
asset, because associated cash flows do not belong in the
operating section. (unrealized gains/losses are also added back from the
income
statement)

ii. Investing activities

Changes in equipment, assets or investments relate to cash from

investing. Usually cash changes from investing are a "cash out" item,
because cash is used to buy new equipment, buildings or short-term
assets such as marketable securities. How ever, when a company divests
of an asset, the transaction is considered "cash in" for calculating cash
from investing.

Investing activities include:

1. Purchase or Sale of an asset (assets can be land, building, equipment,
marketable securities, etc.)
2. Loans made to suppliers or received from customers
3. Payments related to mergers and acquisitions

iii. Financing activities

Financing activities include the inflow of cash from investors such as

banks and shareholders, as well as the outflow of cash to shareholders
as dividends as the company generates income. Other activities which
impact the long-term liabilities and equity of the company are also listed
in the financing activities section of the cash flow statement.

Changes in debt, loans or dividends are accounted for in cash

from financing. Changes in cash from financing are "cash in" when
capital is raised, and they're "cash out" when dividends are paid. Thus, if
a company issues a bond to the public, the company receives cash
financing; however, when interest is paid to bondholders, the company is
reducing its cash.

Financing activities include:

1. Proceeds from issuing short-term or long-term debt
2. Payments of dividends
3. Payments for repurchase of company shares
4. Repayment of debt principal, including capital leases
5. For non-profit organizations, receipts of donor-restricted cash that
is limited to long-term purposes

Items under the financing activities section include:

1. Dividends paid
2. Sale or repurchase of the company's stock
3. Net borrowings
4. Payment of dividend tax

Uses/Significance/Advantages of Cash Flow Statement:

a. It is especially useful in preparing cash budgets.

b. It helps the newly formed companies to know their inflow and outflow
of cash.
c. It helps the investors to judge whether the company is financially
sound or not.
d. It helps the company to know whether it w ill be able to cover the
payroll and other expenses.
e. It helps the lenders to know the company’s ability to repay.
f. A cash flow statement is provided on monthly basis or quarterly basis
or six monthly basis or yearly basis.
g. These statements help to have an accurate analysis of the
firm’s ability to meet its current liabilities.
h. A cash flow statement is helpful for planning and managing
future financial commitments.
i. cash flow statement summarizes the company’s cash receipts and
cash payments over a period of time.
j. It is useful for determining the short term ability of the concern to
meet its liabilities i.e. helps the management in taking short-term
financial decisions.
k. A cash flow statement gives vital information not only about
the company’s performance but also about its major activities during the
year.
l. Cash Flow statement is also a control device for the management.
m. Since it gives a clear picture of cash inflow from operations (and
not income flow of operation), it is, therefore, very useful to internal
financial management such as in considering the possibility of retiring
long-term debts, in planning replacement of plant facilities or in
formulating dividend policies.
n. It enables the management to account for situation when business
has earned huge profits yet run without money or w hen it has suffered a
loss and still has plenty of money at the bank.

Disadvantages/Limitations of Cash Flow Statement:

1. By itself, it cannot provide a complete analysis of the financial position

of the firm.
2. It can be interpreted only w hen it is in confirmation with other
financial statements and other analytical tools like ratio analysis.
3. It may not give accurate details about the money coming into and
going out of the business. Costs may change and this could cause the
business to loose money.
4. Since it shows only cash position, it is not possible to arrive at
actual profit and loss of the company by just looking at this statement
alone.
5. In isolation this is of no use and it requires other financial statements
like balance sheet, profit and loss etc, and therefore limiting its use
6. It is difficult to precisely define the term ‘cash’.
7. Working capital is a wider concept of funds. Therefore a funds
flow statement gives a clearer picture than a cash flow statement.

UNIT 6 :
 FINANCIAL PLANNING
Meaning of Financial Planning:

Financial planning means deciding in advance the course of action to

be undertaken in future with respect to the financial management of a
business enterprise. This function is mainly concerned with the
economical procurement and profitable use of funds. It involves the
determination of objectives, policies and procedures relating to the
finance function.

A financial plan is a statement estimating the amount of capital

and determining its composition.

Objectives/Need/Importance of Financial Planning:

1. To ensure the availability of sufficient funds.

2. To make a perfect balance of costs and risks.
3. To ensure flexibility so as to adjust as per the requirements.
4. To provide sufficient liquidity throughout the year.
5. To ensure the optimum use of funds.
6. To minimize the cost of capital.
7. To improve the profitability of the enterprise.
8. To make adequate provision for funds for meeting the
contingencies likely to arise in future.
9. To ensure growth and expansion of the business.
10. To maximize the value of the firm.

Steps Involved in Financial Planning

1. Estimating the total capital requirements (long-term as well as short-

term) of the enterprise.
2. Determining the forms and the proportion of various securities to
be issued to raise the necessary capital.
3. Setting financial objectives.
4. Formulating financial policies.
5. Laying down the financial procedures.
6. Making financial forecasting.

Characteristics/Essentials/Requisites of a good financial plan:

OR
Principles Governing a Sound Financial Plan:

1. The financial plan should be so simple that it may easily be

understood by everyone.
2. It should have long-term view.
3. It should be a flexible one so that it can be adjusted as per
the requirements.
4. It must be visualized with much foresight.
5. It must ensure the optimum use of funds.
6. It should make adequate provision for funds for meeting
the contingencies likely to arise in future.
7. It should provide sufficient liquidity throughout the year.
8. It should keep the cost of capital minimum.
9. It should keep in mind the temperament of the investors

UNIT 7 :
CAPITAL EXPENDITURE
Meaning of Capital Structure:

Capital structure of a company is the composition of its long-term

finance. It is the mix or proportion of a firm's debt and equity. It is
related to the long-term financial requirements of the business
enterprise. It is determined by the long-term debts and equity capital
used by the business enterprise. As a matter of fact, the capital structure
of a business enterprise should be ideal i.e. according to the
requirements of the business enterprise.

Determinants of Capital Structure/Factors Influencing

Capital structure:

The capital structure of a company depends upon a large number of

factors.
The factors influencing the capital structure of a company are as follows:

1. Financial Leverage or Trading on Equity : The use of long-term

fixed interest bearing debts and preference share capital along with
equity share capital is called financial leverage or trading on equity.
Effects of leverage on the shareholders return or earnings per share
have already been
discussed in this chapter. The use of long- term debt increases,
magnifies the earnings per share if the firm yields a return higher than
the cost of debt. The earnings per share also increase with the use of
preference share capital but to the act fact that interest is allowed to be
deducted while
computing tax, the leverage impact of debt is much more.

2. Growth and Stability of Sales : The capital structure of a firm is

highly influenced by the growth and stability of its sales. If the sales of a
firm are expected to remain fairly stable, it can raise a higher level of
debt. Stability of sales ensures that the firm will not face any difficulty in
meeting its fixed commitments of interest payment and repayments of
debt. Similarly, the rate f growth in sales also affects the capital
structure decision.

3. Cost of Capital : Every rupee invested in a firm has a cost. Cost

of capital refers to the minimum return expected by its suppliers.
The capital structure should provide for the minimum cost f capital.
The main sources of finance for a firm are equity, preference share
capital and debt capital. The return expected by the supplier of capital
depends upon the risk they have to undertake. Usually, debt is a cheaper
source of finance compared to preference and equity capital due to
(i) fixed rate of interest on debt.
(ii) legal obligation to pay interest.

4. Cash Flow : A firm which shall be able to generate larger and stable
cash inflows can employ more debt in its capital structure as compared
to the one which has unstable and lesser ability to generate cash
inflow. Debt financial implies burden of fixed charge due to the fixed
payment of
interest and the principal. Whenever a firm wants to raise
additional funds, it should estimate, project its future cash inflows to
ensure the coverage of fixed charges.

5. Retaining Control : Whenever additional funds are required by a firm,

the management of the firm wants to raise the funds without any loss of
control over the firm. In case the funds are raised though the issue of
equity shares, the control of the existing shareholder is diluted. Hence
they might raise the additional funds by way of fixed interest bearing
debts and preference share capital in order to retain control over the
company. Preference shareholders and debenture holders do not have
the voting right. Hence, from the point of view of control, debt financing
is recommended.

6. Flexibility : Capital structure of a firm should be flexible, i.e. it

should be such as to be capable of being adjusted according to the needs
of the changing conditions. It should be possible to raise additional funds
as and when to be required without much difficulty and delay.

7. Size of the Business Enterprise : The capital structure of a

business enterprise is also influenced by the size of business enterprise.
It may be small, medium or large. A large-sized business enterprise
requires much more capital as compared to a small-sized
business enterprise.

8. Nature of the Business Organisation : The capital structure of

a business enterprise is also influenced by nature of business
organisation. It may be manufacturing, financing, trading or public utility
type.

9. Period of Finance : The Period of finance, i.e., short, medium or long

term is also another factor which determines the capital structure of
a business enterprise. For example, short-term finances are raised
through borrowings as compared to long-term finance which is raised
through issue of shares.

10. Purpose of Financing : The purpose of financing should also be kept

in mind in determining the capital structure of a business enterprise.
The funds may be required either for betterment expenditure or for
some productive purposes. The betterment expenditure, being non-
productive, may be incurred out of funds raised by issue of shares or
from retained profits. On the contrary, funds for productive purposes
may be raised through borrowings.

11. Requirements of the Potential Investors : The capital structure of

a business enterprise is also affected by the requirement of the
potential investors. Different classes of investors go for different types of
securities. It is necessary to meet the requirements of both institutional
as well as private investor. Investors who are interested in the stability
and safety and regularity of income prefer debentures and preference
shares. On the contrary, investors who want to take more risk so as to
have higher income and to take part in the day to day management of the
company prefer equity shares.

12. Legal Considerations : At the time of determining the capital

structure of a company, the financial manager should also take into
account the legal and regulatory framework. For example, in case of the
redemption period of debenture is more than 18 months, then credit
rating is required as per SEBI guidelines. Moreover, approval from SEBI
is required for raising funds from capital market. But no such approval is
required if the firm avails loans from financial institutions. Similarly, in
India, banking companies are not allowed by the Banking Companies Act
to issue any type of securities except shares.

13. Capital Market Conditions : Capital market conditions also influence

the capital structure of a business enterprise. Capital Market Conditions
do not remain the same for ever. Sometimes there may be depression
while at other times there may be boom in the market. In case of boom
period,
it is advisable to issue shares which can fetch higher premium due
to large profits. On the contrary, during the depression period, it is
advisable to issue debentures or raise long-term debts as investors would
prefer safety.
14. Inflation : Another factor to consider in the financing decision
is inflation. By using debt financing during periods of high inflation, we
will repay the debt with dollars that are worth less. As expectations of
inflation increase, the rate of borrowing will increase since creditors
must be
compensated for a loss in value. Since inflation is a major driving
force behind interest rates, the financing decision should be cognizant
of inflationary trends.

15. Risk : There are two types of risk that are to be considered
while planning the capital structure of a firm viz (i) business risk and
(ii) financial risk. Business risk refers to the variability to earnings
before interest and taxes. Business risk can be internal as well as
external. Internal risk is caused due to improper products mix non
availability of raw materials, incompetence to face competition, absence
of strategic management etc. internal risk is associated with efficiency
with which a firm conducts it operations within the broader environment
thrust upon it. External business risk arises due to change in operating
conditions caused by conditions thrust upon the firm which are beyond
its control e.g. business cycle.

UNIT 8 :
WORKING CAPITAL
MANAGEMENT
Meaning of Working Capital:

Working capital is that part of the total capital of an enterprise which is

required to be invested in the short term or current assets. This capital is
needed in an enterprise to meet its day to day expenses. Working capital shows
the strength of a business in a short period of time. If a company has some
amount of working capital, it means that the company has certain amount of
liquid assets out of which it can meet its day to day expenses.

Working capital is also known as short term capital or operating capital

or circulating capital.

Concept of Working Capital:

There are two concepts of working capital working capital. They are as follows:
1. Gross Working Capital
2. Net Working Capital
1. Gross Working Capital

Gross working capital is the total current assets of an enterprise. In this

concept, we do not deduct current liabilities from current assets, but we use
current liabilities as a source of fund. When we buy goods on credit, it means we
save
our cash to the extent of the value of goods purchased on credit and we can
use this as working capital for paying other expenses. The mathematical formula
for calculating the gross working capital is as follows:

Gross Working Capital = Total Current Assets

Current assets are those assets which can be converted into cash within
one accounting year. For example, cash, bank, debtors, bill receivables,
closing stock, prepaid expenses, accrued incomes, marketable securities etc.

2. Net Working Capital

Net working capital is difference between the total current assets and
total current liabilities of an enterprise. The excess of current assets over
current liabilities is also called net current assets. In this concept, a business
enterprise
has to maintain the minimum level of working capital for smooth operation
of the business activities. This concept of working capital is used for
the preparation of balance sheet. In the vertical form of balance sheet, we
show excess of current assets over current liabilities. The mathematical formula
for calculating the net working capital is as follows:

Net Working Capital = Current Assets - Current Liabilities

Current Liabilities are those liabilities which can be paid within one
accounting year. For example, creditors, outstanding expenses, bank overdraft,
bills payable, short term loans, income tax payable, incomes received
in advance, dividend payable etc.

Importance of / Need for Working Capital

A business enterprise needs working capital for various reasons. When

creditors demand their money from a company, its high working capital saves
the company from this situation. Selling of current assets is easy in small period
of
time but a company can not sell their fixed assets within small period of
time. So, if a company has sufficient working capital, it can easily pay off its
creditors and create his reputation in market. But if a company has zero
working capital, then it can not pay its creditors in time. In this situation, the
company may either become bankrupt or take a loan at higher rate of interest.
In both the conditions, it is very dangerous. Therefore, the company’s finance
manager tries to keep some amount of working capital for creating goodwill in
market.

Positive working capital enables the company to pay its day to day expenses
like payment of wages, salaries, raw materials or goods and other
operating expenses. Adequate working capital not only enables the company to
pay its matured liabilities but also to pay its outstanding liabilities without any
delay.

Determinants of Working Capital Requirements/Factors

Influencing Working Capital Requirements

The following are the various factors that determine the working
capital requirements of a company:

1. Size of Business
The amount of working capital required in a business firm is largely affected
by its size or scale of business operations. The business of a form may be small
or large. In small business, the company needs smaller amount of working
capital, but in large business, it requires larger amount of working capital.

2. Nature of Business
The amount of working capital required in a business firm is largely affected
by the nature of its business. Manufacturing concerns require larger amount
of working capital, whereas trading concerns require smaller amount of
working capital.

3. Nature of Demand
Nature of demand also absolutely affects the working capital need.
Some product can be easily sold by businessman, in that business; you need
small amount of working capital because your earned money from sale can
easy fulfill the shortage of working capital. But, if demand is very less, it is
required that you have to invest large amount of working capital because your
all fixed expenses must be paid by you.

4. Production Policy
Production policy is also main determinant of working capital
requirement. Different company may different production policy. Some
companies stop or decrease the production level in off seasons, in that time,
company may also reduce the number of employees or decrease the purchasing
of new raw material, so, it will certainly decrease the amount of working capital
but on the side, some company may continue their productions in off season, in
that case, they need definitely large amount of working capital.

5. Credit Policy
Credit policy is relating to purchasing and selling of goods on credit basis. If
company purchases all goods on credit and sells on cash basis or advance basis,
then it is certainly company need very low amount of working capital. But
if in company, goods are purchased on cash basis, and sold on credit basis,
it means, our earned money will receive after sometime and we require
large amount of working capital for continuing our business.

6. Dividend Policy
Dividend policy also effect working capital requirement. Company can
distribute major part of net profit. But, if there is no reserve, we have to invest
large amount in working capital because, lacking of reserve will affect on
adversely on fulfill our liabilities. In that case, we have to yield working capital
by taking short term loan for paying uncertain liability.

7. Working Capital Cycle

Working capital cycle shows all steps which starts from cash purchasing of
raw material and then this converted into finished product, after this it is
converted into sale, if it is credit sale, debtors will also the part of working
capital cycle and when we gets money from our debtors, it is the final part of
working capital cycle.
If we receive fastly from our debtors, we need small amount working
capital. Otherwise, for purchasing new raw material, we need more amount of
working capital.

8. Manufacturing Cycle
Manufacturing cycle means the process of converting raw material into
finished product. Long manufacturing cycle will create the situation in which we
require large amount of working capital. Suppose, we have to construct the
building, for constructing colony of buildings, it may consume the time more
than 5 years, so according to this we need working capital.

9. Business Cycle
There are two main part of business cycle, one is boom and other is
recession. In boom, we need high money or working capital for development of
business but in recession, we need only low amount of working capital.

10. Price Level Changes

If there is increasing trend of products prices, we need to store high amount
of working capital, because next time, it is precisely that we have to pay more
for purchasing raw material or other service expenses. Inflation and deflation
are
two major factors which decide the next level of working capital in business.

11. Effect of External Business Environmental Factors

There are many external business environmental factors which affect the
need of working capital like fiscal policy, monetary policy and bank policies
and facilities.
Over-Trading and Under-Trading
Over-trading and under-trading are the facets of over P-capitalization and under
capitalization.

Over-trading

Over-trading means a situation w here a company does more business than

what its finances allow . The result of over-trading is disastrous as it gives rise
to increase in size, diminishing margin of safety and feeling a sense of stress
and
strain. Thus it is advisable for every company to carry on its business in terms of
the financial resources that it has and not to do more business or trading
than its finances permit. Over- trading is an aspect of under-capitalization.

A company which is under-capitalized will try to do too much with the

limited amount of capital which it has. For example it may not maintain proper
stock of stock. Also it may not extend much credit to customers and may insist
only on cash basis sales. It may also not pay the creditors on time. One can
detect cases of over-trading by computing the current ratio and the various
turnover ratios. The current ratio is likely to be very low and turn-over ratios
are likely to be very higher than normally in the industry concerned.

Over-trading can be defined as “Transacting more business than the

firm's working capital can normally sustain, thus placing serious strain on its
cash flow and risking collapse or insolvency.”

Over-trading is a term in financial statement analysis. Over-trading often

occurs when companies expand its ow n operations too quickly
(aggressively). Over-traded companies enter a negative cycle, where increase in
interest
expenses negatively impact net profit leads to lesser w working capital leads
to increase borrowings leads to more interest expense and the cycles
continues. Over-traded companies eventually face liquidity problems and/or
running out of working capital.

Under-Trading

Conditions/Symptoms of Over-trading:

· Rapid grow the in business development and sales.

· Lesser net profit.
· The business running a business with limited know ledge.
· Cash flow problem or short of w working capital.
· Bad cash budget or unrealistic.
· Having large amount of unpaid vendors.
· High amount of financial interest expenditure.
· High gearing ratio.
· Keen market competition.
· Overstock or slow movement of inventory

Under-trading is the reverse of over-trading w here the funds of a company are not
utilized fully because of insufficient management. This is due to the
under employment of assets of the business, leading to the fall of sales and results in
financial crises. This makes the business unable to meet its commitments
and ultimately leads to forced liquidation. The symptoms in this case would be a very
high current ratio and very low turnover ratio. Under-trading is an aspect of over-
capitalization and leads to low profits, low rate of return on investment, decline in
the share prices in the market, loss of good will etc.

Capitalization

Capitalization comprises of share capital, debentures, loans, free reserves, etc.

Capitalization represents permanent investment in companies excluding long-term
loans. Capitalization can be distinguished from capital structure.
Capital structure is a broader term and it deals with qualitative aspect of finance,
while capitalization is a narrower term and it deals with the quantitative aspect.

Capitalization is generally of the following two types:

1. Over Capitalization
2. Under Capitalization

Over-capitalization

Meaning of Over-capitalization:

Over-capitalization is a situation in which actual profits of a company are

not sufficient enough to pay dividends at a proper rate on shares over a period
of time. This situation arises when the company raises more capital than what
is actually required. In such a situation, a part of the total capital of the
company always remains idle and it results in lower earnings.

Causes of Over-capitalization:

The main causes of over-capitalization are:

1. High promotion cost - When a company goes for high promotional expenditure,
i.e., making contracts, canvassing, underwriting commission, drafting of documents,
etc. and the actual returns are not adequate in proportion to high expenses, the
company is overcapitalized in such cases.

2. Purchase of assets at higher prices - When a company purchases assets at an

inflated rate.
The result is that the book value of assets is more than the actual returns. This
situation gives rise to over-capitalization of company.
3. A company’s flotation n boom period - At times company has to secure it’s
solvency and thereby float in boom periods. That is the time when rate of returns are
less as compared to capital employed. This results in actual earnings lowering down
and earnings per share declining.

4. Inadequate provision for depreciation - If the finance manager is unable to provide

an adequate rate of depreciation, the result is that inadequate funds are
available when the assets have to be replaced or when they become obsolete.
New assets have to be purchased at high prices which prove to be expensive.

5. Liberal dividend policy - When the directors of a company liberally divide the
dividends into the shareholders, the result is inadequate retained profits which are
very essential for high earnings of the company. The result is deficiency in company.
To fill up the deficiency, fresh capital is raised which proves to be a costlier affair and
leaves the company to be over- capitalized.

6. Over-estimation of earnings - When the promoters of the company overestimate

the earnings due to inadequate financial planning, the result is that company goes for
borrowings which cannot be easily met and capital is not profitably invested. This
results in consequent decrease in earnings per share.

Effects of Over-capitalization

On Shareholders -

Over capitalization has the following effect on shareholders:

1. Since the profitability decreases, the rate of earning of shareholders
also decreases.
2. The market price of shares goes down because of low profitability.
3. The profitability going down has an effect on the shareholders. Their earnings
become uncertain.
4. With the decline in goodwill of the company, share prices decline. As a result
shares cannot be marketed in capital market.

On Company -

Over capitalization has the following effect on the company:

1. Because of low profitability, reputation of company is lowered.
2. The company’s shares cannot be easily marketed.
3. With the decline of earnings of company, goodwill of the company declines and the
result is fresh borrowings are difficult to be made because of loss of credibility.
4. In order to retain the company’s image, the company indulges in malpractices like
manipulation of accounts to show high earnings. The company cuts down its
expenditure on maintenance, replacement of assets, adequate depreciation, etc.

On Public -
Over-capitalization has the following adverse effects on the public:
1. In order to cover up their earning capacity, the management indulges in tactics
like increase in prices or decrease in quality.
2. Return on capital employed is low. This gives an impression to the public that
their financial resources are not utilized properly.
3. Low earnings of the company affects the credibility of the company as the
company is not able to pay it’s creditors on time.
4. It also has an effect on working conditions and payment of wages and salaries also
lessen.

Remedies for Over-capitalization:

Restructuring of the firm is to be executed to avoid the over-capitalization situation

of the company. It involves:
1. Reduction of debt burden/ Reduction of funded debts.
2. Negotiation with term lending institutions for reduction in interest obligation/
Reduction of interest on debentures and loans.
3. Redemption of preference share through a scheme of capital reduction.
4. Reduction of the face value and paid-up value of equity shares.
5. Reduction in the number of equity shares.
6. Ploughing back of profits.
7. Initiating merger with well managed profit making companies interested in
talking over ailing company.

Under-Capitalization

An under-capitalized company is one which earns exceptionally high profits

as compared to industry. An under-capitalized company situation arises when
the estimated earnings are very low as compared to actual profits. This gives rise to
additional funds, additional profits, high goodwill, and high earnings and thus the
return on capital shows an increasing trend.

Causes of Under-capitalization

The main causes of under-capitalization are:

· Low promotion costs
· Purchase of assets at deflated rates
· Conservative dividend policy
· Flotation of company in depression stage
· High efficiency of directors
· Adequate provision of depreciation
· Large secret reserves are maintained.

Effects of Under Capitalization

On Shareholders
a. Company’s profitability increases. As a result, rate of earnings go up.
b. Market value of share rises.
c. Financial reputation also increases.
d. Shareholders can expect a high dividend.

On company

1. With greater earnings, reputation becomes strong.

2. Higher rate of earnings attract competition in market.
3. Demand of workers may rise because of high profits.
4. The high profitability situation affects consumer interest as they think that the
company is overcharging on products.

On Society

1. With high earnings, high profitability, high market price of shares, there can be
unhealthy speculation in stock market.
2. ‘Restlessness in general public is developed as they link high profits with high
prices of product.
3. Secret reserves are maintained by the company which can result in paying lower
taxes to government.
4. The general public inculcates high expectations of these companies as these
companies can import innovations, high technology and thereby best quality of
product.

Remedies for Under-capitalization:

The possible corrections for under-capitalisation may be outlined as under:

1. Splitting up of the shares: The effect of this measure will be more apparent than
real because the overall rate of earnings in this case will remain the same though the
dividend per share will now be a smaller amount. Thus, split up of the company’s
shares will reduce the dividend per share.

2. Issue of bonus shares: This will reduce both the dividend per share and earning
per share of the company. The most widely used and effective remedy for under
capitalisation is the conversion of reserves and accumulated profits into shares. This
will affect both dividend per share and the over-all rate of earnings.

3. Increase in par value of shares: The values of assets, under this scheme, may be
revised upwards and the existing shareholders may be given new shares carrying
higher par (face) value. In this way, the rate of earnings will decline though the
amount of dividend per share may not be affected. As a further step, the com pay
may offer the shareholders a share split- up and an increase in par-value.
In short, the remedies of under-capitalisation are:
1. Splitting up of shares.
2. Increasing the number of shares. Increase in the par value of shares. Issue of
Bonus shares.
3. Fresh issue of shares.

Both over-capitalization and under-capitalization are detrimental to the interests of

the society.

UNIT 9 :
BASICS OF CAPITAL
BUDGETING
Meaning of Capital Budgeting:

Capital expenditure budget or capital budgeting is a process of making

decisions regarding investments in fixed assets or capital assets such as land,
building, machinery or furniture. Normally capital expenditure is one which is
intended to benefit in the future period of time i.e. more than one year.

Capital budgeting is the planning process used to determine whether

an organization's long term investments such as purchase of new
machinery, replacement of old machinery, Purchase of new plants, Introduction
of new products, and research development projects are worth pursuing. It is a
budget for major capital expenditures.

The word ‘investment’ refers to the expenditure which is required to be made

in connection with the acquisition and the development of long-term or fixed
assets. It refers to process by which management selects those investment
proposals which are worthwhile for investing available funds. For this
purpose, management is to decide whether or not to acquire, or add to or
replace fixed assets in the light of overall objectives of the firm.

Capital budgeting is an extremely important aspect of a company's

financial management. If a company makes a mistake in its capital budgeting
process, then it has to live with that mistake for a long period of time as it
cannot be
reversed.

Nature of Capital Budgeting

Nature of capital budgeting can be explained in brief as under

Capital expenditure plans involve a huge investment in fixed assets. Capital
expenditure once approved represents long-term investment that cannot be
reserved or
withdrawn without sustaining a loss. Preparation of coital budget plans
involve forecasting of several years profits in advance in order to judge the
profitability of projects. It may be asserted here that decision regarding capital
investment should be taken very carefully so that the future plans of the
company are not affected adversely.

Importance/Need of Capital Budgeting

Capital budgeting decisions are of paramount importance in financial

decision. So it needs special care on account of the following reasons:

1) Long-term Implications :
A capital budgeting decision has its effect over a long time span and
inevitably affects the company’s future cost structure and growth. A wrong
decision can prove disastrous for the long-term survival of firm. On the other
hand, lack of investment in asset would influence the competitive position of the
firm. So the capital budgeting decisions determine the future destiny of the
company.

2) Involvement of large amount of funds :

Capital budgeting decisions need substantial amount of capital outlay.
This underlines the need for thoughtful, wise and correct decisions as an
incorrect decision would not only result in losses but also prevent the firm from
earning
profit from other investments which could not be undertaken.

3) Irreversible decisions :
Capital budgeting decisions in most of the cases are irreversible because it
is difficult to find a market for such assets. The only way out will be scrap
the capital assets so acquired and incur heavy losses.

4) Risk and uncertainty :

Capital budgeting decision is surrounded by great number of
uncertainties. Investment is present and investment is future. The future is
uncertain and full of risks. Longer the period of project, greater may be the risk
and uncertainty.
The estimates about cost, revenues and profits may not come true.

5) Difficult to make :
Capital budgeting decision making is a difficult and complicated exercise for
the management. These decisions require an over all assessment of future
events which are uncertain. It is really a marathon job to estimate the future
benefits and cost correctly in quantitative terms subject to the uncertainties
caused by economic-political social and technological factors.
Kinds of capital budgeting decisions:
Generally the business firms are confronted with three types of capital
budgeting decisions.

Accept-Reject Decisions:

I. Mutually Exclusive Decisions; and Capital Rationing Decisions.

II. Accept-Reject Decisions : Business firm is confronted with

alternative investment proposals. If the proposal is accepted, the firm incur
the investment and not otherwise. Broadly, all those investment proposals which
yield a rate of return greater than cost of capital are accepted and the others
are rejected. Under this criterion, all the independent proposals are accepted.

III. Mutually Exclusive Decisions : It includes all those projects which

compete with each other in a way that acceptance of one precludes the
acceptance of other or others. Thus, some technique has to be used for selecting
the
best among all and eliminates other alternatives.

IV. Capital Rationing Decisions : Capital budgeting decision is a simple process

in those firms where fund is not the constraint, but in majority of the cases,
firms have fixed capital budget. So, large amount of projects compete for these
limited budgets. So the firm rations them in a manner so as to maximize the
long run returns. Thus, capital rationing refers to the situations where the firm
has more acceptable investment requiring greater amount of finance than is
available with the firm. It is concerned with the selection of a group of
investment out of many investment
proposals ranked in the descending order of the rate or return.

Procedure of Capital Budgeting:

Capital investment decision of the firm have a pervasive influence on the

entire spectrum of entrepreneurial activities so the careful consideration should
be regarded to all aspects of financial management.
In capital budgeting process, main points to be borne in mind how much
money will be needed of implementing immediate plans, how much money is
available for its completion and how are the available funds going to be assigned
to the various capital projects under consideration. The financial policy and risk
policy of the management should be clear in mind before proceeding to the
capital budgeting process. The following procedure may be adopted in preparing
capital budget:

(1) Organisation of Investment Proposal

The first step in capital budgeting process is the conception of a profit
making idea. The proposals may come from rank and file worker of any
department or from any line officer. The department head collects all the
investment proposals and reviews them in the light of financial and risk policies
 of the organisation in order to send them to the capital expenditure planning
committee for consideration.

(2) Screening the Proposals

In large organisations, a capital expenditure planning committee is
established for the screening of various proposals received by it from the heads
of various departments and the line officers of the company. The committee
screens the
various proposals within the long-range policy-frame work of the organisation.
It is to be ascertained by the committee whether the proposals are within
the selection criterion of the firm, or they do no lead to department imbalances
or they are profitable

(3) Evaluation of Projects

The next step in capital budgeting process is to evaluate the different
proposals in term of the cost of capital, the expected returns from alternative
investment opportunities and the life of the assets with any of the following
evaluation techniques:
1.
Pay-Back Period Method
2.
3.
Accounting Rate of return Method
4.
5.
Net Present Value Method
6.
7.
Profitability-Index Method
8.
9.
Internal Rate of Return Method
10.

(4) Establishing Priorities

After proper screening of the proposals, uneconomic or unprofitable proposals
are dropped. The profitable projects or in other words accepted projects are
then put in priority. It facilitates their acquisition or construction according to
the sources available and avoids unnecessary and costly delays and serious
overruns. Generally, priority is fixed in the following order.
1.
Current and incomplete projects are given first priority.
2.
3.
Safety projects ad projects necessary to carry on the legislative requirements.
4.
5.
 Projects of maintaining the present efficiency of the firm.
6.
7.
Projects for supplementing the income.
8.
9.
Projects for the expansion of new product.
10.

(5) Final Approval

Proposals finally recommended by the committee are sent to the top
management along with the detailed report, both o the capital expenditure and
of sources of funds to meet them. The management affirms its final seal to
proposals taking in view the urgency, profitability of the projects and the
available financial resources. Projects are then sent to the budget committee for
incorporating them in the capital budget

(6) Evaluation
Last but not the least important step in the capital budgeting process is
an evaluation of the programme after it has been fully implemented.
Budget proposals and the net investment in the projects are compared
periodically and
on the basis of such evaluation, the budget figures may be reviewer
and presented in a more realistic way.

Significance of capital budgeting

The key function of the financial management is the selection of the

most profitable assortment of capital investment and it is the most important
area of decision-making of the financial manger because any action taken by the
manger
in this area affects the working and the profitability of the firm for many years
to come. The need of capital budgeting can be emphasized taking into
consideration the very nature of the capital expenditure such as heavy
investment in capital projects, long-term implications for the firm, irreversible
decisions and complicates of the decision making. Its importance can be
illustrated well on the following other grounds:

(1) Indirect Forecast of Sales

The investment in fixed assets is related to future sales of the firm during the
life time of the assets purchased. It shows the possibility of expanding
the production facilities to cover additional sales shown in the sales budget. Any
failure to make the sales forecast accurately would result in over investment
or under investment in fixed assets and any erroneous forecast of asset needs
may lead the firm to serious economic results

(2) Comparative Study of Alternative Projects

Capital budgeting makes a comparative study of the alternative projects for
 the replacement of assets which are wearing out or are in danger of
becoming obsolete so as to make the best possible investment in the
replacement of assets. For this purpose, the profitability of each project is
estimated.

(3) Timing of Assets-Acquisition

Proper capital budgeting leads to proper timing of assets-acquisition
and improvement in quality of assets purchased. It is due to ht nature of
demand and supply of capital goods. The demand of capital goods does not arise
until
sales impinge on productive capacity and such situation occurs
only intermittently. On the other hand, supply of capital goods with their
availability is one of the functions of capital budgeting.

(4) Cash Forecast

Capital investment requires substantial funds which can only be arranged
by making determined efforts to ensure their availability at the right time. Thus
it facilitates cash forecast.

(5) Worth-Maximization of Shareholders

The impact of long-term capital investment decisions is far reaching. It
protects the interests of the shareholders and of the enterprise because it avoids
over investment and under-investment in fixed assets. By selecting the most
profitable projects, the management facilitates the wealth maximization of
equity share-holders.

(6) Other Factors

The following other factors can also be considered for its significance:
1.
It assists in formulating a sound depreciation and assets replacement policy.
2.
3.
It may be useful n considering methods of coast reduction.
4.
5.
A reduction campaign may necessitate the consideration of purchasing most up-
to—date and modern equipment.
6.
7.
The feasibility of replacing manual work by machinery may be seen from the
capital forecast be comparing the manual cost an the capital cost.
8.
9.
The capital cost of improving working conditions or safety can be obtained
through capital expenditure forecasting.
10.
11.
 It facilitates the management in making of the long-term plans an assists in the
formulation of general policy.
12.
13.
It studies the impact of capital investment on the revenue expenditure of the
firm such as depreciation, insure and there fixed assets.
14.

Limitations of Capital Budgeting

The limitations of capital budgeting are as follows:

1. It has long term implementations which can't be used in short term and it
is used as operations of the business. A wrong decision in the early stages
can affect the long-term survival of the company. The operating cost
gets increased when the investment of fixed assets is more than required.
2. Inadequate investment makes it difficult for the company to increase
it budget and the capital.
3. Capital budgeting involves large number of funds so the decision has to
be taken carefully.
4. Decisions in capital budgeting are not modifiable as it is hard to locate
the market for capital goods.
5. The estimation can be in respect of cash outflow and the revenues/saving and
costs attached which are with projects.

rofit Maximization vs.

Wealth Maximization
Objective
Profit Maximization Objective (Traditional Approach):

The traditional approach of financial management was all about

profit maximization. Earlier the main objective of companies was only to make
more and more profits. This approach of financial management had many
limitations:

Limitations of Profit Maximization Objective

1.
The term ‘profit’ is vague.
2.
3.
The term ‘maximum’ is ambiguous.
4.
5.
The time factor is ignored.
6.
7.
It does not consider the time value of money.
8.
9.
It ignores the risk factor.
10.
11.
Business may have several other objectives other than profit maximization.
Companies may have goals like: a larger market share, high sales, greater
stability and so on. The traditional approach did not take into account these
aspects.
12.
13.
Social Responsibility is one of the most important objectives of many firms. Big
companies make an effort towards giving back something to the society. They
use a certain amount of the profits earned for social causes. It seems that the
traditional approach did not consider this point.
14.

Wealth Maximization Objective (Modern Approach):

Modern Approach is about the idea of wealth maximization that removes all
the limitations of the profit maximization objective. Wealth maximization
involves increasing the Earning per share of the shareholders and to maximize
the net
present worth. Wealth means net present worth which is the difference
between gross present worth of some decision or course of action (capitalized
value of the expected cash benefits) and the investment required to achieve
these benefits
(original cost).

The Wealth Maximization approach is concerned with the amount of cash

flow generated by a course of action rather than the profits. Any course of
action that has net present worth above zero creates wealth should be selected.
The goals of financial management may be such that they should be beneficial to
owners, management, employees and customers. These goals may be achieved
only by maximizing the value of the firm.

Elements of Wealth Maximization:

The elements involved in wealth maximization of a firm are as follows:

1. Increase in Profits
A firm should increase its revenues in order to maximize its value. For
 this purpose, the volume of sales or any other activities should be stepped up. It
is a normal practice for a firm to formulate and implement all possible plans of
expansion and take every opportunity to maximize its profits. In theory,
profits are maximized when a firm is in equilibrium. At this stage, the average
cost is minimum and the marginal cost and marginal revenue are equal. A word
of
caution, however, should be sounded here. An increase in sales will
not necessarily result in a rise in profits unless there is a market for increased
supply of goods and unless overhead costs are properly controlled.

2. Reduction in Cost
Capital and equity funds are factor inputs in production. A firm has to
make every effort to reduce cost of capital and launch economy drive in all
its operations.

3. Sources of Funds
A firm has to make a judicious choice of funds so that they maximize its
value. The sources of funds are not risk-free. A firm will have to assess risks
involved in each source of funds. While issuing equity stock, it will have to
increase
ownership funds into the corporation. While issuing debentures and
preferred stock, it will have to accept fixed and recurring obligations. The
advantages of leverage, too, will have to be weighed properly.

4. Minimum Risks
Different types of risks confront a firm. "No risk, no gain" - is a common
adage. However, in the world of business uncertainties, a corporate manager
will have to calculate business risks, financial risks or any other risk that may
work to the disadvantage of the firm before embarking on any particular course
of action. While keeping the goal of maximization of the value of the firm, the
management will have to consider the interest of pure or equity stockholders as
the central focus of financial policies.

5. Long-run Value
The goal of financial management should be to maximize long run value of
the firm. It may be worthwhile for a firm to maximize profits by pricing its
products high, or by pushing an inferior quality into the market, or by ignoring
interests
of employees, or, to be precise, by resorting to cheap and "get-rich-
quick" methods. Such tactics, however, are bound to affect the prospects of a
firm rather adversely over a period of time. For permanent progress and
sound reputation, it will have to adopt an approach which is consistent with the
goals of financial management in the long-run.

Advantages of Wealth Maximization:

1.
 Wealth maximization is a clear term. Here, the present value of cash flow is taken
into consideration. The net effect of investment and benefits can be measured clearly
(i.e. quantitatively).
2.
3.
It considers the concept of time value of money. The present values of
cash inflows and outflows help the management to achieve the overall
objectives of a company.
4.
5.
The concept of wealth maximization is universally accepted, because, it takes
care of interests of financial institution, owners, employees and society at large.
6.
7.
Wealth maximization guides the management in framing consistent
strong dividend policy, to earn maximum returns to the equity holders.
8.
9.
The concept of wealth maximization considers the impact of risk factor, while
calculating the Net Present Value at a particular discount rate; adjustment is
made to cover the risk that is associated with the investments.
10.

Criticisms of Wealth Maximization:

The objective of wealth maximization is not descriptive. The concept

of increasing the wealth of the stockholders differs from one business entity to
another. It also leads to confusion in and misinterpretation of financial policy
because different yardsticks may be used by different interests in a company.