IMTS Finance Management (Finance Management) by IMTS INSTITUTE

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FINANCE MANAGEMENT

IMTS (ISO 9001-2008 Internationally Certified) FINANCE MANAGEMENT

FINANCE MANAGEMENT

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CONTENTS:

FINANCIAL MANAGEMENT UNITI:

01-27 Meaning and Importance of Finance-Objectives, Functions and Scope

of Finance-Role of Finance Manager-Organization of Finance Functions.

UNIT II:

28-63

Capital Expenditure Evaluations-Methods of Appraisals-Pay back period, Net Present Value, Internal Rate of Return, Accounting Rate of Return, Profitability Index-Capital rationing.

UNIT III:

64-92

Concept of Working Capital –Gross and Net Working Capital –Factors influencing working capital-Methods of forecasting working capital-Financing Current Assets.

UNIT IV:

93-123

Management of Cash, Receivables and inventories - Cash PlanningCredit Policies- Regulations of Bank Finance.

UNIT V:

124-143

Budgetary control- Budget manual-Classification and Preparation of various Budgets-Functional Budgets-Fixed and Flexible Budgets-Cash Budget-Zero Base Budgeting and Performance Budgeting-Ethic in Finance.

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UNIT I MEANING AND IMPORTANCE OF FINANCE In our modern economy, finance is defined as the provision of money at the time when it is required. Finance is one of the major elements, which activates the overall growth of economy. Finance is the life blood of economic activity. This is because in the modern money oriented economy, finance is one of the basic foundations of all kinds of economic activities. It is the master key which provides access to all the sources for being employed in manufacturing and merchandising activities. It has rightly been said that business needs money to make more money. However, it is also true that money begets more money only when it is properly managed. Hence, efficient management of every business enterprise is closely linked with efficient management of its finances. A well knit financial system directly contributes to the growth of the economy. An efficient financial system calls for the effective performance of financial institutions, financial instruments and financial markets. Finance has been traditionally classified into two classes: (i) Public finance and (ii) Private finance. Public finance deals with the requirements, receipts and disbursements of funds in the government institutions. Private finance is concerned with requirements receipts and disbursement of funds in case of an individual, a profit seeking business organization and a non profit organization. Thus, private finance can be classified into: (i) Personal finance; (ii)Business finance and (iii)Finance of non profit organization.

MEANING OF BUSINESS FINANCE/ FINANCIAL MANAGEMENT. The term ‘business finance’ connotes finance of business activities. It is composed of two words. (i)Business and (ii) Finance. The word ‘business’ literally means a ‘state of being busy’. All activities relating to the production and distribution of goods and services for satisfying human wants are known as business. Broadly speaking, the term ‘Business’ includes industry, trade and commerce. Finance may be defined as the provision of money at the time when it is required.

Finance refers to the management of flows of money through an organization. It concerns with the application of skills in the manipulation, use and control of money. The term ‘Business finance’ is an activity or a process which is concerned with acquisition of funds, use of funds and distribution of profits by a business firm.

Thus,

business finance usually deals with financial planning, acquisition of funds, use and allocation of funds and financial controls.

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MEANING OF FINANCIAL MANAGEMENT/BUSINESS FINANCE: Financial management means the entire gamut of managerial efforts devoted to the management of finance – both its sources and uses – of the enterprise.

It is mainly

concerned with the proper management of funds. The finance manager must see that the funds are procured in a manner that the risk, cost and control considerations are properly balanced in a given situation and there is optimum utilization of funds. Every management aims to utilize its funds in a best possible and profitable way. So this subject is acquiring a universal applicability. It is indispensable in any organization as it helps in: •

Financial planning and successful promotion of an enterprise

•

Acquisition of funds as and when required at the minimum possible cost;

•

Proper use and allocation of funds

•

Taking sound financial decisions

•

Improving the profitability through financial controls

•

Increasing the wealth of the investors and the nation

•

Promoting and mobilizing individual and corporate savings.

We can say that financial management as practiced by corporate (business) firms can be called corporation finance or business finance.

DEFINITIONS BUSINESS FINANCE. Wheeler defines business finance as “that business activity which is concerned with the acquisition and conservation of capital funds in meeting the financial needs and overall objectives of business enterprise”. According to Guthmann and Dougall, business finance deals primarily with raising, administering and disbursing funds by privately.

Financial management is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operations. -- Joseph & Massie.

According to Soloman, “Financial management is concerned with the efficient use of an important economic resource, namely, capital funds”.

“The finance function is the process of acquiring and utilizing funds of a business”. ----R.C.Osborn.

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OBJECTIVES OF FINANCIAL MANAGEMENT.

Financial management evaluates how funds are used & procured. In all cases, it involves a sound judgement, combined with a logical approach to decision-making. The core of financial policy is to maximize earnings in the long run & optimize them in the short-run. There are various alternatives available for using business funds. Each alternative course has to be evaluated in detail. The pros and cons of various decisions have to looked into before making a fund selection. The decisions will have to take into consideration the commercial strategy of the business.

Financial management provides a framework for

selecting a proper course of action and deciding a viable commercial strategy. The main objective of a business is to maximize the owner’s economic welfare. This objective can be achieved by: •

Profit maximization and

•

Wealth maximization.

1. PROFIT MAXIMIZATION: Earning profits by a corporate or a company is a social obligation. Profit is the only means through which an efficiency of organization can be measured. Profit earning is the main aim of every economic activity.

A business being an

economic institution must earn profit to cover its costs and provide funds for growth. No business can survive without earning profit. Profit is a measure of efficiency of a business enterprise. Profits also serve as a protection against risks which cannot be ensured. The accumulated profit enables a business to face risk like fall in prices, competition from other units, adverse government policies etc. Thus profit maximization is considered as the main objective of business. The following arguments are advanced in favour of profit maximization as the objective of business: Advantages/Merits •

Profit is a barometer through which the performance of a business unit can be measured. Thus profit maximization is justified on the grounds of rationality.

•

Profits ensure maximum welfare to the share holders, employees and prompt payment to creditors of a company.

•

When profit earning is the aim of business, then profit maximization should be the obvious objective.

•

Economic and business conditions do not remain same in all the time. There may be adverse business conditions like recession, depression, severe competition etc. A business will be able to survive under favourable situation, only if it has some past earnings to rely upon. Therefore business should try to earn more and more when situation is favourable.

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Profit maximization increases the confidence of management in expansion and diversification programmes of a company.

•

Profit maximization attracts the investors to invest their savings in securities.

•

Profit indicates the efficient use of funds for different requirements.

•

Profitability is essential for fulfilling social goals also. A firm by pursuing the objective of profit maximization also maximizes socio economic welfare.

However, profit maximization objective has been criticized on many grounds.

Criticisms /drawbacks / points against profit maximization •

Profit is not a clear term. Is it accounting profit? Economic profit? Profit before tax? After tax? Net profit? Gross profit on earnings per share? Further it is possible that profits may increase but earnings per share decline. For example, if a company has presently 10,000 equity shares issued and earns a profit of Rs.1,00,000, the earnings per share are Rs.10. Now if the company further issues 5,000 shares and makes a total profit of Rs.1,20,000, the total profits have increased by Rs.20,000, but the earnings per share will decline to Rs.8.

•

Profit maximization objective ignores the time value of money and does not consider the magnitude and timing of earnings. It treats all earnings are equal though they occur in different periods.

•

Profit maximization does not consider the element of risk.

•

The effect of dividend policy on the market price of shares is also not considered in the objective of profit maximization. In case, earnings per share is the only objective, then an enterprise may not think of paying dividend at all, because retaining profits in the business or investing them in the market may satisfy this aim.

•

A firm pursuing objective of profit maximization starts exploiting workers and the consumers. Hence it is immoral and leads to a number of corrupt practices.

•

It leads to colossal inequalities and lowers human values which are an essential part of an ideal social system.

•

The true and fair picture of the organization is not reflected through profit maximization.

•

Profit maximization attracts cut throat competition

•

A huge profit invites problems from workers. They demand high salary and fringe benefits.

•

The modern concept of marketing does not encourage profit maximization. A huge profit ultimately disturbs the morale of the customers.

He feels exploited by the

company. •

Some of the industries would like to attain ‘Industry leadership’. They do not bother about the increase in cost and getting a low profit with huge market share.

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2. WEALTH MAXIMIZATION Wealth maximization is the appropriate objective of an enterprise. The concept of ‘Wealth Maximization’ refers to the gradual growth of the value of assets of the firm in terms of benefits it can produce. When the firm maximizes the stock holder’s wealth to maximize his individual utility, it means that by maximizing stock holder’s wealth, the firm is operating consistently towards maximizing stockholder’s utility. A stock holder’s current wealth in the firm is the product of the number of shares occurred, multiplied with the current stock price per share.

Stock holder’s current wealth of a firm = No of shares owned x Current stock price per share Wo = NPo Symbolically, given the number of shares that the stock holders owns, the higher the stock price per share, the greater will be the stock holders wealth. Thus a firm should aim at maximizing the current stock price. This objective helps increasing the value of shares in the market.

The share’s market price serves as a

performance index on report card of its progress. It also indicates how well is doing on behalf of the shareholders. We can conclude that Maximum utility refers to maximum stock holder’s wealth refers to maximum stock price per share.

ELEMENTS OF WEALTH MAXIMIZATION: The goals of financial management may be such that they should be beneficial to the owners, management, employees and customers. These goals may be achieved only by maximizing the value of the firm. The elements involved in the maximization of the value of a firm are: Elements of wealth maximization

Judicious choice of funds

Increase in profits

Reduction in cost

Long-run Value Minimized Risk

Increase in profits: A firm should increase its revenue in order to maximize its value. For this purpose, the volume of sales or any other activity should be stepped up. It is a normal practice for a

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firm to formulate and implement all possible plans of expansion and take every opportunity to maximize its profits. An increase in sales will not necessarily result in the rise of profits unless there is a market for increased supply of goods and unless the overhead costs are properly controlled. Reduction of cost: Capital and equity funds are factor inputs in production. A firm has to make every effort to reduce the cost of capital and launch an economy drive in all its operations. 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 the risks involved in each source of funds. Maximum risk: Different types of risks confront a firm, “no risk, no gain” is a common adage. However, in the world of business uncertainties, a corporate management will have to calculate business risks, financial risks or any other risks 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 either pure or equity stockholders as the central focus of financial policies. Long run value: The goal of financial management should be to maximize the 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 product into a market, or by ignoring interest of employees, or to be precise, by resorting to cheap and “getting rich quick” methods. Such tactics, however, are bound to affect the prospects of a firm rather adversely over a period of time.

For a

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. “More haste, less speed” – is the principle it may profitably follow.

Implications of wealth maximization: There is a rationale in applying wealth maximizing policy as an operating financial management policy.

It serves the interests of suppliers of loaned capital, employees,

management and society.

Besides shareholders, there are short term and long term

suppliers of funds who have financial interests in the concern.

Short term lenders are

primarily interested in liquidity position so that they get their payments in time. The long term lenders get a fixed rate of interest from the earnings and also have a priority over share holders in return of their funds. Wealth maximization objective not only serves shareholder’s interests by increasing the value of holdings but ensures security to lenders also. The employees may also try to acquire share of company’s wealth through bargaining etc.

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FINANCE MANAGEMENT Their productivity and efficiency is the primary consideration in raising company’s wealth. The survival of management for a longer period will be served if the interests of various groups are served properly. Management is the elected body of shareholders. The shareholders may not like to change a management if it is able to increase the value of their holdings. The efficient allocation of productive resources will be essential for raising the wealth of the company. The economic interests of society are served if various resources are put to economical and efficient use.

Advantages of wealth maximization: •

Wealth maximization is a clear term. Here the present value of cash flow it taken into consideration.

The net effect of investment and benefits can measure clearly.

(quantitatively) •

It considers the concept of time value of money. The present value of cash inflows and outflows helps the management to achieve the overall objective of a company.

•

The concept of wealth maximization is universally accepted, because, it takes care of interests of financial institutions, owners, employees and the society at large.

•

Wealth maximization guides the management in framing a consistent strong dividend policy to reach maximum returns of the equity holders.

•

The concept of wealth maximization considers the impact of risk factor and while calculating the NPV at a particular discount rate, adjustment is being made to cover the risk that is associated with the investments.

Criticism of wealth management: The wealth maximization objective has been criticized by certain financial theorists mainly on the following accounts: •

It is a prescriptive idea. The objective is not descriptive of what the firm actually do

•

The objective of wealth management is not necessarily socially desirable

•

There is some controversy as to whether the objective is to maximize the stock holder’s wealth or the wealth of the firm which includes other financial claimholders such as debenture holders, preferred stockholders etc.

•

The objective of wealth maximization may also face difficulties when ownership and management are separated as is the case in most of the large corporate form of organizations.

When managers act as agents of the real owners (equity

shareholders), there is a possibility for a conflict of interest between shareholders and the managerial interests. The managers act in such a manner which maximizes the managerial utility but not the wealth of stockholders or the firm. In spite of all the criticism, wealth maximization is the most appropriate objective of a firm and the side coast in the form of conflicts between the stockholders and debentures holders, firm and society and stockholders and managers can be minimized.

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FUNCTIONS OF FINANCE Finance function is the most important of all business functions. It remains a focus of all activities. It is not possible to substitute or eliminate this function because the business will close down in the absence of finance. It starts with the setting up of an enterprise and remains at all times.

The

development and expansion of business rather needs more commitment for funds. The funds will have to be raised from various sources. The sources will be selected in relation to the implications attached with them. The money once received will have to be returned also if its use is proper, then its return will be easy, otherwise it will create difficulties for repayment. The management should have an idea of using the money profitable. The inflows or outflows of funds should be properly matched.

AIMS OF FINANCE FUNCTION. The primary aim of finance function is to arrange as much funds for the business as are required from time to time. This function has the following aims. 1. Acquiring sufficient funds: The main aim of finance function is to assess the financial needs of an enterprise and then finding out suitable sources for raising them. The sources should be commensurate with the needs of the business. If funds are needed for longer periods then long term sources like share capital, debentures, term loans may be explored. A concern with longer gestation periods should rely more on owner’s funds instead of interest bearing securities because profits may not be there for some years. 2. Proper utilization of funds: Though raising of funds is important but their effective utilization is more important. The funds should be used in such a way that maximum benefits are derived from them. The return from their use should be more than their cost. It should be ensured that funds do not remain idle at any point of time. Those projects should be preferred which are beneficial to the business. 3. Increasing profitability: The planning and control of finance function aims at increasing profitability of the concern.

Finance function should be so planned that the concern neither suffers from

inadequacy of funds nor wastes more funds than required. A proper control should also be exercised so that scarce resources are not frittered away on uneconomical operations. The cost of acquiring funds also influences profitability of the business. Finance function also requires matching of cost and returns from funds. 4. Maximizing firm’s value: Finance function also aims at maximizing the value of the firm. It generally said that a concern’s value is linked with its profitability. Even though profitability influences a firm value but it is not all.

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FINANCE MANAGEMENT Besides profits, the type of sources used for raising funds, the cost of funds, the condition of money market, the demand for products are some other considerations which also influence a firmâ&#x20AC;&#x2122;s value.

NATURE AND SCOPE OF FINANCE FUNCTION. 1. Estimating financial requirements: The first task of a financial management is to estimate short term and long term financial requirements of his business. For this purpose he will prepare a financial plan for present as well as for future. The amount required for purchasing fixed assets as well as needs of funds for working capital will have to be ascertained. The estimations should be based on sound financial principle so that neither there are inadequate nor excess funds with the concern. 2. Deciding capital structure: The capital structure refers to the kind and proportion of different securities for raising funds. After deciding about the quantum of funds required, it should be decided which type of securities should be raised. A decision about various sources for funds should be linked to the cost of raising funds. If cost of raising funds is very high then such sources may not be useful for long period. A decision about the kind of securities to be employed and the proportion in which these should be used is an important decision which influences the short term and long term financial planning of an enterprise. 3. Selecting a source of finance: After preparing a capital structure, an appropriate source of finance is selected. Various sources from which finance may be raised include share capital, debentures, financial institutions, commercial banks, public deposits etc. If finances are needed for short periods then banks, public deposits and financial institutions may be appropriate. On the other hand, if long term finance are required, then share capital and debentures may be useful. The need, purpose, object and cost involved may be the factors influencing the selection of a suitable source of financing. 4. Selecting a pattern of investment: When funds have been procured then a decision about investment pattern is to be taken. The selection of an investment pattern is related to the use of funds. A decision will have to be taken as to which assets are to be purchased? The funds will have to be spent first on fixed assets and then an appropriate portion will be retained for working capital. While spending on various assets, the principle of safety, profitability and liquidity should be ignored. One may not like to invest on a project which may be risky even though there may be more profits. 5. Proper cash management:

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FINANCE MANAGEMENT Cash management is also an important task of finance manager. He has to assess various cash needs at different times and then make arrangements for arranging cash. Cash may be required to (a) purchase raw materials, (b) make payments to creditors, (c) meet wage bills, (d) meet day to day expenses. The usual sources of cash may be (a) cash sales, (b) collection of debts, (c) short term arrangements with banks etc. The cash management should be such that neither there is a shortage of it and not it is idle. A proper idea on sources of cash inflow may also enable to asset the utility of various sources. Some sources may not be providing that much cash which we should have thought all this information will help in efficient management of cash. 6. Implementing financial controls: An efficient system of financial management necessitates that use of various control devices.

Financial control devices generally used are: (a) Return on investment, (b)

budgetary control, (c) Break even analysis, (d) Cost control, (e) Ratio analysis, (f) Cost and internal audit. Return on investment is the best control device to evaluate the performance of various devices to evaluate the performance of various financial policies. The higher this percentage better may be the financial performance. The use of various control techniques by the finance manager will help him in evaluating the performance in various areas and take corrective measures whenever needed. 7. Proper use of surplus: The utilization of profits on surpluses is also an important factor in financial management. A judicious use of surpluses is essential for expansion and diversification plans and also in protecting the interest of shareholders. The ploughing back of profits is the best policy of further financing, but it clashes with the interests of shareholders. A balance should be struck in using funds for paying dividend and retained earnings for financing expansion plans etc. A finance manager should consider the influence of various factors, such as: (a) Trend of earnings of the enterprise, (b) Expected earnings in future, (c) Market value of shares, (d) Need for funds for financing expansion etc. A judicious policy for distributing surpluses will be essential for maintaining proper growth of the unit.

VARIOUS APPROACHES TO FINANCE FUNCTION. A number of approaches are associated with finance function, but for the sake of convenience various approaches are divided into two broad categories: 1. The Traditional Approach 2. The Modern Approach

1. THE TRADITIONAL APPROACH: The traditional approach to the finance function relates to the initial stages of its evolution during 1920s and 1930s when the term ‘Corporation finance’ was used to describe what is known in the academic world today as the financial management’.

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It broadly covered the following three aspects. •

Arrangement of funds from financial institutions

•

Arrangement of funds through financial instruments. viz., shares, bonds etc.

•

Looking after the legal and accounting relationship between a corporation and its sources of funds. According to this approach, the scope of finance function was confined to only

procurement of funds needed by a business on most suitable terms. The utilization of funds was considered beyond the purview of finance function. It was felt that decisions regarding the application of funds are taken somewhere else in the organization. However, institutions and instruments for raising funds were considered to be a part of finance function. The scope of the finance function, there evolved around the study of rapidly growing capital market institutions, instruments and practices involved in raising of external funds. The traditional approach to the scope and functions of finance has now been discarded as it suffers from many serious limitations. Criticisms/ Limitations of traditional approach. Outsider-looking in approach: It is outsider looking in approach that completely ignores internal decision making as to the proper utilization of funds. Ignored routine problems: The approach gave undue emphasis to the financial problems arising during the course of incorporation, mergers, consolidation and reorganization of corporate enterprises. This approach ignored the day to day financial problems of business undertaking. Ignored non-corporate enterprises: The approach focused attention only on the financial problems of corporate enterprises. Non corporate industrial organizations outside its scope. Ignored working capital financing: The focus of traditional approach was on procurement of long term funds. Thus, it ignored the important issue of working capital finance and management. No emphasis on allocation of funds: The issue of allocation of funds which is so important today is completely ignored.

2. THE MODERN APPROACH: The traditional approach outlived its utility due to changed business situations since mid- 1950s. Technological improvements, widened marketing operations, development of a strong corporate structure, keen and healthy business competition – all made it imperative for the management to make optimum use of available financial resources for continued survival. The modern approach views finance function in broader sense.

It includes both

raising of funds as well as their effective utilization under the purview of finance. The finance function does not stop only by finding out sources of raising enough funds, their proper utilization is also to be considered.

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The cost of raising funds and the returns form their use should be compared. The funds raised should be able to give more returns than the costs involved in procuring them.

The utilization of funds requires decision making.

Finance has to be

considered as an integral part of overall management. So finance function, according to this approach covers •

Financial planning

•

Raising of funds

•

Allocation of funds

•

Financial controls

The new approach is an analytical way of dealing with financial problems of a firm. The techniques of models, mathematical programming, simulations and financial engineering are used in financial management to solve complex problems of present day finance. The modern approach considers the three basic management decisions, i.e., investment decisions, financing decisions and dividend decisions within the scope of finance functions.

IMPORTANCE OF FINANCIAL MANAGEMENT The importance of financial management cannot be overemphasized.

In every

organization, where funds are involved, sound financial management is necessary. Sound financial management is essential in both profit and non profit organizations. The financial management helps in monitoring the effective deployment of funds in fixed assets and in working capital. The finance manager estimates the total requirements of funds, both in the short period and the long period. The finance manager assesses the financial position of the company through the working out of the return on capital, debt-equity ratio, and cost of capital from each source, etc and comparison of the capital structure with that of similar companies. Financial management also helps in ascertaining how the company would perform in future. It helps in indicating whether the firm will generate enough funds to meet its various obligations like repayment of the various installments due on loans, redemption of other liabilities etc. Sound financial management is indispensable for any organization. It helps in profit planning, capital spending, measuring costs, controlling inventories, accounts receivable etc. Financial management essentially helps in optimizing the output from a given input of funds. CONFLICT OF GOALS: MANAGEMENT VERSUS OWNERS In a company, the decision taking authority lies in the hands of management. Since the company is a complex organization of various interested parties, management has the difficult role of reconciling objectives of these parties.

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In doing so, management may not necessarily act in the best interest of the owners (shareholders) and may pursue its own personal goals.

But the possibility of pursuing

exclusively its own personal goals is considered remote because, the continuous supervision by the companies’ owners, employees, creditors, customers and government will restrict managements’ freedom to act in its own interest.

It is certain that management will like to survive over the long run. Thus, overall management objective is very likely to be directed towards this goal. A management can survive only when it is successful: and it is successful when it manages the company better than someone else. Every group connected with the company will evaluate management performance from the point of view of the fulfillment of its own objective.

The survival of management will be threatened if the objective of any of these groups remains unfulfilled. The wealth maximization objective may be generally in harmony with the interest of various groups such as owners, employees, creditors and society. Thus, it may be consistent with the management objective of survival. There can, however, arise situations where a conflict may occur between shareholders and managements’ goals. For example, management may play safe and create satisfactory wealth for shareholders than the maximum.

Such “satisfying behaviour of

management will frustrate the objective of SWM as a normative guide to management.

Q.WHAT DO YOU UNDERSTAND BY FINANCIAL DECISIONS? DISCUSS THE MAJOR FINANCIAL DECISIONS. Financial decisions refer to decisions concerning financial matters of a business firms. There are many kinds of financial management decisions that the firm makes in pursuit of maximizing shareholders wealth, viz., kinds of assets to be acquired, pattern of capitalization, distribution of firm income etc.

Financial decisions can be classified into four major groups: 1. Investment decisions 2. Financing decisions 3. Dividend decisions 4. Working capital management decisions 1. INVESTMENT DECISIONS: Investment decision relates to the determination of total amount of assets to be held in the firm, the composition of these assets and the business risk complexions of the firm as perceived by its investors. It is the most important financial decision. Since funds involve cost and are available in a limited quantity, its proper utilization is very necessary to achieve the goals of wealth maximization.

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FINANCE MANAGEMENT The investment decisions can be classified under two broad groups: â&#x20AC;˘

Long term investment decisions and

â&#x20AC;˘

Short term investment decisions.

The long term investment decisions is referred to as the capital budgeting and the short term investment decision as working capital management. Capital budgeting: Capital budgeting is the process of making investment decisions in capital expenditure. These are expenditure, the benefits of which are expected to be received over a long period of time exceeding one year. The investment proposals should be evaluated in terms of expected profitability, cost involved and the risks associated with the projects. The investment decisions is important not only for the setting up of new units, but also for the expansion of present units, replacement of permanent assets, research and development project costs and reallocation of funds, in case, investments made earlier do not fetch result as anticipated earlier. Short term investment decision: Short term investment decision, on the other hand, relates to the allocation of funds as among cash and equivalent, receivables and inventories. Such a decision is influenced by trade off between liquidity and profitability. The reason, is that the more liquid the asset, the less it is likely to yield and the more profitable an asset, the more liquid it is. A sound short term investment decision or working capital management policy is one which ensures higher profitability, proper liquidity and sound structural health of the organization. 2. FINANCING DECISIONS: Once the firm has taken the investment decision and committed itself to new investment, it must decide the best means of financing these commitments. Since, firms regularly make new investments, the needs for financing and financing decision is not only concerned with how best to finance new assets, but also concerned with the best overall mix of financing for the firm. A finance manager has to select such sources of funds which will make optimum capital structure. The important thing to be decided here is the proportion of various sources in the overall capital mix of the firm. The debt equity ratio should be fixed in such a way that it helps in maximizing the profitability of the concern. The raising of more debts will involve fixed interest liability and dependence upon outsider. It may help in increasing the return on equity but will also enhance the risk. The raising of funds through equity will bring permanent funds to the business but the shareholders will expect higher rates of earnings. If the capital structure is able to minimize the risk and raise the profitability, then the market prices of the shares will go up maximizing the wealth of shareholders. 3. DIVIDEND DECISION: The third major financial decision relates to the disbursement of profits back to investors who supplied capital to the firm. The term dividend refers to that part of profits of a company which is distributed by it among its shareholders.

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The dividend decision is concerned with the quantum of profits to be distributed among shareholders. A decision has to be taken whether all the profits are to be distributed or to retain all the profits in business or to keep a part of profits in the business and distribute others among shareholders. The higher rate of dividend may raise the market price of shares and thus maximize the wealth of shareholders. The firm should also consider the question of dividend stability, stock dividend (bonus shares) and cash dividend.

4. WORKING CAPITAL MANAGEMENT DECISIONS: Working capital (net) generally stands for excess of current assets over current liabilities.

Working capital management decisions therefore refers to all aspects of the

administration of both current assets and current liabilities. A finance manager should therefore chalk out appropriate working capital management policies in respect of each of the components of working capital. This is so because both inadequate as well as excessive working capital positions are bad for any business. Inadequacy of working capital may lead the firm to insolvency and excessive working capital implies idle funds which earn no profits for the business. Working

capital

management decisions of a firm have a great effect on its profitability liquidity and structural health of the organization.

Q. “INVESTMENT, FINANCING AND DIVIDEND DECISIONS ARE ALL INTER RELATED”, COMMENT. (OR) Q. “LIQUIDITY AND PROFITABILITY ARE COMPETING GOALS FOR THE FINANCE MANAGER” – COMMENT. Financial management decisions are inter related because the underlying objective of all these decisions is the same, i.e., maximization of shareholder’s wealth. All these decisions influence one another and are inter depended. For example, the decision to invest in some proposal cannot be taken isolation without having necessary finance available for the same. The financing decision in turn is influenced by and also influences the dividend decision. In case the profits are retained for financing of the investment, the profits available for distribution to the shareholders as dividends are reduced. An efficient financial management, thus has to take the optimal joint decision by evaluating each of the decision involved in relation to its effect on shareholders wealth and by considering the joint impact of these decisions on the market value of the company’s shares.

Liquidity versus Profitability The finance manager is always faced with the dilemma of liquidity Vs Profitability. He has to strike a balance between the two. Liquidity means that:

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•

The firm has adequate cash to pay for its bills

•

The firm has sufficient cash to make unexpected large purchases and above all,

•

The firm has cash reserve to meet emergencies at all times.

Profitability goal, on the other hand, requires that the funds of the firm are so used as to yield the highest return.

Financial management

Maximization of share value

Financial decision Trade off

Investment Decision

Liquidity Decision

Financing Decision

Dividend Decision

Liquidity the other Returnand profitability are very closely related. When one increases, Risk decreases. Apparently, liquidity and profitability goals conflict in most of the decisions which the finance mangers take.

For example if higher inventories are kept in anticipation of

increased in price of raw materials, profitability goal is approached but liquidity of the firm is endangered. There is also a direct relationship between higher risk and higher return. Higher risk on the one hand endangers the liquidity of the firm; higher return on the other hand increases its profitability. A company may increase its profitability by having a very high debt equity ratio. However, when the company raises funds from outsider sources, it is committed to make the payment of interest etc at fixed time and in fixed amounts and hence to that extent its liquidity is reduced. Thus, in every area of financial management the finance manager is to choose between risk and return and generally he chooses in between the two. He should forecast cash flows and analyze the various sources of funds. Forecasting of cash flows and managing the flow of internal funds are the functions which lead to liquidity. Cost control and forecasting future profits are the functions of finance managers which lead to profitability.

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FINANCE MANAGEMENT An efficient finance manager fixes that level of operations where both return and risk are optimized. Such a level is termed as risk return trade off and every financial decision involves this trade off. At this level the market value of the company’s shares would be the maximum. The inter relationship between market value, financial decisions and risk return trade off is depicted in the following chart.

Q.WHAT ARE THE FACTORS THAT INFLUENCE FINANCIAL DECISIONS. There are a number of (both external as well as internal) factors that influence the financial decisions. A list of the important external as well as internal factors influencing the decisions is given below. External factors: •

State of economy

•

Structure of capital and money markets

•

Requirements of investors

•

Government policy

•

Taxation policy

•

Lending policy of financial institutions.

Internal factors: •

Nature and size of business

•

Expected return, cost and risk

•

Composition of assets

•

Structure of ownership

•

Trend of earnings

•

Age of the firm

•

Liquidity position

•

Working capital requirements

•

Conditions of debt agreements

Q.EXPLAIN THE FUNCTIONAL AREAS OF FINANCIAL MANAGEMENT. 1. Estimation of the financial requirements: The requirement of finance to a business concern is continuous. It is needed in all the stages of business cycle namely initial growth, saturation and declining stage. Funds are needed to establish the industry both for meeting capital expenditure and revenue expenditure. Total estimation of funds for these assets are the first assignment of the subject financial management. Funds are also needed at the growth stage for expansion and to increase the production to meet the demand of consumers. The requirement of finance arises even at the stage of saturation. It is needed for diversifying the product, so that a firm can continuously stay on in the saturation stage. If the firm became sick to rejuvenate the activities of such business concern, rescheduling

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repackage of financial services are needed. Hence it is the first task of finance manager. A wrong assessment of financial needs may jeopardize the survival of a concern. 2. Selection of the right sources of funds: After estimating the total funds of business concern, it is the second important step of the finance manager to select the right type of sources of funds at the right time at the right costs. A concern may resort to issue of share capital and debentures. Financial institutions may be requested to provide long term funds. The working capital needs may be met by getting cash credit or overdraft facilities from commercial banks. A finance manager has to be very careful and cautious in approaching different sources. A small concern may find difficulties in raising funds for want of adequate securities or due to its reputation.

The

selections of a suitable source of funds will influence the profitability of the concern. This selection should be made with great caution. 3. Allocation of funds: After mobilizing the total funds of a firm, it is the responsibility of finance manager to distribute the funds to capital expenditure and revenue expenditure. The evaluation of different proposals of project must be made before making a final decision on investment. Each investment must yield fair amount of returns, so that it should contribute to the goal of ‘Wealth Maximization’. 4. Analysis and interpretation of financial performance: The analysis and interpretation of financial statements is an important task of a finance manager. He is expected to know about the profitability, liquidity position, short term and long term financial position of the concern. For this purpose, a number of ratios have to be calculated. The interpretation of various ratios is also essential to reach certain conclusions. Financial analysis and interpretation has become an important area of financial management. 5. Cost – Volume – Profit Analysis: It is another important tool of the financial management, that helps the management to evaluate different proposals of investments.

Make or buy decision, deletion and

continuation of a product line decision can be made by adopting CVP/BEP analysis. This helps the management to achieve long term objective of a firm. 6. Capital budgeting: Capital budgeting is the process of making investment decisions in capital expenditure. It is an expenditure the benefits of which are expected to be received over a period of time exceeding one year. Capital budgeting decisions are vital to any organization.

An unused investment

decision may prove to be fatal for the very existence of the concern. The crux of capital budgeting is the allocation of available resources to various proposals.

The crucial factor which influences the capital budgeting decision is the

profitability of the prospective investment.

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For making correct capital budgeting decisions, the knowledge of its techniques is essential. A number of methods like payback period method, rate of return method, net present value method, internal rate of return method and profitability index method may be used for making capital budgeting decisions. 7. Working capital management: Working capital refers to that part of the firm’s capital which is required for financing short term or current assets such as cash, receivables and inventories. It is essential to maintain a proper level of these assets. Financial manager is required to determine the quantum of such assets. Cash is required to meet day to day needs and purchase inventories etc. scarcity of cash may adversely affect the reputation of a concern.

The

The receivables

management is related to the volume of production and sales. For increasing sales, there may be a need to give more credit facilities. Though sales may go up but the risk of bad debts and cost involved in it may have to be weighted against the benefits. Inventory control is also an important factor in working capital management. The inadequacy of inventory may cause delays or stoppages of work.

Excess

inventory, on the other hand, may result in blocking of money in stocks, more costs in stock maintaining etc. Proper management of working capital is an important area of financial management. 8. Profit planning and control: Profit planning and control is an important responsibility of the finance manager. Profit is also used as a tool for evaluating the performance of management.

Profit is

determined by the volume of revenue and expenditure. Revenue may accrue from sales, investment in outside securities or income from other sources. The expenditure may include manufacturing costs, trading expenses, office and administrative expenses, selling and distribution expenses and financial cost. The excess of revenue over expenditure determine the amount of profit.

Profit

planning and control directly influence the declaration of dividend, creation of surpluses, taxation etc. Break even analysts and cost – volume – profit relationship are some of the tools used in profit planning and control. 9. Dividend policy: Dividend is the reward of the shareholders for investments made by them in the shares of the company. The investors are interested in earnings the maximum return on their investments whereas management wants to retain profits for further financing. The company should distribute a reasonable amount as dividend to its members and retain the rest for its growth and survival. A dividend policy is influenced by a number of factors such as magnitude and trend of earnings, desire and type of shareholders, future requirements of the company, government’s economic policy, taxation policy etc. Dividend policy is an important area of

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financial management because the interests of the shareholders and the needs of the company are directly related to it. 10. Maintaining liquidity and wealth maximization: This is considered to be the prime objective of a business firm. Liquidity of a firm increases the borrowing capacity.

Expansion and diversification activities can be comfortably executed.

Increased liquidity

builds the firm’s ability to meet short term obligation towards creditors or bankers. Once the flow of funds is assumed continuously, flexibility in the planning for investments can be maximized. This helps the firm to meet all types of obligation to the target group like investors, creditors, employees management, government and society.

Thus ‘Wealth Maximization’

takes place in the form of growth of capital over the years.

ROLE OF FINANCE MANAGER Q.CRITICALLY ANALYZE THE FUNCTIONS OF FINANCIAL MANAGER IN A LARGE SCALE INDUSTRIAL ESTABLISHMENT. (OR) Q.WHAT ARE THE RESPONSIBILITIES OF THE FINANCIAL MANAGER IN A MODERN BUSINESS ORGANIZATION? Introduction: Finance manager is a person who heads the department of finance.

He forms

important activities in connection with each of the general functions of management. Specifically, the finance manager should anticipate financial needs, acquire financial resources and allocate funds to various departments of the business. Since the financial manager is an integral part of the top management, he should shape his decisions and recommendations to contribute to the overall progress of the business.

It is his primary

objectives to maximize the value of the firm to its stockholders. TRADITIONAL ROLE 1. Financial forecasting and planning: A financial manager has to estimate the financial needs of a business. How much money will be required for acquiring various assets?

The amount will be needed for

purchasing fixed assets and meeting working capital needs. He has to plan the funds needed in the future. How these funds will be acquired and applied is an important function of a finance manager. 2. Acquisition of funds: After making financial planning, the next step will be to acquire funds. There are a number of sources available for supplying funds. These sources may be shares, debentures, financial institutions, commercial banks etc. The selection of an appropriate source is a delicate task.

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The choice of a wrong source for funds may create difficulties at a larger stage. The pros and cons of various sources should be analyzed before making a final decision.

3. Investment of funds: The funds should be used in the best possible way. The cost of acquiring them and the returns should be compared. The channels which generate higher returns should be preferred. The technique of capital budgeting may be helpful in selecting a project. The objective of maximizing profits will be achieved only when funds are efficiently used and they do not remain idle at any time. A financial manager has to keep in mind the principles of safety, liquidity and soundness while investing funds.

4. Helping in valuation decision: A number of mergers and consolidations take place in the present competitive industrial world. A finance manager is supposed to assist management in making valuations etc. For this purpose, he should understand various methods of valuing shares and other assets so that correct values are arrived at.

5. Maintain proper liquidity: Every concern is required to maintain some liquidity for meeting day to day needs. Cash is the best source for maintaining liquidity. It is required to purchase raw materials, pay workers, meet other expenses etc. A finance manager is required to determine the need for liquid assets and then arrange liquid assets in such a way that there is no scarcity of funds.

Changing role of finance manager

The changed business environment in the result part has widened the role of a financial manager.

The increasing pace of industrialization, rise of larger scale units,

innovations in information processing techniques, intense competition etc have increased the need for financial planning and control.

The size and extent of business activities are

dependent upon the availability of finances. Financial reporting may be used as a technique for control. In the present business context, a financial manager is expected to perform the following functions.

Changing role of Finance Manager

Traditional role Financial forecasting & planning

New role Mergers â&#x20AC;&#x201C;Tax planning

Acquisition of funds

Cost reduction strategies

Investment of funds

Access for foreign Investment

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Helps in valuation decision

FOREX Management

Maintains proper liquidity

Information Technology

Communication Network Learning attitude etc.

New role: In addition to the traditional role, the finance manager has to look into the areas where he has to operate his function in the changing environment. •

The government of India has thrown open challenge before the corporate by introducing liberalization, privatization and globalization in the year 1991. From then on continuous changes are taking place in the economic environment. Hence it has become an ardent necessity for the finance manager to look into the areas of mergers, acquisitions, tax planning, tax management, personality development etc.

•

The new economic policy introduced in the year 1991 facilitated the multinational companies to enter into the country more freely without any restrictions. Hence the concept of mega mergers entered into corporate world.

The technicalities,

negotiations, mode of mergers, acquisitions within the country and outside must be known to the finance manager to operate his function under the global environment. •

In addition to this, the finance manager has to guide the management in adopting tax planning technique and to introduce cost reduction strategies, so that it would help to participate in the competition effectively.

•

The vision of corporate are aiming at global market, this necessitated the requirement of knowing the knowledge of imports and exports, managing the foreign exchange risk (FERA) and important aspects of international financial management.

In addition to the above roles, he has to adopt himself to changing information technology which calls for expected knowledge in the field of computers. This would not only reduces the cost of operation but also provides greater flexibility. To conclude, the financial manager of a company must be more vibrant, dynamic and should have continuous learning attitude. He should develop the attitude of research and innovations to discharge his duties competitively.

Q.EXPLAIN THE INTERFACE OF THE FINANCE FUNCTION WITH OTHER AREAS. (OR) Q.FINANCE FUNCTION OF A BUSINESS IS CLOSELY RELATED TO ITS OTHER FUNCTIONS. ‘DISCUSS’. Finance function

Purchase

Production

Function

Distribution Function

Accounting Function

Personnel

R&D

Function

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Finance function of a business is closely related to its other functional areas. Funds will be wasted in the absence of efficient production and in the absence of proper marketing; the firm will not be able to engage funds judiciously in the business. Most of the important decisions of a business enterprise are taken on the basis of availability of funds. Financial policies of a firm should be devised in such a manner so as to match the requirements of other functional areas. The relationship between finance function and other business functions of an enterprise is discussed below: 1. Purchase function: Materials required for production of commodities should be procured on economic terms and should be utilized in efficient manner to achieve maximum productivity. In this function the finance manager plays a key role in providing finance. In order to minimize cost and exercise maximum control, various material management techniques such as economic order quantity (EOA), determination of stock level, perpetual inventory system etc are applied. The task of the finance manager is to arrange the availability of cash when the bills for purchase become due.

2. Productivity function: Production function occupies the dominant position in business activities and it is a continuous process. Production function involves heavy investment in fixed assets and in working capital; naturally, a tighter control by the finance manager on the investment in productive assets becomes necessary.

It must be seen that there is neither over

capitalization nor under capitalization â&#x20AC;&#x201C; cost â&#x20AC;&#x201C; benefit criteria should be the prime guide in allocating funds and therefore finance and production manager should work in unison.

3. Distribution function: As goods produced are meant for sale, a distribution function is an important business activity. While choosing different distributing channels, media of advertisement and sales promotion devices, the cost benefit criterion should be the guiding factor. If cost reduction in distribution function is effected without compromising efficiently, it will lead to increased benefit to the enterprise in the form of higher profit and to the consumers in the form of lower cost. As every aspect of distributory function involves cash outflow and every distributing activity is aimed at bringing about inflow of cash, both the functions are closely inter related and hence should be carried out in closed unison.

4. Accounting function: The efficiency of the whole organization can be greatly improved with correct recording of financial data.

All the accounting tools and control devices, necessary for

appraised of finance policy can be correctly formulated if the accounting data are properly

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recorded. For example, the cost of raising funds, expected returns on the investment of such funds, liquidity position, forecasting of sales etc can be effectively carried out if the financial data so recorded are reliable. Hence, the relationship between accounting and finance is intimate and the finance manager has to depend heavily on the accuracy of the accounting data.

5. Personnel function: Personnel function has assumed a prominent place in the domain of business management. No business function can be carried out effectively unless there is a sound personnel policy backed up by efficient management of personnel. A sound personnel policy includes proper wage structure, incentives schemes, promotional opportunity, human resource development and other fringe benefits provided to the employees.

All these matters affect finance. It means that expenditure incurred on

personnel management and the expected return on such investment though labour productivity should be considered in framing a sound personnel policy. Therefore the relation between the finance and personnel department should be intimate. 6. Research and development: In the world of innovations and competitiveness expenditure and research and development is a productive investment and research and development itself is an aid to survival and growth of the firm.

However sometimes expenditure on research and

development involves heavier amount which cripples the enterprise and the expenditure ultimately ends in a fiasco. On the other hand, heavily cutting down expenditure of research and development blocks the scope of improvement and diversification of the product. So there must be a balance between the amount necessary for continuing research and development work and the funds available for such a purpose. Usually, this balance is struck out by joint efforts of finance manager and the person at the helm of research and development. PROCESS OF FINANCIAL MANAGEMENT

Financial planning And control Feedback

Financial decisions Market price Share Risk and 1. Investment decision Of share holder return The financialdecision management process begins with the financial 2. Financing wealth While P planning and decisions. Characteristics 3. Dividend decision W=NP implementing these decisions, Of thethe firmfirm has to acquire certain risk and return characteristics.

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These characteristics determine the market price of shares and shareholder wealth. The process must include the feedback system to enable it take corrective measures, if required. The figure below depicts the process of financial management:

ORGANISATION OF FINANCE FUNCTIONS. Q.HOW SHOULD THE FINANCE OF AN ENTERPRISE BE ORGANISED? DISCUSS.

Board of Directors Managing Directors Finance committee

Vice president Production

Vice president Finance

Financial controller

Planning and control

Annual Reports

Vice president Sales

Treasurer

Budgeting

Profit analysis

Accounting and payroll

Additional Cash Receivables Relations Audit with Funds Management Management The finance function is very vital for every type of business enterprise. There is aBanks need to set & Financial up a sound and efficient organization to achieve its goals. However, organization of finance Institutions function is not standardized one. It varies from enterprise to enterprise, depending upon its nature, size and other requirements. In a small concern, whose operations are simple and there is little delegation of authority no separate executive is appointed to handle finance function. It is the owner who performs all these functions himself. But in medium and large scale concerns, a separate department to organize all financial activities may be created at top level under a direct supervision of Board of Directors or a highly placed official. This function may be headed by a committee or a top management executive. All important financial decisions are taken by the committee or the executive but routine decisions are left to the lower levels of management.The finance function is centralized because of its importance. The financial decisions are crucial for the survival of the concern. In large concerns, for organizing finance functions, the Controller and Treasurer are appointed.

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FUNCTIONS OF CONTROLLER: Planning and control: To establish, coordinate and administer, as part of management, a plan for the control of operations. This plan would provide to the extent required in the business, profit planning, programmes for capital investing and for financing, sales forecasts and expense budgets. Reporting and interpreting: To compare actual performance with operating plans and standards, and to report and interpret the results of operations to all levels of management and to the owners of business. To consult with the management about the financial implications of the business. Tax administration: To establish and administer tax policies and procedures. Government reporting: To supervise co-ordinate the preparation of report to government agencies. Protection of assets: To ensure protection of business assets through internal control, internal auditing and assuring proper insurance coverage. Economic appraisal: To appraise economic and social forces and government influences and interpret their effect upon business. FUNCTIONS OF TREASURER: Provision of finance: To establish and execute programmes for the provision of the finance required by the business, including negotiating its procurement and maintaining the required financial arrangements. Investor relations: To establish and maintain an adequate market for the company’s securities and to maintain adequate contact with the investment community. Short term financing: To maintain adequate sources for the company’s current borrowings from the money market. Banking and custody: To maintain banking arrangements, to receive, have custody of and disburse the company’s moneys and securities and to be responsible for the financial aspects of real estate transactions. Credit and collections: To direct the granting of credit and the collection of accounts receivables of the company. Investments:

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FINANCE MANAGEMENT To invest the companyâ&#x20AC;&#x2122;s funds as required and to establish and coordinate policies for investment in pension and other similar trusts. Insurance: To provide insurance coverage as may be required.

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UNIT-II CAPITAL EXPENDITURE EVALUATIONS CAPITAL BUDGETING Q.GIVE THE MEANING AND DEFINITION OF CAPITAL BUDGETING. MEANING: Capital budgeting is the process of making investment decisions in capital expenditure. A capital expenditure may be defined as an expenditure the benefits of which are expected to be received over period of time exceeding one year. The main characteristic of a capital expenditure is that the expenditure is incurred at one point of time whereas benefits of the expenditure are realized at different points of time in future or a capital expenditure is an expenditure incurred for acquiring or improving the fixed assets, the benefits of which are expected to be received over a number of years in future. Kinds of Capital Budgeting Proposals (i)

Cost of acquisition of permanent assets as land and building, plant and machinery, goodwill etc

(ii)

Cost of addition, expansion, improvement or alteration in the fixed assets

(iii)

Cost of replacement of permanent assets

(iv)

Research and development project cost etc.

Kinds of capital budgeting proposals

Replacement Expansion

Modernization of investment expenditures

Strategic investment proposals

Diversification

Reasearch & development

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Capital expenditure involves non-flexible long-term commitment of funds. Thus capital expenditure decisions are also called as long term investment decisions. Capital budgeting involves the planning and control of capital expenditure. It is the process of deciding whether or not to commit resources to a particular long term project whose benefits are to be realized over a period of time, longer than one year. Capital budgeting is also known as Investment Decision Making, Capital Expenditure Decisions, Planning Capital Expenditure and Analysis of Capital Expenditure. DEFINITION: Charles T. Horngreen has defined capital budgeting as, “Capital budgeting is long term planning for making and financing proposed capital outlays”. According to G.C.Philippatos, “Capital budgeting is concerned with the allocation of the firm’s scarce financial resources among the available market opportunities.

The

consideration of investment opportunities involves the comparison of the expected future streams of earnings from a project with the immediate and subsequent streams of earning from a project, with the immediate and subsequent streams of expenditures for it”. Richard and Greenlaw have referred to capital budgeting as acquiring inputs with long run return. In the words of Lynch, “Capital budgeting consists of planning development of available capital for the purpose of maximizing the long term profitability of the concern”.

Q.EXPLAIN THE NATURE OF INVESTMENT DECISIONS/ FEATURES OF INVESTMENT DECISIONS.

Capital expenditure for long period

FEATURES OF CAPITAL BUDGETING

Forecasting

Planning asset capacities The important features which distinguish capital budgeting decision from the ordinary day to day business decisions are: (i)

Capital budgeting decisions involve the exchange of current funds for the benefits to be achieved in future

(ii)

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

(iii)

The funds are invested in non flexible and long term activities

(iv)

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

(v)

They involve generally huge funds

(vi)

They are irreversible decisions

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They are ‘strategic’ investment decisions, involving large sums of money, major departure from the past practices of the firm, significant change of the firm’s expected earnings associated with high degree of risk, as compared to ‘tectical’ investment decisions which involve a relatively small amount of funds that do not result in a major departure from the past practices of the firm.

Q.DISCUSS THE NEED AND IMPORTANCE OF CAPITAL BUDGETING DECISIONS. Capital budgeting decisions are most important business decisions.

All types of

capital investment are made only after evaluating its cost benefit analysis. Following are the cause of its importance in management decisions.

The success and failure of business

mainly depends on how the available resources are being utilized. Capital budgeting decisions are vital to any organization as they include the decisions as to: •

Whether or not funds should be invested in long term projects such as setting of an industry, purchase of plant and machinery etc.

•

Analysis the proposal for expansion or creating additional capacities

•

To decide the replacement of permanent assets such as building and equipments

•

To make financial analysis of various proposals regarding capital investments so as to choose the best out of many alternative proposals.

The need, significance or importance of capital budgeting arises mainly due to the following: a) Involvement of heavy funds: Capital budgeting decisions require large capital outlays. It is therefore absolutely necessary that the firm should carefully plan its investment programme so that it may get the finances at the right time and they put to most profitable use. An opportune investment decision can give spectacular results. On the other hand, an ill-advised and incorrect decision can jeopardize the survival of even the biggest firm. b) Long term implications: Capital expenditure involves not only large amount of funds but also funds long term or more or less on permanent basis. The long term commitment of funds increases the financial risk involved in the investment decision.

Greater the risk

involved, greater is the need for careful planning of capital expenditure, i.e., Capital budgeting. c) Irreversible decisions: In most cases, capital budgeting decisions are irreversible. This is because it is very difficult to find a market for the capital assets. The only alternative will be to scrap the capital assets so purchased or sell them at a substantial loss in the event of the decision being proved wrong. d) Most difficult to make: The capital budgeting decisions require an assessment of future events which are uncertain. It is really a difficult task to estimate the probable future events, the probable benefits and costs accurately in quantitative terms because of economic, political, social and technological factors. e) Long-term effect on profitability: Capital budgeting decisions have a long term and significant effect on the profitability of a concern. Not only the present earnings of the firm are

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FINANCE MANAGEMENT affected by the investments in capital assets, but also the future growth and profitability of the firm depends upon the investment decision taken today. An unwise decision may prove disastrous and fatal to the very existence of the concern. Capital budgeting is of utmost importance to avoid over investment or under investment in fixed assets. f) National importance:

Investment decision though taken by individual concern is of

national importance because it determines employment, economic activities and economic growth. Thus we may say that without using capital budgeting techniques a firm may involve itself in losing project. Proper timing of purchase, replacement, expansion and alternation of assets is essential. Q.DISCUSS IN DETAIL THE CAPITAL BUDGETING PROCESS. Capital budgeting is a complex process as it involves decisions relating to the investment of current funds for the benefit to the achieved in future and the future is always uncertain.

However, the following procedure may be adopted in the process of capital

budgeting: a) Identification of Investment Proposals: The capital budgeting process begins with the identification of investment proposals. The proposal or the idea about potential investment opportunities may originate from the top management or may come from the rank and file worker of any department or from any officer of the organization. The departmental head analyses the various proposals in the light of the corporate strategies and submits the suitable proposals to the Capital Expenditure Planning Committee in case of large organizations or to the officers concerned with the process of long term investment decisions.

b) Screening the Proposals: The Expenditure Planning Committee screens the various proposals received from different departments. The committee views these proposals form various angles to ensure that these are in accordance with the corporate strategies or selection criterion of the firm and also do not lead to departmental imbalances.

c) Evaluation of Various Proposals: The next step in the capital budgeting process is to evaluate the profitability of various proposals. There are many methods which may be used for this purpose such as pay back period method, rate of return method, net present value method, internal rate of return method etc. All these methods of evaluating profitability of capital investment proposals have been discussed in detail separately in the following pages of this chapter. It should be noted that various proposals to the evaluated may be classified as: â&#x20AC;˘

Independent proposals

â&#x20AC;˘

Contingent or dependent proposals and

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Mutually exclusive proposals.

Independent proposals are those which do not compete with one another and the same may be either accepted or rejected on the basis of a minimum return on investment required. The contingent proposals are those whose acceptance depends upon the acceptance of one or more other proposals, e.g., further investment in building or machineries may have to be undertaken as a result of expansion programme. Mutually exclusive proposals are those which compete with each other and one of those may have to be selected at the cost of the other.

d) Fixing Priorities: After evaluating various proposals, the unprofitable or uneconomic proposals may be rejected straight away. But it may not be possible for the firm to invest immediately in all the acceptable proposals due to limitation of funds. Hence it is very essential to rank the various proposals and to establish priorities after considering urgency, risk and profitability involved therein.

e) Final Approval and Preparation of Capital Expenditure Budget: Proposals meeting the evaluation and other criteria are finally approved to be included in the Capital Expenditure Budget. However, proposals involving smaller investment may be decided at the lower levels for expeditious action. The capital expenditure budget lays down the amount of estimated expenditure to be incurred on fixed assets during the budget period.

f) Implementing proposal: Preparation of a capital expenditure budgeting and incorporation of a particular proposal in the budget does not itself authorize to go ahead with the implementation of the project. A request for authority to spend the amount should further be made to the Capital Expenditure Committee which may like to review the profitability of the project in the changed circumstances. Further while implementing the project, it is better to assign responsibilities for completing the project within the given time frame and cost limit so as to avoid unnecessary delays and cost over runs. Network techniques used in the project management such as PERT and CPM can also be applied to control and monitor the implementation of the projects.

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

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looked into and the causes of the same be identified so that corrective action may be taken in further.

Q.WHAT ARE THE KINDS OF INVESTMENT DECISIONS? Capital budgeting refers to the total process of generating, evaluating, selecting and following up on capital expenditure alternatives.

The firm allocates or budgets financial

resources to new investment proposals-Basically, the firm may be conformed with three types of capital budgeting decisions.

Accept reject decision: This is a fundamental decision in capital budgeting. If the project is accepted, the firm would invest in it. If the proposal is rejected, the firm does not invest in it. In general, all those proposals which yield a rate of return greater than a certain required rate of return or cost of capital are accepted and the rest are rejected.

Mutually Exclusive Project Decisions:

Mutually exclusive projects are those which

compete with projects in such a way that the acceptance of one will exclude the acceptance of the other projects. The alternatives are mutually exclusive and only one may be chosen.

Capital Rationing Decision:

In a situation where the firm has unlimited funds, all

independent investment proposals yielding return greater than some predetermined level are accepted. However, this situation does not prevail in most of the business firms in actual practice.

They have a fixed capital budget.

A large number of investment proposals

complete for these limited funds. The firm must therefore, ration them.

The firm allocates funds to projects in a

manner that it maximizes long run returns. Thus capital rationing refers to a situation in which a firm has more acceptable investments than it can finance. It is concerned with the selection of a group of investment proposals out of many investment proposals acceptance under the accept-reject decision. Capital rationing employs ranking of the acceptable investment projects.

The

projects can be ranked on the basis of a predetermined criterion such as the rate of return. The projects are ranked in the descending order of the rate of return

Cash flow for investment analysis The evaluation of long-term investment decisions or investment analysis to be consistent with the firmâ&#x20AC;&#x2122;s goal involves the following three basic steps: 1. Estimation or determination of cash flows. 2. Determining the rate of discount or cost of capital. 3. Applying the technique of capital budgeting to determine the viability of the investment proposal.

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FINANCE MANAGEMENT The first important step i.e., estimation or determination of cash flows. If a firm makes an investment today, it will require an immediate cash outlay, but the benefits of this investment will be received in future. Thus, it will have an effect on future cash flows over the life of the asset. While taking such financial decision, the firm has to compare the total inflows with the total of cash outflows from the investment. But, the estimation of future cash outflows is not an easy task because of uncertainties of the future.

CONCEPT OF CASH FLOWS. Q.DISTINGUISH BETWEEN ACCOUNTING PROFITS AND CASH FLOWS.WHY ARE CASH FLOWS CONSIDERED TO BE A BETTER MEASURE OF ECONOMIC VIABILITY AS COMPARED TO ACCOUNTING PROFITS? There are two alternative criteria available for ascertaining future economic benefits of an investment proposal, (i) accounting profits, and (ii) cash flows. The term ‘accounting profit’ refers to the figure of profit as determined by the income statement or profit and loss account, while ‘cash flow refers to cash revenue minus cash expenses. The difference between these two criteria arises primarily because of certain noncash expenses such as depreciation, being charged to profit & loss account. Thus, the accounting profits have to be adjusted for such non-cash charges to determine the actual cash inflows. In fact, cash flows are considered to be better measure of economic viability as compared to accounting profits for the following reasons: 1. The appropriate objective of a firm is not to maximize profits; rather it is to maximize the shareholder’s wealth which depends upon the present value of cash flows available to them and not the accounting profits. When the firm makes a new investment, traditional accounting procedure spread out the initial investment be capitalizing it over the life of the asset and then reducing future net benefits by subtracting an annual depreciation charge. But this accounting treatment does not reflect the original need for cash at the time of investment, nor does the accounting treatment reflect the actual size of the net cash inflows or outflows in later years. Only cash flows reflect the actual cash transactions associated with the project, and since investment analysis is concerned with the question: Are future economic inflows sufficiently large to warrant the initial investment? Only the cash flow method is appropriate for investment decision analysis.

2. The second reason for considering cash flows to be a better measure of economic viability as compared to accounting profits pertains to accounting ambiguities in determining net profits. there are many ambiguities that arise in accounting profit approach on account of various accounting practices regarding method of valuation of inventory, allocation of costs, method of depreciation and amortization of various

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FINANCE MANAGEMENT other expenses. Thus, different net profits may be arrived at under different accounting practices and procedures. But, there will be only one set of cash flows associated with the project. The cash flow approach, thus, avoids the accounting ambiguities and is a better measure as compared to the accounting profits approach.

3. The third reason in favour of cash flow approach is its recognition of time value of money. It recognizes the time value of money by considering the actual cash inflows and outflows. On the other hand, usual accounting practices considers revenues when earned and expenses when incurred on the accrual basis rather than when cash is actually effected. It may, sometimes amount to only paper profits if the revenue (sale) is not realized. Therefore, from the view point of investment analysis, the ash flow approach is the only appropriate method.

Q.EXPLAIN IN DETAIL (1) CONVENTIONAL AND NON-CONVENTIONAL CASH FLOWS; AND (2) INCREMENTAL CASH FLOWS. (1) CONVENTIONAL AND NON-CONVENTIONAL CASH FLOWS

CONVENTIONAL CASH FLOWS When an initial cash outlay (outflow) is followed be a series of cash inflows of uniform or unequal amounts, it is called conventional cash flows. Most of the capital investment decisions follow this pattern. for example, a firm may invest Rs.2,00,000 initially in a project at time zero and may expect to receive an annual cash inflow of Rs.40,000 at the end of each year for 8 years.

The other example of conventional cash flows could be where a firm may invest sayRs.5,00,000 initially and as a result may expect to receive cash flows of Rs.1,00,000 at the end of first year,Rs.1,50,000 at the end of second year,Rs.2,00,000 at the end of third year, Rs.1,00,000 at the end of fourth year and Rs.1,50,000 at the end of fifth year. NON-CONVENTIONAL CASH FLOWS Non-conventional cash flows on the other, refers to the cash flow pattern where not one but a series of cash outflows are followed by a series of cash inflows of equal amounts. For example, a project may require an investment of Rs.1,50,000 in the beginning of first year and another Rs.30,000 at the beginning of second year followed by cash inflows of Rs.30,000 ,Rs.40,000 ,Rs.70,000,Rs.80,000 and Rs.40,000 at the end of each year of the first five years respectively. Another example of non-conventional cash flows may be where a firm may purchase a machine for Rs.1,00,000 initially at time zero and may expect to receive annual cash inflows of Rs.25,000 each year for5 years and then another cash outflow of Rs.30,000 may be

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required for overhauling of the machine in the sixth year to generate further cash inflows of Rs.20,000 each year for next 5 years.

(2) INCREMENTAL CASH FLOWS. All investment decisions involve comparison of alternative proposals. In case of a single proposal, the comparison will be between investing in the project and not-investing in the project. However, in case of two or more proposals, the comparison will be between investing in one project or the other. Single project proposals are evaluated on the basis of ‘absolute cash flows’, whereas, competing project proposals are evaluated on the basis of ‘relative or incremental cash flows’. The term ‘incremental cash flows’ refer to the differential cash flows between the two proposals.

Incremental Cash Flows For Proposal 1 And Proposal 2 Cash Flows Year( t 0 )Rs.

(Rs.)

Proposal 1

50,000

20,000

15,000

10,000

5,000

Proposal2

30,000

11,000

9,000

5,000

2,000

20,000

9,000

6,000

5,000

3,000

Q.EXPLAIN THE VARIOUS TYPES (COMPONENTS) OF CASH FLOWS.

Q.EXPLAIN IN DETAIL THE DETERMINATION OF RELEVANT CASH FLOWS. 1. INITIAL INVESTMENTThe initial investment is an outlay of cash that takes place in the initial period t=0 when an asset is purchased. It comprises, primarily, of cost of the new asset to purchase land, building, machinery, etc, including expenses on insurance, freight, loading and unloading, installation cost and expenses on modification and repairs, etc. before the asset is put to use .In addition to the cost of the asset, new investment in capital assets may also require increased investment in working capital, i.e. the excess of current assets over current liabilities. Thus, the net working capital increases are also added to the cost of the asset. Further, if the new investment makes use of some existing facilities, the opportunity cost of the same should also be added to arrive at the amount of initial investment. For example, if a firm proposes to invest in a machine to be installed at some surplus land of the firm, the firm should find out the opportunity cost of selling the land and add the same while calculating the initial investment. In the same manner, in case of replacement decisions, the existing asset may be sold if the new asset is purchased.

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The sale proceeds of the discarded asset should, therefore, be deducted while determining the amount of initial investment.

Until recently a deduction (tax credit) under income tax act equal to 25 percent of the cost of the asset was allowed as investment allowance in the period in which the asset was installed for production. However, the investment allowance has now, been discontinued fro st

1 April 1990.The computation of cash outflows, comprising the initial investment has been shown in the following table.

Computation of initial investment Rs. Purchase price of the asset(including duties and taxes if any)

Add: Insurance, freight, Loading, Unloading and Installation Costs

Add: Net Increase in Working Capital Requirements

Add: Opportunity cost(if any)

Less: Cash inflows in the form of sale proceed(of the old assets in case of replacement decisions)

Less: Investment Allowance(if any, discontinued from 1.4.1990)

2. OPERATING CASH FLOWS/NET ANNUAL CASH FLOWS Every investment in capital assets is expected to generate future benefits in the form of net annual cash flows from operations. These annual cash inflows should be estimated on an after-tax basis. In simple words, net annual cash flows refer to the annual net earnings (profit) before depreciation and after taxes.

Depreciation being a non cash charge is added back to the earnings before tax, but tax, being a cash expense has to be deducted to determine the net annual cash flows. The net amount cash flows can be determined as below:

NCF = Cash Revenues – Cash Expenses – Tax or, NCF = Net Earnings After Tax + Depreciation – Tax

The following table will be useful in determining net annual cash inflows.

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Determination of Net Annual Cash Inflows Years 1

4â&#x20AC;Śâ&#x20AC;Śn (amount in Rs)

Cash Revenues (Sales) Less: Cash Expenses (Operating costs) Earnings Before Depreciation and Tax (CFBT) Less: Depreciation Earnings Before Tax Less: Tax Earnings After Tax Add. Depreciation Cash Inflows After Tax (CFAT)

3. TERMINAL CASH FLOWS At the end of the economic life of a capital asset i.e., the last year when the asset is terminated, there is usually, some value in the asset left. The asset may be sold at that point of time as scrap or it may fetch some salvage value. This inflow to a firm in the last (terminal) year is called terminal cash flow. Similarly in the case of replacement decision where an old existing asset is replaced with a new asset, the reduction in cost of the new asset, i.e., the sales value of the old asset, is the terminal cash flow of the asset replaced. In addition to the salvage value of the asset, the firm may also recover the increased net working capital that was tied up in the initial year. Thus, this release of working capital should also be added to the salvage value of the asset to determine the terminal cash flows.

EXPLAIN

THE

VARIOUS

FACTORS

WHICH

INFLUENCE

THE

CAPITAL

EXPENDITURE DECISIONS. There are many other factors which have to be taken into consideration while taking a capital expenditure decision. These are: 1. Urgency: Sometimes an investment is to be made due to an urgency for the survival of the firm or to avoid heavy losses.

In such circumstances, the proper evaluation of the proposal

cannot be made through profitability tests. The examples of such an urgency are: breakdown of some plant and machinery, fire, accident etc.

2. Degree of certainty: Profitability is directly related to risk, higher the profits, greater is the risk or uncertainty.

Sometimes, a project with some lower profitability may be selected due to

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FINANCE MANAGEMENT constant flow of income as compared to another project with an irregular and uncertain flow of income.

3. Intangible factors: Sometimes a capital expenditure has to be made due to certain emotional and intangible factors such as safety and welfare of workers, prestigious project, social welfare, goodwill of the firm etc.

4. Legal factors: An investment which is required by the provisions of law is solely influenced by this factor and although the project may not be profitable yet the investment has to be made.

5. Availability of funds: As the capital expenditure, generally requires large funds, the availability of funds is an important factor that influences the capital budgeting decisions. A project, howsoever profitable, may not be taken for want of funds and a project with a lesser profitability may be sometimes preferred due to lesser pay-back period for want of liquidity.

6. Future earnings: A project may not be profitable as compared to another today, but it may promise better future earnings. In such cases it may be preferred to increase earnings.

7. Obsolescence: There are certain projects which have greater risk of obsolescence than others. In case of projects with high rate of obsolescence, the project with a lesser pay-back period may be preferred than one which may have high rate of obsolescence, the project with a lesser pay-back period may be preferred than one which may have higher profitability but still longer pay-back period.

8. Research and Development Projects: It is necessary for the long term survival of the business to invest in research and development projects though it may not look to be profitable investment.

9. Cost Considerations: Cost of the capital project, cost of production, opportunity cost of capital, etc are other considerations involved in the capital budgeting decisions.

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FINANCE MANAGEMENT Q.STATE THE LIMITATIONS OF CAPITAL BUDGETING. 1. The analytical techniques (investment return and time) are, to some extent, estimates. Even with all the knowledgeable factors’ collected and duly analyzed, there are many unknown factors which cannot be foreseen, controlled or avoided. 2. Capital investment can be determined in some cases with a high degree of accuracy; but in the development of a new product, or in the opening of anew sales territory, the amount can only be approximated. 3. All the techniques of capital budgeting presume that various investment proposals under consideration are mutually exclusive which may not practically be true in some particular cases. 4. The techniques of capital budgeting require estimation of future cash inflows and outflows. The future is always uncertain and the data collected for future may not be exact. Obviously the results based upon wrong data may not be good. There are certain factors like morals of the employees, goodwill of the firm etc which cannot be correctly quantified but which other wise substantially influence the capital decision. 5. To estimate the useful or economic life of an investment is perhaps the most tenuous thing. 6. Urgency is another limitation in the evaluation of capital investment decisions. 7. Uncertainty and risk pose the biggest limitation to the techniques of capital budgeting. METHODS OF APPRAISALS OF CAPITAL BUDGETING Q. EXPLAIN THE VARIOUS CAPITAL BUDGETING EVALUATION TECHNIQUES. Q. EXPLAIN THE METHODS OF RANKING INVESTMENT PROPOSALS. At any given time, large number of investment proposals can be there and the funds available or funds which can be raised are always limited. So, it is not possible to take up all the proposals of investment. It is essential to select from amongst the competing proposals those which give the highest benefits. The essence of capital budgeting is the ‘balancing Act’ of matching the available resources with the acceptable projects. There are a large number of methods in practice all over the world in the sphere of capital expenditure decisions.

Which ever method is selected, it should:

1) Provide a basis for distinguishing between acceptable and non-acceptable projects; 2) Rank different proposals in order of priority. 3) Have suitable approach to choose from among the alternatives available; 4) Adopt ‘criterion’ which can assess any kind of project; 5) Be logical by recognizing the time value of money and the importance of returns. The following is the popular classification of various methods of capital budgeting:

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A) Traditional Methods (Non-discounted cash flow methods) 1. Pay-back period method 2. Improvement in traditional approach to pay-back period method. 3. Accounting rate of return or average rate of return method.

B) Non-traditional (or) (Discounted cash flow methods- DCF methods) 1. Net Present Value(N.P.V) Method; 2. Profitability Index(or) Excess Present Value Index Method (P.I Method) 3. Internal Rate of return (I.R.R) method.

(A) Traditional methods These methods generally ignore ‘time value of money’ and treat incomes estimated for different future periods alike. These methods have been traditionally used in business units.

1. PAY-BACK PERIOD METHOD The ‘Pay-back’ method sometimes called ‘pay-out’ or ‘pay-off’ period method represents the period in which the total investment in permanent assets pay back itself. This method is based on the principle that every capital expenditure pays itself back within a certain period, out of the additional earnings generated from capital assets. Thus, it measures the period of time for the original cost of the project to be recovered from the additional earnings of the project itself. Under the method the various investments are ranked according to the length of their pay-back periods in such a manner that investment with a shorter pay-back period is preferred to the one which has a longer pay-back period. In case of evaluation of a single project, it is adopted if it pays back for itself within a period specified by the management and if the project does not pay itself within the period specified by the management then it is rejected. The pay-back period can be ascertained in the following manner.

Methods of calculation of pay-Back period (A) when cash inflows are uniform Calculate annual net earnings (profit) before depreciation and after taxes, these are called annual cash inflows. If annual net cash inflows are uniform, the following formula can be used to ascertain pay-back period.

Pay-back period = Initial Cost of Asset/Initial Investment in Project Annual cash inflow (B) when cash inflows are not uniform

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FINANCE MANAGEMENT Pay-back period is computed with the help of ‘cumulative cash inflows’ when cash flows are not uniform. Of course formula method cannot be used here. st

Starting from the 1 year, the net cash inflows are shown cumulatively. When the cumulative inflows are equal to the investment, the total time period in years and months is noted. Here the pay-back period is the time taken for the cumulative net cash inflows to equal the investments.

Merits The pay back period method has the following merits: (i)

It is easy to understand

(ii)

It is simple to operate.

(iii)

This method makes it clear that there is no profit on any project unless pay back period is over.

(iv)

By using this method, the business unit can judge the period for which its funds will remain tied up if the project is approved.

(v)

This method is particularly suitable in industries where risk of obsolescence is high. In such cases, project having short pay-back period shall be preferred.

(vi)

This method is preferable, where funds are in very short supply. They may be invested to yield more by selecting projects having shorter pay back periods.

Demerits The method has the following demerits: (i)

This method is delicate and rigid. A slight change in the division of labour and cost of maintenance will affect the earnings and as such may also affect the pay back period.

(ii)

It treats each asset individually in isolation with other assets, while assets, in practice, cannot be treated in isolation.

(iii)

It ignores capital wastage and economic life by restricting consideration to the project’s gross earnings.

(iv)

It overplays the importance of liquidity as a goal of capital expenditure decisions. While no firm can ignore its liquidity requirements but there are more direct and less costly means of safeguarding liquidity levels. The overlooking of profitability and over stressing the liquidity of funds can in no way be justified.

(v)

It overlooks the cost of capital which is the main basis of sound investment decisions.

(vi)

It overstates the worth of flows within the pay-back period in that it assigns implicitly equal importance to cash flows at the end of years 1 and year ‘n’.

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It ignores the earnings beyond the payback period while in many cases these earnings are substantial. This is true particularly in respect of research and welfare projects.

PROBLEM NO: 1 A Project Costs Rs.1,00,000 and yields an annual cash inflows of Rs.20,000 for 8 years. Calculate its pay-back period. Solution The Pay-back period for the project is as follows:

Pay back Period = Initial Outlay of the Project Annual Cash Inflow

= 1,00,000 20,000

= 5 Years.

PROBLEM NO: 2 There are two projects A and B . The cost of the projects is rs.30,000 in each case. The cash inflows are as under: Cash inflows Year

Project A

Project B

10,000

2,000

10,000

4,000

10,000

24,000

Calculate pay back period. Solution The Pay-back period is 3 years in both the cases. However, Project A should be preferred because the cash inflows in Project A are greater when compared to Project B during the initial years.

Project

Project A Cash inflow

Project B Cumulative

Cash inflows

cash inflows st

End of 1 year

Cumulative cash inflows

10,000

2,000

year

10,000

20,000

4,000

6,000

3 year

10,000

30,000

24,000

30,000

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PROBLEM NO: 3 A project costs Rs.5,00,000 and yields annually a profit of Rs.80,000 after depreciation at 12% p.a. but before tax at 50%.calculate pay-back period. Solution:

Rs. Profit before tax

80,000

Less tax @ 50%

40,000

Profit after tax

40,000

Add back depreciation @ 12% on Rs.5,00,000

60,000

Profit before depreciation but after tax or annual cash inflow

1,00,000

Pay back period = Cost of the project Annual cash inflow = 5,00,000

= 5 years

1,00,000 Problem.No.4 Calculate the pay back period for a project which requires a cash outlay of Rs.1,00,000 and generates cash inflows of Rs.25,000,Rs.35,000,Rs.30,000 and Rs.25,000 in the first, second, third and fourth years respectively. Solution: Project A Project Cash inflow st

1 year nd

Cumulative cash inflow

25,000

year

35,000

60,000

3 year

30,000

90,000

25,000

1,15,000

4 year

The cost of the project is Rs.1,00,000. In the first 3 years Rs.90,000 is recovered. The th

remaining Rs.10,000 is recovered in the 4 year. Time required to earn Rs.25,000 is twelve months. 10,000 x 12 Time required to earn Rs.10,000 = ---------------25,000

= 4.8 months.

Pay-back period = 3 years and 4.8 months.

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2. IMPROVEMENTS IN TRADITIONAL APPROACH TO PAY-BACK METHOD: The popularity of pay-back method has promoted efforts to eliminate some of its major draw backs. The following are some of the more popular improvements to traditional pay-back period concept.

(a) Post pay-back profitability method: A serious limitation of pay-back period is that it ignores the post pay-back returns of projects. To rectify the defect, post pay-back profitability and an index are used by some firms. Post pay-back profitability is computed by ascertaining the amount of net cash inflows estimated in each of the years, after the pay-back period. They are shown as a percentage of the investments in the project.

Post pay – back profits Post pay-back profitability index = ------------------------------- x 100 Initial investment

Projects with higher index are preferable when two or more projects have more less similar pay-back period. (b)Post pay-back period method: Here the length of the post pay-back period with positive cash inflows is the criterion. It is also called ‘surplus life over pay-back’ method. Projects with longer post pay-back periods with significant even cash flows are preferred. (c)Pay-back reciprocal method (or) ‘Unadjusted rate of return method’: Pay-back reciprocal method is employed to estimate the rate of return of income generated by a project. Such rate of return can be used as a criterion to rank different projects and choose the ones with the highest rate of return. Annual cash inflow Pay-back reciprocal (or) adjusted rate of return = ---------------------------- x 100 Investment

This method can be employed only when the following two conditions are fulfilled: •

Annual cash inflows are uniform throughout a project’s life time

•

The project under consideration has a long life, preferably at least twice the pay-back period.

(d)Discounted pay-back method: The most serious limitation of pay-back period method is that it ignores time value of money by treating cash inflows in different future years alike. To circumvent the limitation and to make pay-back period method more effective, the discounting concept is ‘infused’ into the traditional pay-back period method.In this method, the estimated future net cash-inflows are

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discounted at an appropriate rate (usually cost of capital rate) to find their present values. The discounted cash flows are used to ascertain pay-back period. Problem.No.5 Calculate discounted pay-back period from the information given below: Cost of project

Rs.6,00,000

Life of project

5 years

Annual cash inflow

- Rs.2,00,000

Cut-off rate

10%

Solution: Years 1

Inflows Rs. 2,00,000

P.V. at 10 Discount factor .909

Present value Rs. 1,81,800

Cummulative Present value Rs. 1,81,800

2,00,000

.826

1,65,200

3,47,000

2,00,000

.751

1,50,200

4,97,200

2,00,000

.683

1,36,600

6,33,800

2,00,000

.621

1,24,200

7,38,000

Cumulative present value of cash inflows at the end of the third year is Rs.4,97,200 and it is Rs.6,33,800 at the end of the fourth year.

Hence, discounted pay-back period falls in

between 3 and 4 years. To be exact, 1,02,800 Discounted pay-back period = 3 years + -----------1,36,600 = 3 他 years approx Problem.No.6 For each of the following projects compute (i) pay-back period, (ii) post-back profitability and (iii) post-back profitability index: (a) Initial Outlay

Rs.50,000

Annual Cash Inflow (After tax but before depreciation) Estimated Life

Rs.10,000 8 years

(b) Initial Outlay

Rs.50,000

Annual Cash Inflow (After tax but before depreciation) First Three years

Rs.15,000

Next Five years

Rs.5,000

Estimated Life

8 years

Salvage

Rs.8,000

Solution: Investment (a) (i) Pay-back period

---------------------------Annual Cash Inflow

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50,000 =

------------- = 5 years 10,000

(ii) Post Pay back Profitability

Annual Cash Inflow (Estimated LifePay back period) =

10,000(8 – 5) = Rs. 30,000

30,000 (iii) Post back Profitability Index

------------ x 100 = 60% 50,000

(b) (i) As the Cash Inflows are not equal during the life of the investment, the Pay back period can be calculated. st

1 year’s Cash Inflow 2

year’s Cash Inflow

3 year’s Cash Inflow th

4 year’s Cash Inflow Hence, the pay-back period is 4 years. (ii) Post pay back Profitability = Annual Cash Inflows x Remaining Life after pay-back period = Rs. 5,000 x 4 = Rs.20,000 20,000 x 100 (iii) Post Pay-back Profitability Index = --------------------- = 40% 50,000

3. ACCOUNTING RATE OF RETURN METHOD: This method takes into account the earnings expected from the investment over their whole life. It is known as Accounting Rate of Return method for the reason that under this method, the Accounting concept of profit (net profit after tax and depreciation) is used rather than cash inflows. According to this method, various projects are ranked in order of the rate of earnings or rate of return. The project with the higher rate of return is selected as compared to the one with lower rate of return. This method can also be used to make decisions as to accepting or rejecting a proposal. The expected return is determined and the project which has a higher rate of return than the minimum rate specified by the firm called the cut off rate, is accepted and the one which gives a lower expected rate of return than the minimum rate is rejected.

Computation of Accounting or Average Rate of Return: There are three variations of the accounting rate of return (a)Total income method (or) Return per unit of investment method:

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Here, the total income, after depreciation and tax, over the life time of a project is shown as a percentage of net investment in the project (Original cost – Scrap value).

Formula:

A.R.R =

Total earnings (after depreciation and tax) x 100 Original cost of investment – scrap value

(b)Annual return on original investment method Formula: A.R.R = Annual average net earnings

x 100

Original investment – scrap value Here, annual average net earnings is the average of net profit after depreciation and tax of all the years in the economic life of the investment. If there is scrap value, it may be subtracted from the original investment.

(c)Annual return on average investment method: Formula: A.R.R = Annual average net earnings x 100 Average investments Average investment is again a disputed term.

The following four alternative

interpretation of ‘Average investment’ are in practical use. (i)Average investment =

Original investment 2

(ii) Average investment = Original investment – Scrap value of the asset/Project 2 (iii)Average investment = Original investment + Scrap value of the asset 2 (iv)Average investment =

Original investment – Scrap value + additional net 2 working capital + Scrap value

Merits: 1. It is also simple and easy to understand like pay back method 2. It takes into consideration the total earnings from the project during its entire economic life 3. This approach gives due weight to the profitability of the project 4. Investment with extremely long lives, the simple rate of return will be fairly close to the true rate of return. It is often used by financial analysts to measure performance of a firm. Demerits: This method suffers from the following limitations:

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1. One apparent disadvantage of this approach is that its results by different methods are inconsistent 2. This method also ignores the time factor which is very crucial in business decisions as the4 amount of interest and discount is powerfully affected by it 3. This method does not determine the fair rate of return on investment. It is left to the discretion by the management. So use of this arbitrary rate of return may well cause serious distortions in the selection of capital projects. 4. It is simple an averaging technique which does not take into account the various impacts of external factors on overall profits of the firm.

Problem.No.7 A project requires an investment of Rs.5,00,000 and has a scrap value of rs.20,000 after 5 years. It is expected to yield profits after taxes and depreciation during the five years amounting to Rs.40,000, Rs.60,000,

Rs.70,000 ,Rs. 50,000 and Rs.20,000.Calculate the

average rate of return on investment. Solution:

Total Profit = Rs.40,000+60,000+70,000+50,000+20,000 = Rs.2,40,000

Rs.2,40,000 Average Profit = ------------------ = Rs.48,000 5 Net Investments in the project = Rs.5,00,000 – 2,00,000 (Scrap value) = Rs.4,80,000

Average Rate of Return

Average Annual Profit

x 100

Net Investment in the Project =

48,000 x 100

= 10%

4,80,000

Problem.No.8 Calculate the average rate of return of project ‘A’ and project ‘B’ from the following. Project A

Project B

Investment

20,000

30,000

Expected life(No salvage value) years

2,000

3,000

1,500

3,000

1,500

2,000

1,000

Project net income(after interest Depreciation and taxes) Years

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1,000

6,000

10,000

If the required rate of return is 15% which project should be undertaken?

Solution: Particulars

Project A

Average annual net earnings

6000=

Project B Rs.1500

10,000 = Rs.2000

4 Assigned Investment

Rs.20,000

Rs.30,000

1500

2000

Annual average net earnings x100

------- x100 = 7.5%

------- x 100 = 6.67%

Original invest – Scrap value

20000

30000

Annual rate of return on average

1500

2000

investment =

--------- x 100 = 15%

-------x100 =13.33%

10000

15000

Annual rate

return

original

investment =

Average annual net earnings x 100 Average investment Average investment =

Original investment 2

Project A

= 20000

= Rs.10,000

Project B

= 30000

= Rs.15,000

Project A is preferred. DISCOUNTED CASH FLOW METHOD: The discounted cash flow method is an improvement on the pay back method. This method takes into account the profitability and also the time value of money. These methods also called modern methods of capital budgeting are becoming increasingly popular day-byday. This method is based on the fact that future value of money will not be equal to the present value of money. There are three types of discounted cash flow method. •

Net present value method

•

Profitability index method

•

Internal rate of return method

1. NET PRESENT VALUE METHOD: The net present value method is a modern method of evaluating investment proposals. This method takes into consideration the time value of money and attempts to

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FINANCE MANAGEMENT calculate the return on investments by introducing the factor of time element. It recognizes the fact that a rupee earned today is worth more than the same rupee earned tomorrow. The net present value method is based on the fact that the cash flow arising at different periods of time differ in value and are not capable of comparison unless their equivalent present values are found. The present values of all inflows and outflows of cash occurring during the entire life of the project is determined separately for each year discounting these flows by the firm’s cost or a pre-determined rate. The following are the necessary steps to be followed for adopting the net present value method of evaluating investment proposals. •

First of all determine an appropriate rate of interest that should be selected as the minimum required rate of return called the ‘cut off’ rate of discount rate. This rate should be a minimum rate of return below which the investor considers that it does not pay him to invest.

•

The discount rate should be either the actual rate of interest in the market on long term loans or it should reflect the opportunity cost of capital of the investor

•

Compute the present value of total investment outlay i.e., cash outflows are ascertained at the determined rate. If the total investment is to be made in the initial year the present value shall be the same as the cost of investment

•

Compute the present value of total investment proceeds i.e., cash inflows (profit before depreciation and after tax) at the above determined discount rate

•

Calculate the net present value of each project by subtracting the present value of cash inflows from the present value of cash outflows for each project

•

If the net present value is positive or zero i.e., when present value of cash inflows exceeds or is equal to the present values of cash out flows, the proposals may be accepted. But in case the net present value is negative, i.e., when the present value of cash inflows is less than the present value of cash flows, the proposals should be rejected.

•

To select between mutually exclusive projects, the projects should be ranked in order to present values i.e., the first preference should be given to the project having the maximum positive net present value.

The present value of Re.1 due in any number of years can be found with the use of the following mathematical formula.

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PV =

1 (1 + r ) n

Where PV = Present value r = rate of interest discount rate n = number of years The present value for all cash inflows for a number of years is thus found as follows:

PV =

A1 A2 A3 An + + + ............. + 2 3 (1 + r ) (1 + r ) (1 + r ) (1 + r ) n

Merits: 1. It considers the time value of money 2. It considers income over the entire life of the project 3. This method is helpful in comparing the two projects in which the same amount of investment is required 4. Conclusions drawn by this method are not affected by decisions regarding various accounting policies (e.g.) regarding valuation of stock, depreciation etc. Demerits: 1. Some argue that this method is too difficult to use 2. This method is not helpful in comparing projects in which different amount of investments are required 3. This method may be misleading in comparing projects of unequal lines 4. This method is based on the estimates of future earnings. 5. Unless we know the life of the project accurately, estimates of future earnings cannot be made.

Problem.No.9 Bombay traders are proposing to undertake a project at an initial outlay of Rs.50,000 and expect to earn yearly net cash inflows of Rs.15,000 for a period of 6 years. The companyâ&#x20AC;&#x2122;s cost of capital is 10%.present value of Re.1 for 6 years at 10% p.a interest is Rs.4,335. Determine the net present value. Solution: The present value of Rs.1 received annually for all 6 years The present value of Rs.15,000 received annually for all 6 years (-) Cash outlay

Rs.4.335 15,000 x 4.335 65,000 50,000

Net present value 15,000 Problem.No.10

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Priya & co. is considering 2 mutually exclusive projects. Both require an initial cash outlay of Rs.10,000 each and have a life of 5 years. The companyâ&#x20AC;&#x2122;s required rate of return is 10% and pays tax at a 50% rate. The project will be depreciated on a straight line basis. The net cash flows before taxes expected to be generated by the projects are as follows:

Year 1

Project 1 Rs.

4,000

Project 2 Rs.

6,000

3,000

2,000

5,000

Calculate Net present value of each project. Advise the company as to which project should be accepted and why? Solution: Project 1 Computation of NPV

Particulars

Cash flow

4,000

(-)Depreciation (10,000/5)

2,000

(-)Tax @ 50%

1,000

Profit after tax

1,000

(+) Depreciation

2,000

3,000

Annual cash inflows

Computation of NPV

Years

Cash inflow

Present value of 10%

Present

value

cash inflow 1

3000

0.909

2727

3000

0.826

2478

3000

0.751

2253

3000

0.683

2049

3000

0.621

1863

Present value of total cash expenses = 11370 (-) Capital outlay

= 10000 --------

Net Present Value

= 1370

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Particulars

Cash flow

6,000

3,000

2,000

5,000

(-) Depreciation (10,000/5)

2,000

4,000

1,000

----

3,000

(-)Tax @ 50%

2,000

5,000

----

1,500

Profit after tax

2,000

500

----

1,500

(+) Depreciation

2,000

4,000

2,500

2,000

3,500

Annual cash inflows

Computation of NPV Years

Cash inflow

Present value of 10%

Present value of cash inflow

4,000

0.909

3,636

2,500

0.826

2,065

2,000

0.751

1,502

2,000

0.683

1,366

3,500

0.621

2,173

Present value of total cash expenses = 10,742 (-) Capital outlay

= 10,000 --------

Net Present Value

742 --------

Project 1 is preferred. Problem.No.11 Project X initially costs Rs.25,000.It generates the following cash flows. Years

Cash inflows (Rs.)

Present value of Re.1 at 10%

9,000

.909

8,000

.826

7,000

.751

6,000

.683

5,000

.621

Taking the cut-off rate as 10% suggest whether the project should be accepted or not.

Solution: Computation of NPV Years

Cash

Present value of

inflow

Re.1 at 10%

cash inflow

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9,000

0.909

8,181

8,000

0.826

6,608

7,000

0.751

5,257

6,000

0.683

4,098

5,000

0.621

3,105

Present value of total cash expenses = 27,249 (-) Capital outlay

= 25,000 --------

Net Present Value

= 2,249 --------

Problem.No.12 The following are the cash inflows and outflows of a certain project.

Years

Outflows

Inflows

Rs.

(Rs.)

1,50,000

30,000

20,000

30,000

60,000

80,000

30,000

The salvage value at the end of 5 years is Rs.40,000. Taking the cut off rate as 10%.calculate net present value. Solution: Net Present Value

Rs.1,86,060 â&#x20AC;&#x201C; 1,77,270 =

Rs.8,790.

Calculations of Present Value of Outflows

Years 0 1

Outflow Rs. 1,50,000 30,000

Present Value @ 10% Discount factor 1 0.999

Present Value Rs. 1,50,000 27,270 1,72,270

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Calculations of Present Value of Cash Inflows Years 1 2 3 4 5 5(salvage)

Outflow Rs. 20,000 30,000 60,000 80,000 30,000 40,000

Present Value @ 10% Discount factor

Present Value Rs.

0.909 0.826 0.751 0.683 0.620 0.620

18,180 24,780 45,060 54,640 18,600 24,800 1,86,060

2. PROFITABILITY INDEX METHOD It is also a time-adjusted method of evaluating the investment proposals. Profitability index also called as benefit-cost ratio (B/C) or desirability factorâ&#x20AC;&#x2122; is the relationship between present value of cash inflow and the present value of of cash outflow. This is a refinement of the net present value method. Instead of working out the net present value, a present value index is found out by comparing the total of present value of future cash inflows and the total of the present value of future cash out flows.

Formula: Excess present value index method

Present value of cash inflow x 100 Present value of cash outflows

The profitability index may be found for net present values of inflows. P.I (Net) =

NPV(Net Present Value) Initial cash outlay

The net profitability index can also be found as profitability index (gross) minus one. The proposal is accepted if the profitability index is more than one and is rejected in case the profitability index is less than one. The various projects are ranked under this method in order of their profitability index, in such a manner that one with higher profitability index is ranked higher than the other with lower profitability index. The main disadvantage of this method is that it is not easy to rank projects on the basis of net present value when the costs of the projects differ.

Merits and Demerits: P.I Method possesses all the merits and demerits of N.P.V method because P.I is a refinement of N.P.V method. However it is more useful in ranking two or more projects. Thus, P.I is more suitable for comparative assessment of projects whereas N.P.V is appropriate to decide about a particular project.

Problem.No.13

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The initial cost of an equipment is Rs.6,000. Cash inflows for 5 years are estimated to be rs.2,000 per year. The managementâ&#x20AC;&#x2122;s desired minimum rate of return is 15%.Calculate net present value and excess present value index to arrive at the correct decision. Solution: Profitability index method present value of cash inflow Excess present value index = --------------------------------------- x 100 Present value of cash outflow

6704 =

-------- x 100 6000

111.73%

Present value of Rs.1 received annually for 5 years = 3.352

Present value of Rs.2000 received annually for 5 years (2000 x 3.352) = 6704

Problem.No.14 The initial cash outlay of a project is Rs.50,000 and it generates the following cash inflows in four years

Year

Cash inflows

Rs.20,000

Rs.15,000

Rs.25,000

Rs.10,000

Using present value index method, appraise profitability of the proposed investment assuming 10% rate of discount. Solution: Calculations of Present Values and Profitability Index Year

Cash Inflows

Present

Rs.

Factor

Value

Present Value Rs.

@10% 1

20,000

0.909

18,180

15,000

0.826

12,390

25,000

0.751

18,775

10,000

0.683

6,830 56,175

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58 Rs.

Profitability Index (gross) =

Total Present Value

56,175

Less: Initial Outlay

50,000

Net Present Value

6,175

Present Value of Cash Inflows Initial Cash Outflow =

56,175

= 1.1235

50,000 As the P.I is higher than 1, the proposal can be accepted. NPV Net Profitability Index = -------------------------------Initial Cash Outlay

6,175 = -------------- = 0.1235 50,000

N.P.I = 1.1235 â&#x20AC;&#x201C; 1 = 0.1235

As the net profitability index is positive, the proposal can be accepted. 3. INTERNAL RATE OF RETURN METHOD (IRR): This method is popularly known as time adjusted rate of return method.

The internal rate of return is defined as the interest rate that equates the present value of the expected future receipts of the investment outlay. The IRR is found out by trial and error. First, we compute the present value of cash inflows from an investment, using an arbitrarily selected interest rate. Then we compare the present value so obtained with the investment cost. If the present value is higher than the cost figure, we try a higher rate of interest and go through the procedure again. Conversely, if the present value is lower than the cost, lower the interest rate and repeat the process. The interest rate that brings about this equality is defined as the internal rate of return. This rate of return is compared to the cost of capital and project having higher difference. If they are mutually exclusive, one is adopted and the other one is rejected. As this determination of internal rate of return involves a number of attempts to make the present value of earnings equal to the investment, this approach is also called trial and error method. Time adjusted rate of return is the maximum rate of interest that could be paid for the capital employed over the life of an investment without loss on the project.

Merits: The internal rate of return method has the following merits:

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1. Like the net present value method, it takes into account the time value of money and can be usefully applied in situations which even as well as uneven cash flow at different periods of time 2. It provides for uniform ranking of various proposals due to the percentage rate of return 3. The determination of the cost of capital is not pre-requisite for the use of this method and hence it is better that net present value method where the cost of capital cannot be ignored 4. It considers the profitability of the project for its entire economic life and hence enables evaluation of true profitability. Demerits: 1. It is difficult to understand and is the most difficult method of evaluation of investment proposals 2. The results of NPV method and IRR method may differ when the projects under evaluation differ in their size, life and timings of cash flows. 3. This method is based upon the assumption that the earnings are reinvested at the internal rate of return for the remaining life of the project, which is not a justified assumption particularly when the average rate of return earned by the firm is not close to the internal rate of return. In this sense, net present value seems to be better as it assumes that the earnings are reinvested at the rate of firm’s cost of capital.

Problem.No.15 A company is considering an investment proposal which needs an initial outlay of Rs.1,50,000. It is estimated to fetch net cash inflows of Rs.60,000 p.a for 4 years. Calculate the I.R.R of the project and decide its acceptability if the company’s cut-off rate for investments is 18%. Solution: PV factor =

Initial investment Annual cash inflows

1,50,000 = ----------------

2.5

60,000

IRR = 22% approx.

This project can be accepted because the IRR (22%) is more than the company’s cut-off rate for investment. i.e., 18%.

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Problem.No.16 Initial investment Rs.60,000 Life of the asset – 4 years Estimated net annual cash flows: st

1 year nd

Rs.15,000

year -

Rs.20,000

3 year -

Rs.30,000

Rs.20,000

Year

P.V at 14%

P.V at 15%

.877

.869

.769

.756

.674

.657

.592

.571

Calculate internal rate of return by trial and error method. Solution: Cash Flow Table at Various Assumed Discount Rates of 10% 12% 14% & 15% Discounted Year

Annual

12%

14%

15%

rate 10%

Cash Flow

P.V.F

(Rs.)

P.V

P.V.F.

P.V.

Rs.

P.V.F

Rs.

P.V

P.V.F

Rs.

P.V Rs.

15,000

0.909

13,635

0.892

13,380

0.877

13,155

0.869

13,035

20,000

0.826

16,520

0.797

15,940

0.769

15,380

0.756

15,120

30,000

0.751

22,530

0.711

21,330

0.674

20,220

0.657

19,710

20,000

0.683

13,660

0.635

12,700

0.592

11,840

0.571

11,420

66,345

63,350

60,595

59,285

The present value of net cash flows at 14% rate of discount is Rs.60,595 and at 15% rate of discount it is Rs.59,285. So the initial cost of investment which is Rs.60,000 falls in between these two discount rates. At 14% the NPV is +595, but at 15% the NPV is -715, we may say that IRR = 14.5% (approx). Q.WRITE A SHORT NOTE ON THE COMPARISION BETWEEN NPV AND IRR. ☺

In the present value method, the present value is determined by discounting the future cash flows of a project at a predetermined or specified rate called the cut-off rate based on cost of capital. But under the internal rate of return method, the cash flows are discounted at a suitable rate by hit and trial method which equates the present value so calculated to the amount of the investment. Under IRR method, discount rate is not predetermined or known as is the case in NPV.

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The NPV method recognizes the importance of market rate of interest or cost of capital. It arrives at the amount to be invested in a given project so that its anticipated earnings would recover the amount invested in the project at market rate. Contrary to this, the IRR method does not consider the market rate of interest and seeks to determine the maximum rate of interest at which funds invested in any project could be repaid with the earnings generated by the project.

☺

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

☺

The results shown NPV method are similar to that of IRR method under certain situations, whereas, the two give contradictory results under some other circumstances. However, it must be remembered that NPV method using a predetermined cut-off rate is more reliable than the IRR method for ranking two or more capital investment proposals.

Q. STATE THE SIMILARITIES OF RESULTS UNDER NPV AND IRR Both NPV and IRR methods would show similar results in terms of accept or reject decisions in the following cases:

Independent investment proposals which do not compete with one another and which may be either accepted or rejected on the basis of a minimum required rate of return.

Conventional investment proposals which involve cash outflows or outlays in the initial period followed by a series of cash inflows. The reason for similarity of results in the above cases lies in the basis of decision-making in the two methods. Under NPV method, a proposal is accepted if its net present value is positive, whereas, under IRR method it is accepted if the internal rate of return is higher than the cutoff rate. The projects which have positive net present value, obviously, also have an internal rate of return higher than the required rate of return.

Q.UNDER WHAT CIRCUMSTANCES MAY NPV AND IRR GIVE CONFLICTING RECOMMENDATIONS?

WHICH

CRITERIA

SHOULD

FOLLOWED

SUCH

CIRCUMSTANCES AND WHY? Conflict between NPV and IRR results. In case of mutually exclusive investment proposals, which compete with one another in such a manner that acceptance of one automatically excludes the acceptance of the other, the NPV method and IRR method may give contradictory results, the net present value may

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suggest acceptance of one proposal whereas, the internal rate of return may favour another proposal .such conflict in rankings may be caused by any one or more of the following problems:

Significant difference in the size (amount) of cash outlays of various proposals under consideration.

Problem of difference in the cash flow patterns or timings of the various proposals , and

Difference in service life or unequal expected lives of the projects.

In such cases, while choosing among mutually exclusive projects, one should always select the project giving the largest positive net present value using appropriate cost of capital or predetermined cut off rate. The reason for the same lies in fact that the objective of a firm is to maximize shareholderâ&#x20AC;&#x2122;s wealth and the project with the largest NPV has the most beneficial effect on share prices and shareholderâ&#x20AC;&#x2122;s wealth. Thus, the NPV method is more reliable as compared to the IRR method in ranking the mutually exclusive projects. In fact, NPV is the best operational criterion for ranking mutually exclusive investment proposals.

CAPITAL RATIONING Capital rationing refers to a situation where a firm is not in a position to invest in all profitable projects due to the constraints on availability of funds. We know that the resources are always limited and the demand for them far exceeds their availability. It is for this reason that the firm cannot take up all the projects though profitable, and has to select the combination of proposals that will yield the greatest profitability.

ExampleLet us assume that firm has only Rs.10 lacs to invest and more funds cannot be provided. The various proposals along with their cost and profitability index are as follows:

Proposal

Cost of the project

Profitability index

3,00,000

1.46

1,00,000

0.098

5,00,000

2.31

2,00,000

1.32

1,50,000

1.25

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FINANCE MANAGEMENT In this example all proposals except No.2 give profitability index exceeding one and are profitable investments. The total outlay required to be invested in all other (profitable) project is Rs.11,50,000 (1+3+4+5) but total funds available with the firm are Rs.10 lacs and hence the firm has to do capital rationing and select the most profitable combination of projects within a total cash outlay of Rs.10 lacs. Project No.5 which has the lowest profitability index among the profitable proposals cannot be taken.

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UNIT-III WORKING CAPITAL MANAGEMENT Q. GIVE THE MEANING AND DEFINITION OF WORKING CAPITAL. MEANINGA business unit or an industrial establishment requires two types of finance, Viz., longterm finance and short-term finance. Long term funds are required to create production facilities through purchase of fixed assets such as plant and machinery, land, building, furniture, etc. Investment in this assets represent that part of firm’s capital which is blocked on a permanent or fixed basis is called fixed capital. Funds are also need for short-term purpose for the purchase of raw-materials, payment of wages and other day-to-day expenses, etc. These funds are known as working capital. In simple words, working capital refers to that part of the firm’s capital which is required for financing short term or current assets such as cash, marketable securities, debtors and inventories. Funds, thus, invested in current assets keep revolving fast and are being constantly converted into cash and this cash flow out again in exchange for other current assets. Hence, it is also known as revolving or circulating capital or short –term capital. DEFINITIONAccording to Genestenberg “Circulating capital means current assets of a company that are changed in the ordinary course of business from one from to another, as for example, from cash to inventories, inventories to receivable, receivable into cash”. In the words of Shubin,” working capital is the amount of funds necessary to cover the cost of operating the enterprise.”

Q.EXPLAIN THE CONCEPTS OF WORKING CAPITAL? There are two concepts of working capital: i)

Gross working capital.

ii)

Net working capital.

Gross working capitalIn the broader sense, the term working capital refers to the gross working capital and represents the amount of funds invested in current assets. Thus, the gross working capital is the capital invested in total current assets of the enterprise. Current assets are those which in the ordinary course of business can be converted into cash within a short period of normally one accounting year. Net working capitalIn a narrow sense, the term working capital refers to the net working capital.Net working capital is the excess of current assets over current liabilities, or say: Net working capital = current assets – current liabilities.

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FINANCE MANAGEMENT Net working capital may be positive or negative. When the current assets exceed the current liabilities the working capital is positive and the negative working capital results when the current liabilities are more than the current assets. Current liabilities are those liabilities which are intended to be paid in the ordinary course of business within a short period of normally one accounting year out of the current assets or the income of the business. The gross working capital concept is financial or going concern concept whereas net working capital is an accounting concept of working capital. These two concepts of working capital are not exclusive; rather both have their own merits. The gross concept is sometimes preferred to the net concept of working capital for the following reasons: It enables the enterprise to provide correct amount of working capital at the right time. Every management is more interested in the total current assets with which it has to operate than the source from where it is made available. The gross concept takes into consideration the fact that every increase in the funds of the enterprise would increase its working capital. The gross concept of working capital is more useful in determining the rate of return on investments in working capital. The net working capital concept, however, is also important for the following reasons: It is a qualitative concept which indicates the firmâ&#x20AC;&#x2122;s ability to meet is operating expenses and short-term liabilities. It indicates the margin of protection available to the short-term creditors, i.e, the excess of current assets over current liabilities. It is an indicator of the financial soundness of an enterprise. It suggests the need for financing a part of the working capital requirements out of permanent sources of funds. To conclude, it may be said that, both, gross and net, concepts of working capital are important aspects of the working capital management. The net concept of working capital may be suitable only for proprietary form of organizations such as sole-trader or partnership firms. But the gross concept is very suitable to the company form of organization where there is a divorce between ownership, management and control. However it is made clear that as per the general practice, net working capital is referred to simply as working capital.

Q. DISCUSS THE NEED (OR) OBJECTS OF WORKING CAPITAL IN A BUSINESS. The need for working capital cannot be over emphasized. Every business needs some amount of working capital. The need of working capital arises due to the time gap between production and realization of cash from sales. There is an operating cycle involved in the sales and realization of cash. There are time gaps in purchase of raw material and production; production and sales; and sales and realization of cash. Thus, working capital is need for the following purposes:

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☺ For the purchases of raw materials, components and spares. ☺ To pay wages and salaries. ☺ To incur day-to-day expenses and overheads costs such as fuel, power and office expenses. etc., ☺ To meet the selling cost as packing, advertising etc. ☺ To provide credit facilities to the customers. ☺ To maintain the inventories of raw materials, work-in-progress, stores and spares and finished goods.

Q. EXPLAIN THE VARIOUS CLASSIFICATION OR KINDS OF WORKING CAPITAL. Working capital may be classified in two ways: a) On the basis of concept. b) On the basis of time. On the basis of concept, working capital is classified as gross working capital and net working capital. This classification is important from the point of view of the financial manager. On the basis of time, working capital may be classified as: 1. Permanent or fixed working capital. 2. Temporary or variable working capital. Kinds of working capital

On the basis of concept

Gross

On the basis of time

Net

Permanent or

Working Capital Working Capital Fixed Working

Variable Working Capital

Regular

Temporary or

Reserve

Capital

Seasonal

Special

ON THE BASIS OF CONCEPTThere are two concepts of working capital: iii)

Gross working capital.

iv)

Net working capital.

ON THE BASIS OF TIMEPermanent working capitalTo carry on business, a certain minimum level of working capital is necessary on a continuous and uninterrupted basis. For all practical purposes this requirement has to be met

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FINANCE MANAGEMENT permanently as with other fixed assets. This requirement is referred to as permanent or fixed working capital. Permanent working capital is fixed over a period of time. Permanent working capital is permanently needed for the business and therefore it should be financed out of long-term funds. For example, every firm has to maintain a minimum level of raw materials, work-inprogress, finished goods and cash balances. This minimum level of current assets is called permanent or fixed working capital as this part of capital is permanently blocked in current assets. The permanent working capital can further be classified as regular working capital and reserve working capital. Regular working capital is required to ensure circulation of current assets from cash to inventories, from inventories to receivables and from receivables to cash and so. Reserve working capital is the excess amount over the requirement for regular working capital which may be provided for contingencies that may arise at unstated periods such as strikes, rise in prices, depression etc.

Temporary or variable working capitalThe amount of such working capital keeps on fluctuating from time to time on the basis of business activities. In other words, it represents additional current assets required at different times during the operating year. Variable working capital can be further classified as seasonal working capital and special working capital. Most of the enterprises have to provide additional working capital to meet the seasonal and special needs. The capital required to meet the seasonal needs of the enterprise is called seasonal working capital. Special working capital is that part of working capital which is required to meet special exigencies such as launching of extensive marketing campaigns for conducting research, etc. Temporary working capital differs form permanent working capital in the sense that it is required for short periods and cannot be permanently employed gainfully in the business.

Q. EXPLAIN THE IMPORTANCE / ADVANTAGES OF ADEQUATE WORKING CAPITAL. Working capital is the life blood and nerve centre of a business. Just as circulation of blood is essential in the human body for maintaining life, working capital is very essential to maintain the smooth running of a business. No business can run successfully without an adequate amount of working capital. The main advantages of maintaining adequate amount of working capital are as follows. Solvency of the businessAdequate working capital helps in maintaining solvency of the business by providing uninterrupted flow of production. Goodwill-

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FINANCE MANAGEMENT Sufficient working capital enables a business concern to make prompt payments and hence helps in exacting and maintaining goodwill. Easy loanA concern having adequate working capital, high solvency and good credit standing can arrange loans from banks and others on easy and favourable terms. Cash discountsAdequate working capital also enables a concern to avail cash discount on the purchases and hence it reduces costs. Regular supply of raw materialsSufficient working capital ensures regular supply of raw material and continuous production. Regular payment of salaries, wages and other day-to-day commitmentsA company which has ample working capital can makes regular payment of salaries, wages and day to day commitments which raises the morale of its employees, increase their efficiency, reduce wastages and costs and enhances production and profit. Exploitation of favourable market conditionsOnly concern with adequate working capital can exploit favourable market conditions such as purchasing its requirement in bulk when the prices are lower and by holding its inventories for higher prices. Ability to face crisisAdequate working capital enables a concern to face business crisis in emergencies such as depression because during such periods, generally, there is much pressure on working capital. Quick and regular return on investmentsEvery investor wants a quick and regular return on his investments. Sufficiency of working capital enables a concern to pay quick and regular dividends to its investors are there may not be much pressure to plough back profit. This gains the confidence of its investors and creates a favourable market to raise additional funds in the future. High moraleAdequacy of working capital creates an environment of security. Confidence, high morale and create overall efficiency in a business.

Q. WHAT SHALL BE THE REPERCUSSIONS IF A FIRM HAS (A)) REDUNDANT WORKING CAPITAL (B) INADEQUATE WORKING CAPITAL? Every business concern should have adequate working capital to run its business operations. It should have neither redundant or excess working capital nor inadequate nor shortage of working capital. Both excess as well as short working capital positions are bad for any business. However, out of the two, it is the inadequacy of working capital which is more dangerous from the point of view of the firm.

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FINANCE MANAGEMENT Disadvantages of Redundant or Excessive Working Capital 1. It results in unnecessary accumulation of inventories. Thus the chances of inventory mishandling, waste, theft and losses increase. 2. It is an indication of defective credit policy and slack collection period. Consequently, higher incidence of bad debts adversely affects profits. 3. It may result into overall inefficiency in the organization. 4. Tendencies of accumulating inventories to make speculative profits grow. This may tend to make dividend policy liberal and difficult to cope with in future when the firm is unable to make speculative profits. 5. Excess availability of cash tempts the executives to spend more. 6. Due to low rate of return on investment, the value of shares may also fall.

Dangers of inadequate working capital: 1. It stagnates growth. It becomes difficult for the firm to undertake profitable projects due to non-availability of the working capital funds. 2. It becomes difficult to implement operating plans and achieve the firmâ&#x20AC;&#x2122;s profit target. 3. Operating inefficiencies creep in when it becomes difficult even to meet day-to-day commitments. 4. Fixed assets are not efficiently utilized for the lack of working capital funds. Thus, the rate of return on investment slumps. 5. Paucity of working capital funds renders the firm unable to avail of attractive credit opportunities etc. 6. The firm loses its reputation when it is not in a position to honour its short-term obligations. As a result, the firm faces tight credit terms. 7. It directly affects the liquidity position of the business firm. Therefore every firm should aim at maintaining a right amount of working capital on a continuous basis.

FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS Q. WHAT ARE THE DETERMINANTS OF WORKING CAPITAL NEED OF A CONCERN? OR Q.EXPLAIN VARIOUS FACTORS INFLUENCING WORKING CAPITAL The working capital requirements of a concern depend upon a large number of factors. it is not possible to rank them because all such factors are of different importance and the influence of individual factors changes for a firm over time. However, the following are important factors generally influencing the working capital requirements. 1. Nature or character of businessThe working capital requirements of a firm basically depend upon the nature of its business. Public utility undertakings like Electricity, water supply and railways need very

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FINANCE MANAGEMENT limited working capital because they offer cash sales and supply services not products, and as such no funds are tied up in inventories and receivables. on the other hand trading and financial firms require less investment in fixed assets but have to invest large amounts in current assets like inventories, receivables and cash as such they need large amount of working capital. The manufacturing undertakings also require sizable working capital along with fixed investment. 2. Size of business/scale of operationsThe working capital requirements of a concern are directly influenced by the size of its business which may be measured in terms of scale of operations. Greater the size of a business unit, generally larger will be the requirements of working capital. However, in some cases even a smaller concern may need more working capital due to high overhead charges, inefficient use of available resources and other economic disadvantages of small size. 3. Production policyIn certain industries the demand is subject to wide fluctuations due to seasonal variations. The requirements of working capital, in such cases, depend upon the production policy. The production could be kept either steady by accumulating inventories during slack periods with a view to meet high demand during the peak season or the production could be curtailed during the slack season and increased during the peak season. If the policy is to keep production steady by accumulating the inventories it will require higher working capital.

4. Manufacturing process/length of production cycleIn manufacturing business, the requirements of working capital increase in direct proportion to length of manufacturing process. Longer the process period of manufacture, larger is the amount of working capital required. The longer the manufacturing time, the raw materials and other supplies have to be carried for a longer period in the process with progressive increment of labour and service costs before the finished product is finally obtained. Therefore, if there are alternative processes of production, the process with shortest production period should be chosen. 5. Seasonal variationIn certain industries raw material is not available throughout the year. They have to buy raw materials in bulk during the season to ensure an uninterrupted flow and process them during the entire year. A huge amount is, thus, blocked in the form of material inventories during such season, which gives rise to more working capital requirements. Generally, during the busy seasons, a firm requires larger working capital than in the slack seasons 6. Working capital cycleIn a manufacturing concern, the working capital cycle starts with the purchase of raw material and ends with the realization of cash from the sale of finished products. This cycle involves purchase of raw materials and stores, its conversion into stock of finished goods through work-in-progress with progressive increment of labour and service costs, conversion

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of finished stock into sales, debtors and receivables and ultimately realization of cash and this cycle continues again from cash to purchase of raw material and so on. DEBTORS (RECEIVABLES)

CASH

FINISHED GOODS

[Working CapitalRAW /Operating Cycle of a Manufacturing Concern] MATERIALS WORK-IN-PROGRESS The speed with which the working capital completes one cycle determines the requirements of working capital â&#x20AC;&#x201C;longer the period of the cycle larger is the requirement of working capital. 7. Rate of stock turnoverThere is a high degree of inverse co-relationship between the quantum of working capital and the velocity or speed with which the sales are effected. A firm having a high rate of stock turnover will need lower amount of working capital as compared to a firm having a low rate of turnover. For example, in case of precious stones dealers, the turnover is very slow. They have to maintain a large variety of stocks and the movement of stock is very slow. Thus, the working capital requirements of such a dealer shall be higher than that of a provision store. 8. Credit policyThe credit policy of a concern in its dealings with debtors and creditors influences considerable the requirements of working capital. A concern that purchases its requirements on credit and sells its products/ services on cash requires lesser amount of working capital. On the other hand a concern buying its requirement for cash and allowing credit to its customers ,shall need larger amount of working capital as very huge amount of funds are bound to be tied up in debtors or bills receivables. 9. Business cycleBusiness cycle refers to alternate expansion and contraction in general business activity. In a period of boom i.e., when the business is prosperous, there is a need for larger amount of working capital due to increase in sales, rise in prices, optimistic expansion of business etc. On the contrary in the times of depression i.e., when there is a down swing of the cycle, the business contracts, sales decline, difficulties are faced in collections from debtors and firms may have a larger amount of working capital lying idle. 10. Rate of growth of businessThe working capital requirements of a concern increase with the growth and expansion of its business activity. Although,it is difficult to determine the relationship between the growth

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FINANCE MANAGEMENT in the volume of business and the growth in the working capital of a business ,yet it may be concluded that for normal rate of expansion in the volume of business, we may have retained profits to provide for more working capital but in fast growing concerns ,we shall require larger amount of working capital. 11. Earning capacity and dividend policySome firms have more earning capacity than others due to quality of their products ,monopoly conditions, etc. Such firms with high earning capacity may generate cash profits from operations and contribute to their working capital. The dividend policy of a concern also influences the requirements of its working capital. A firm that maintains a steady high rate of cash dividend irrespective of its generation of profits needs more working capital than the firm that retains larger part of its profit and does not pay so high of cash dividend. 12. Price level changesChanges in the price level also affect the working capital requirements. Generally, the rising prices will require the firm to maintain larger amount of working capital as more funds will be required to maintain the same current assets. The effect of rising prices may be different for different firms. Some firms may be affected much while some others may not be affected at all by the rise in prices. 13. Other factorsCertain other factors such as operating efficiency, management ability, irregularities of supply, import policy, asset structure, importance of labour, banking facilities, etc. also influence the requirements of working capital.

MANAGEMENT OF WORKING CAPITAL Q. WHAT DO YOU UNDERSTAND BY WORKING CAPITAL MANAGEMENT? DISCUSS THE PRINCIPLES OF WORKING CAPITAL MANAGEMENT. Working capital refers to the excess of current assets over current liabilities. Management of working capital therefore, is concerned with the problems that arise in attempting to manage the current assets, the current liabilities and the inter-relationship that exist between them. The basic goal of working capital management is to manage the current assets and current liabilities of a firm in such a way that a satisfactory level of working capital is maintained .this so because both inadequate as well as excessive working capital positions are bad for any business. Inadequacy of working capital may lead the firm to insolvency and excessive working capital implies idle funds which earns no profits for the business. Working capital management polices of a firm have a great effect on its profitability, liquidity and structural health of the organization. In this context, working capital management is three dimensional in nature: i)

Dimension I is concerned with the formulation of policies with regard to profitability, risk and liquidity.

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Dimension II is concerned with the decisions about the composition and level of current assets.

iii)

Dimension III is concerned with the decisions about the composition and level of current liabilities.

PRINCIPLES OF WORKING CAPITAL MANAGEMENT/POLICY The following are the general principles of a sound working capital management policy.

Principles of Working Capital Management

Principle of risk variation

Principle of cost of capital

Principle of equity position

Principle of Maturity of Payment

Working capital management involves two main processes: Determining the size of the amount of working capitalIt is determined on the basic of size, nature and length of the manufacturing cycle. The policy of the management towards sales and purchases also helps in the process of determining the size of the working capital. Arranging the sources of working capitalOnce the size of the working capital is determined, it is the duty of financial manager to select the right sources of working capital this mainly depends on the availability of the sources for funds. The investment of funds on current assets also facilities the financial manager to arrange for working capital requirements. Working capital management in practiced by taking into account the following aspect they are. (a) Management of cash, (b) Accounts receivables management and

management.

Principles of working capital management: Principles of risk variationRisk here refers to the inability of a firm to meet its obligations as and when they become due for payment. Larger investment in current assets with less dependence on short term borrowing increases liquidity, reduces dependence on short term borrowings increase liquidity, reduce risk and there by decrease the opportunity for gain or loss. On the other hand less investment in current assets with greater dependence on short-term borrowings increase risk, reduces liquidity and increase profitability.

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FINANCE MANAGEMENT A conservative management prefers to minimize risk by maintaining a higher level of current assets or working capital while a liberal management assumes greater risk by reducing working capital. However, the goal of the management should be to establish a suitable trade off between profitability and risk. Principles of cost of capitalGenerally, higher the risk lower is the cost and lower the risk higher the cost. A sound working capital management. Should always try to achieve a proper balance between these two. Principle of equity portionAccording to this principle, the amount of working capital invested in each component should be adequately justified by a firm’s equity position. Every rupee invested in the current assets should contribute to the net worth of the firm. The level of current assets may be measured with the help of two ratios: (i) Current assets as a percentage of total assets and (ii) Current assets as a percentage of total sales.While deciding about the composition of current assets, the financial manager may consider the relevant industrial averages. Principles of maturity of paymentAccording to this principle, a firm should make every effort to relate maturities of payment to its flow of internally generated funds. Maturity pattern of various current obligations is an important factor in risk assumption and risk assessments. Generally, shorter the maturity schedule of current liabilities in relation to expected cash inflows, the greater the inability to meet its obligation in time. To achieve the above mentioned objective of working capital management, the financial manager has to perform the following basic functions: 1. Estimating the working capital requirements 2. Financing of working capital needs 3. Analysis and control of working capital

Q.WHAT FACTORS WOULD YOU TAKE INTO CONSIDERATION IN ESTIMATING THE WORKING CAPITAL NEEDS OF A CONCERN? Forecast/estimate of working capital requirements “Working capital is the life-blood and controlling nerve centre of a business”. No business can be successfully run without an adequate amount of working capital. To avoid the shortage of working capital at once,an estimate of working capital requirement should be made in advance so that arrangements can be made to procure adequate working capital. But estimation of working capital requirements is not an easy task and a large number of factors have to be considered before starting this exercise for a manufacturing organization, the following factors have to be taken into consideration while making an estimate of working capital requirements:

Factors requiring consideration while estimating working capital

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1. Total costs incurred on material, wages and overheads. 2. The length of time for which raw materials are to remain in stores before they are issued for production. 3. The length of the production cycle or work-in-progress, i.e., the time taken for conversion of raw material into finished goods. 4. The length of sales cycle during which finished goods are to be kept waiting for sales. 5. The average period of credit allowed to customers. 6. The amount of cash required to pay day-to day expenses of the business. 7. The average amount of cash required to make advance payments, if any. 8. The average credit period expected to be allowed by suppliers. 9. Time-lag in the payment of wages and other expenses. From the total amount blocked in current assets estimated on the basis of the first seven items given above, the total of the current liabilities, i.e., the last two items, is deducted to find out the requirements of working capital.In case of purely trading concerns, points 1, 2 and 3 would not arise but all other factors from points 4 to 9 are to be taken into consideration.In order to provide for contingencies, some extra amount generally calculated as a fixed percentage of the working capital may be added as a margin of safety. Methods of forecasting working capital Suggested Proformas for estimation of working capital requirements are given on the following pages: For a Trading Concern: Proforma Statement of Working Capital Requirements Amount Rs. Current Assets: (i)

Cash

………..

(ii)

Debtors or Receivables (For….month’s sales)

(iii)

Stocks(For….month’s sales

………..

(iv)

Advance payments, if any

………..

(v)

Others

………..

Less: Current Liabilities: (i)

Creditors (For….month’s purchases)

(ii)

Lag in payment of expenses (Outstanding expenses, if any)

Working Capital (C.A –C.L)

………..

……….. -------------

----------………...

Add: Provision/Margin for Contingencies Net working Capital Required

----------. -----------

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Notes: (i)

Profits should be ignored while calculating working capital requirements as funds provided by profits may or may not be used as working capital.

(ii)

Stock and debtors should be taken at cost unless otherwise required in a given question.

For a Manufacturing Concern

Statement of Working Capital Requirements Amount Rs. Current Assets: (i)

Stock of Raw Material (For….month’s consumption)

(ii)

Work-in-Process(For…months):

………..

(a) Raw Materials ……….. (b) Direct Labour ……......

………...

Stock of Finished Goods (For ….month’s sales):

………...

(a) Raw Materials ………... (b) Labour ………..

………...

………... (iv)

Sundry Debtors or Receivables (For …month’s sales):

………... ………...

(a) Raw Materials ………... (b) Labour ………..

………...

-----------

………..

………...

(v)

Payments in Advance (if any)

-----------

(vi)

Balance of Cash (Required to meet day-to-day expenses)

…………

(vii)

Any other (if any)

------------

Less: Current Liabilities: (i)

Creditors (For….month’s purchases of raw materials) ………..

(ii)

Lag in payment of expenses (outstanding

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expenses..months)……… (iii)

Others (if any) ………..

Working Capital (C.A –C.L) Add: Provision/Margin for Contingencies Net working Capital Required

Notes: (I) profits should be ignored while calculating working capital requirements for the following reason; a.

Profits may are to be used as working capital.

Even it profits are to be used for working capital it has to be reduced by the amount of income-tax drawings, dividend paid etc.

(II) calculation of work in process depends upon its degree of completion as regards materials, labour and overheads. However if nothing is given in a question as regards the degree of completion we suggest the students to take 100% cost of materials, labour as well as overheads. Because in such a case the average. Period of work in process must been calculated as equivalent period of completed units. The same approach has been followed by various famous authors on this subject. But some authors have assumed in such a case100% consumption of raw material and 50% (one half on an average) in case of labour and overheads.

(III) calculation for stocks of finished goods and debtors should be made be made at cost unless otherwise asked in the question.

3. Columnar form An alternative Proforma for estimation of working capital requirements in columnar form is given below

Statement of working capital Requirement (A)Current asset particular

Period Week

Total

Raw

Work-in

Finished

materials

process

goods

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78 Rs

……….

………….

…………

……….

For Row

For

Materials

Wages

overheads

……..

……….

………

……..

1.Raw materials (a) stock (b) In work-in-process (c) In finished Goods (d) Credit to Debtors 2. Direct labour (a) In work in process (b) In finished Goods (c) Credit to Debtors 3. Overhead (a) In work-inprocess (b) In finished Goods ( c) credit to Debtors 4. Cash at bank

(A) Total current assets (B) Current Liabilities

Period

particulars

Week

Total

5. Credit by Suppliers 6. Lag in payment of Wages 7. Over heads (B) Total Current liabilities Working capital Requirements = (A-B)

Q.DISCUSS THE VARIOUS SOURCES OF FINANCING WORKING CAPITAL. (OR) Q. EXPLAIN THE SOURCES OF FINANCING OF CURRENT ASSETS. The working capital requirements of a concern can be classified as: a) Permanent or fixed working capital requirements. b) Temporary or variable working capital requirements. In any concern, a part of the working capital investments are as permanent investments in fixed assets. This is so because there is always a minimum level of current assets which are continuously required by the enterprise to carry out its day-to-day business operations and this minimum cannot be expected to reduce at any time. The minimum level of current assets give rise to permanent or fixed working capital as this part of working capital is

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permanently blocked in current assets. Similarly, some amount of working capital may be required to meet the seasonal demands and some special exigencies such as rise in prices, strikes, etc. This proportion of working capital gives rise to temporary or variable working capital which cannot be permanently employed gainfully in business. FINANCING CURRENT ASSETS Sources of working capital

Permanent or Fixed

Temporary or Variable

1. Shares

1.Commercial banks

2. Debentures

2.Indigeneous bankers

3. Public deposits 4. Ploughing back of profits 5. Loans from financial institutions

3.Trade creditors 4.Instalment credit 5.advance 6. Factoring 7. Accrued Expenses 8. Commercial paper

FINANCING OF PERMANANET/FIXED OR LONG-TERM WORKING CAPITAL Permanent working capital should be financed in such a manner that the enterprise may have its uninterrupted use for a sufficiently long period. There are five important sources of permanent or long-term working capital. 1. SharesIssue of shares is the most important source for raising the permanent or long-term capital. A company can issue various types of shares as equity shares, preference shares. Preference shares carry preferential rights in respect of dividend at a fixed rate and in regard to the repayment of capital at the time of winding up the company. Equity shares do not have any fixed commitment charge and the dividend on these shares is to be paid subject to the availability of sufficient profits. As far as possible, a company should raise the maximum amount of permanent capital by the issue of shares. 2. DebenturesA debenture is an instrument issued by the company acknowledging its debt to its holder. It is also an important method of raising long-term or permanent working capital. The debenture-holders are creditors of the company.A fixed rate of interest are paid on debentures. The debentures as a source of finance have a number of advantages both to the investors and the company. Since interests on debentures have to be paid on certain predetermined intervals at a fixed rate and also debentures get priority on repayment at the time of liquidation, they are very well suited to cautious investors. The firm issuing debentures also enjoys a number of benefits such as trading on equity, retention of control, tax benefits, etc.

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FINANCE MANAGEMENT Pubic depositPublic deposits are the fixed deposits accepted by a business enterprise directly from the public. This source of raising short term and medium term finance was very popular in absence of banking facilities. Public deposits sources of fund have a large number of advantages such as very simple and convenient source of finance. But it is not free from certain dangers such as; it is uncertain, unreliable, unsound and unrealistic source of finance. The Reserve Bank of India has also laid down certain limit on public deposit. Non-banking concerns cannot borrow by way of public deposits more than 25% of its paid-up capital and free reserves. Ploughing back of profitsPloughing back of profits means the reinvestments by concern of its surplus earnings in its business. It is an internal source of finance and is most suitable for an established firm for its expansion, modernization and replacement etc. This method of finance has a number of advantages as it is the cheaper rather costfree source of finance; there is no need to keep securities; there is no dilution of control; it ensures stable dividend policy and gains confidence of the public. But excessive resort to Ploughing back of profits may lead to monopolies, misuse of funds, over capitalization and speculation, etc. Loan from financial institutionsFinancial Institutions such as Commercial Banks, Life Insurance Corporation, Industrial Finance Corporation of India, State Financial Corporations, State Industrial Development Corporation, Industrial Development Bank of India, etc, also provide short-term, medium term and long-term loans. This source of finance is more suitable to meet the medium â&#x20AC;&#x201C;term demands of working capital.

FINANCING OF TEMPORARY, VARIABLE OR SHORT-TERM WORKING CAPITAL The main sources of short-term working capital are as follows: 1.indigenous bankersPrivate moneylenders and other country bankers used to be the only source of finance prior tp the establishment of commercial banks. They used to charge very high rates of interest and exploited the customers to the largest extent possible. Now-a-days with the development of commercial banks they have lost their monopoly. 2.Trade creditTrade credit refers to the credit extended by the suppliers of goods in the normal course of business. As present day commerce is built upon credit, the trade credit arrangement of a firm with its supplier is an important source of short-term finance. The credit worthiness of a firm and the confidence of its suppliers are the main basis of securing trade credit. It may take the form of bills payable whereby the buyer signs the bill of exchange payable on a specified future date.

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When a firm delays the payment beyond the due date as per the terms of sales invoice, it is called stretching accounts payable. A firm may generate additional short-term finance by stretching accounts payable. 3.Instalment creditThis is another method by which the assets are purchased and the possession of goods is taken immediately but the payment is made in installments over pre-determined period of time. Generally interest is charged on the unpaid price or it may be adjusted in the price. But, in any case, it provides funds for sometimes and is used as a source of short-term working capital. 4. AdvancesSome business houses get advances from their customers and against orders and this source is a short-term source of finance for them. It is a cheap source of finance and in order to minimize their investment in working capital. 5.Factoring or Accounts Receivables CreditA commercial bank may provide finance by discounting the bills or invoices of its customers. Thus, a firm gets immediately payment for sale made on credit. A factor is a financial institution, which offers services relating to management and financing of debt arising out of credit sales. Factors render services varying from bill discounting facilities offered by commercial banks to a total take over of administration of credit sales

including maintenance of sales ledger,

collection of accounts receivables, credit control and protection from bad debts. 6.Accrued expensesAccrued expenses are the expenses, which have been incurred but not yet due and hence not yet paid also. These simply represent a liability that a firm has to pay for the service already received by it. The most important items of accruals are wages and salaries, interest, and taxes. Wages and salaries are usually paid on monthly, fortnightly or weekly basis for he services already rendered by employees. Like taxes, interest is also paid periodically while the funds are used continuously by a firm. Thus all accrued expenses can be used as a source of finance. Further, as interest is payable on accrued expenses, they represent a free source of financing. However, it must be noted that it may not be desirable or even possible to postpone these expenses for a long period. 7.Deferred incomesDeferred incomes are incomes received in advance before supplying goods or service. These funds increase the liquidity of a firm and constitute an important source of short-term finance. However, firms having great demand for its product and services, and those having good reputation in the market can demand deferred incomes.

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FINANCE MANAGEMENT 8.Commercial paperCommercial paper represents unsecured promissory notes issued by firms to raise short-term funds. In India Reserve Bank of India introduced commercial paper in the Indian money market. But only large companies enjoying high credit rating and sound financial health can issue commercial paper to raise short-term funds. Commercial paper is usually bought by investor including banks, insurance companies, unit trust and firms to invest surplus funds for short-period. A credit rating agency, called CRISIL, has been set up in India by ICICI and UTI to rate commercial papers. Commercial paper is a cheaper source of raising short-term finance as compared to the bank credit. 9.Working Capital Finance by Commercial BanksCommercial banks are the most important source of short-term capital. The major portions of working capital loans are provided by commercial banks. They provide a wide variety of loans tailored to meet the specific requirements of a concern. The different forms in which the banks normally provide loans and advances are as follows: a) Loans b) Cash credits c) Overdrafts d) Purchasing and discounting of bills.

DETERMINATION OF WORKING CAPITAL FINANCING MIX. Q. DISCUSS THE VARIOUS APPROACHES TO DETERMINE AN APPROPRIATE FINANCING MIX OF WORKING CAPITAL. Matching approach (or) hedging approachWhen the firm follows matching approach, long term financing will be used to finance permanent working capital. Temporary working capital should be financed out of short term funds. The rationale underlying matching approach is that the maturity of source of funds should match the nature of assets to be financed. Conservative approachAccording to this approach all requirements of funds should be met from long-term sources. Short-term sources of funds should be used only for emergency requirements. Under a conservative plan, a firm finances its permanent current assets and a part of the temporary current assets with a long-term financing. In periods when the firm has no temporary current assets, it stores liquidity by investing surplus finds in marketable securities. Conservative approach is less risky but more costly on compared to matching approach. In other words it is low profit low risk approach. Aggressive approachUnder an aggressive policy firm uses shorter financing than warranted by the matching plan, i.e., the firm finances a part of its permanent current assets with short term financing. On the other hand, more use of short term financing makes the firm more risky.

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Q. DISCUSS THE NEW TRENDS IN FINANCING OF WORKING CAPITAL BY BANKS. Banks in India have been providing finance to industry and trade on the basis of security. to ensure its equitable distribution in the right channels and credit has been a subject matter of regulation and control by the government .Since November 1965, a credit authorization scheme has been in operation as part of the reserve bank of India’s credit policy.(As was adopted by the RBI to regulated the end use of bank credit)under this scheme ,all scheduled commercial banks are required to obtain prior authorization of reserve bank of India before sanctioning any fresh credit limits of Rs.one crore or more to any single party or any limit that would enable the party avail Rs.one crore or more from the entire banking system on secured or unsecured basis. The limit of Rs.one crore was subsequently raised to Rs.five crores. To regulate and control bank finance, the RBI has been issuing directives and guidelines to the banks from time to time on the recommendation of certain specially constituted committees entrusted with the ask f examining various aspects of bank finance to industry. The following are the important findings and recommendations of various commitments Dehejia committee reportNational credit council constituted a committee under the chairmanship of Shri.V.T.Dehejia in 1968 to ‘determine the extent to which credit needs of industry and trade are likely to be inflated and how such trends could be checked ‘ and to go into establishing some norms for lending operations by commercial banks. The committee was of the opinion that there was also a tendency to divert short-term credit for long-term assets. Although committee was of the opinion that it was difficult to evolve norms for lending to industrial concerns, the committee recommended that the banks should finance industry on the basis of a study of borrower’s total operations rather than security basis alone. The committee further recommended that the total credit requirements of the borrower should be segregated into ‘hard core’ and ‘short-term’ component. The committee was also of the opinion that generally a customer should be required to confine his dealings to one bank only.

Tandon committee reportReserve bank of India set up a committee under the chairmanship of Shri.P.I.Tandon in July 1974 .The terms of reference of the committee were: 1. To suggest guidelines for commercial banks to follow up and supervise credit from the point of view of ensuring proper end use of funds and keeping a watch on the safety of advances.

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FINANCE MANAGEMENT 2. To suggest the type of operational data and other information that may be obtained by banks periodically from the borrowers and by the reserve bank of India from the leading banks. 3. To make suggestions for prescribing inventory norms for the different industries, both in the private and public sectors and indicate the broad criteria for deviating from theses norms. 4. To make recommendations regarding resources for financing the minimum working capital requirements. 5. To suggest criteria regarding satisfactory capital structure and sound financial basis in relation to borrowings. 6. To make recommendations as to whether the existing pattern of financing working capital requirements by cash credit/overdraft system etc., require to be modified, if so, to suggest suitable modifications. The committee was of the opinion that: (i) bank credit is extended on the amount of security available and not according to the level of operations of the customer,(ii) bank credit instead of being taken as a supplementary to other sources of finance is treated as the first source of finance. Chore committee report The reserve bank of India in march, 1979 appointed another committee under the chairmanship of Shri.K.B.Chore to review the working of cash credit system in recent years with particulars reference to the gap between sanctioned limits and the extent of their utilization and also to suggest alternative type of credit facilities which should ensure greater credit discipline. The important recommendations of the committee are as follows: i.

The banks should obtain quarterly statements in the prescribed format from all borrowers having working capital credit limit of Rs.50 lacs and above.

ii.

The banks should undertake a periodic review of limit of Rs.10 las above.

iii. The banks should not bifurcate cash credit accounts into demand loan and cash credit components. iv. If a borrower does not submit the quarterly returns in time the banks may charge penal interest of one percent on the total amount outstanding for the period of default. v.

Banks should discourage sanction of temporary limits by charging additional one percent interest over the normal rate on these limits.

vi. The banks should fix separate credit limits for peak level and non-peak level, wherever possible. vii. Banks should take steps to convert cash credit limits into bill limits for financing sales. Marathe Committee reportThe reserve bank of India, in 1982, appointed a committee under the chairmanship of Marathe to review the working of credit Authorization scheme (CAS) and suggest measures

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for giving meaningful directions to the credit management function of the Reserve Bank. The recommendations of the committee have been accepted by the reserve bank of India with minor modifications. The principal recommendations of the Marathe committee include: i.

The committee has declared the third method of lending as suggested by the Tandon committee to be dropped. Hence, in future, the banks would provide credit fro working capital according to the second method lending.

ii.

The committee has suggested the introduction of the ‘fast track scheme’ to improve the quality of credit appraisal in banks. It recommended that commercial banks can release without prior approval of the reserve Bank 50% of the additional credit required by the borrowers (75% I case of export oriented manufacturing units) where the following requirements are fulfilled: a)

The estimates/projections in regard to production, sales, chargeable current assets, other current assets, current liabilities other than bank borrowings, and net working capital are reasonable in terms of the past trends and assumptions regarding most likely trends during the future projected period.

The classification f assets and liabilities as ‘current’ and ‘non-current’ is in conformity with the guidelines issued by the reserve bank of India.

The projected current ratio is not below 1.33:1

The borrower has been submitting quarterly information and operating statements for the past six months within the prescribed time and undertakes to do the same in future also

The borrower undertakes to submit to the bank his annual account regularly and promptly, further, the bank is required to review the borrower’s facilities at least once in a year even if the borrower does not need enhancement in credit facilities.

Chakravarthy committee reportThe reserve bank of India appointed another committee under the chairmanship of sukhamoy Chakravarthy to review the working of the monetary system of India. The committee

submitted

its

report

April

1985.The

committee

made

two

major

recommendations in regard to the working capital finance. i. Penal interest for delayed paymentThe committee has suggested that the government must insist that all public sector units, large private sector units and government departments must include penal interest payment clause in their contracts for payments delayed beyond a specified period. ii. Classification of credit limit under three different headsThe committee further suggested that the total credit limit to be sanctioned to a borrower should be considered under three different heads: (1) cash credit I to include supplies to government, (2) cash credit II to cover special circumstances, and

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(3) Normal working capital limit to cover the balance credit facilities. Kannan committee report In view of the ongoing liberalization in the financial sector, the Indian banks association (IBA) constituted a committee headed by Shri.K.Kannan, Chairman and managing Director of bank of Baroda to examine all the aspects of working capital finance including assessment of maximum permissible bank finance

(MPBF). The committee

submitted its report on 25 February 1997. It recommended that the arithmetic rigidities imposed by Tandon committee (and reinforced by Chore committee) in the form of MPBF computation so far been in practice, should be scrapped. The committee further recommended

that freedom to each bank be

given in regard to evolving its own system of working capital finance for a faster credit delivery so as to serve various borrowers more effectively. It also suggested that line of credit system. (LCS), as prevalent in many advance countries, should replace the existing system of assessment /fixation of sub-limits within total working capital requirements. The committee proposed to shift emphasis from the liquidity level lending (security based lending) to the cash deficit lending called Desirable Bank finance (DBF).

Problem.No.1 Prepare an estimate of working capital requirement from the following information of a trading concern: a) Project annual sales

1,00,000 units

b) Selling price

Rs.8 per unit

c) Percentage of net profit on sales

25%

d) Average credit period allowed to customers

8 weeks

e) Average credit period allowed by suppliers

4 weeks

f) Average stock holding in terms of sales requirements 12 weeks g) Allow 10% for contingencies. Solution: Step 1: Classify the given information into current assets and current liabilities Step 2: Calculate the cost of sales to find out the components of current assets. This is being done by excluding the percentage of profit out of sales. Statement showing the details of calculating working capital

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Current Assets

Rs.

Debtors: 6,00,000 x 8/52

92,308

Stock: 6,00,000 x 12/52

1,38,462 2,30,770

Less: Current liabilities:

46,154 1,84,616

Creditors: 6,00,000 x 4/52

18,462

Net working capital

2,03,078

Add: 10% contingencies Working capital required Working note: Cost of sales = Sales â&#x20AC;&#x201C; Profit 25 = 8,00,000 - ------- x 8,00,000 100

=8,00,000 - 2,00,000 = 6,00,000 Assumptions: 1. Calculation of debtors and creditors are being done by considering the cost of sales.

Problem.No.2 Prepare an estimate of working capital requirement from the following information of a trading concern: a) Project annual sales

80,000 units

b) Selling price

Rs.8 per unit

c Percentage of net profit on sales d) Average credit period allowed to debtors e) Average credit period allowed by suppliers

20% 10 weeks 8 weeks

f) Average stock holding in terms of sales requirements 10weeks g) Allow 20% for contingencies

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Solution: Statement showing the details of calculating working capital Current Assets

Rs. 10

Debtors: 5,12,000 x ----

98,462

10 Stocks:

5,12,000 x -----

98,462

52 Total current assets

1,96,924 8

Less: Raw materials: 5,12,000 x ----

78,769

52 Net working capital

1,18,155

Add: 20% contingencies

23,631

Total Net working capital

1,41,786

Working note: Cost of goods sold = Sales – Profit 20 = 80,000 x 80 - ------- x 6,40,000 100 = 6,40,000 – 1,28,000 = 5,12,000

Problem.No.3 Proforma cost sheet of a company provides the following particulars: Elements of cost: Materials 40%; direct labour – 20% ; Overheads – 20% .the following further particulars are available: a)

It is proposed to maintained a level of activity of 2,00,000 units.

Raw materials are expected to remain in stores for an average period of one month.

Materials will be in process, an average of half month.

Selling price is Rs.12 per unit.

Finished goods are required to be in stock for an average period of one month.

Credit allowed to debtors is two months.

Credit allowed by suppliers is one month.

You may assume that sales and production follow a consistent pattern.

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FINANCE MANAGEMENT Statement showing the details of net working capital

89 Rs.

Current assets: Raw materials(One month) 2,00,000 x12 x 40 x 100

80,000

Work-in-progress (1/2 month) Raw materials 2,00,000x 12 x 40 x

100

40,000

Labour 2,00,000x 12 x 20 x 100

20,000

Overheads 2,00,000 x 12 x 20

100

20,000

Finished goods( one month) Raw materials 2,00,000x 12 x 20 x 100

80,000

Labour 2,00,000x 12 x 20 x 100

40,000

Overheads 2,00,000x 12 x 20 x 100

40,000

Debtors (Two months) Raw materials 2,00,000x 12 x 40 x 100

1,60,000

Labour 2,00,000x 12 x 20 x 100

80,000

Overheads 2,00,000 x 12 x 20 x 100

80,000

6,40,000

Total current assets Current liabilities Raw materials

80,000

2,00,000x 40 x 12 x 5

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5,60,000

Net working capital Problem.No.4 X and co., is desirous to purchase a business and has consulted you and one point as which you are asked to advise them is the average amount of working capital which will be required is the first year’s working. You are given the following estimates and are instructed to add 10% to your computed figure to allow for contingencies: 1. Amount Blocked up in stocks

Rs.

Stock of finished goods

5,000

Stock of stores, materials

8,000

2. Average credit sales: Inland sales- 6 weeks credit

3,12,000

Export sales 1 ½ weeks credit

78,000

3. Payment in advances: Sunday expenses (paid quarterly in advance)

8,000

4. Undrawn profit on the average throughout the year

11,000

5. Lag in payment of wages and other out goings: Wages -11/2 weeks

2,60,000

Stock of materials-1 ½ months

48,000

Rent, royalties – 6 months

10,000

Clerical staff-1/2 month

62,000

Manager- ½ month

4,800

Miscellaneous expenses- 1 ½ months

48,000

Solution:

Statement showing the details of calculating working capital

Rs.

Current Assets a) Stock of finished goods

5,000

b) Stock of stores, materials

8,000

c) Sundry debtors: i) Inland:

Rs.3,12,000 x 6 =

36,000

52 ii) Export sales Rs.78,000 x 3 =

2,250 .

38,250

d) Payment in Advance: Sundry expenses = 8,000 x 1/4

2,000

Total Current Asset

53,250

Less: Current Liabilities a) Lag in payment of wages: Rs. 2,60,000 x 3 12

= 7,500 2

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b) Lag in payment of materials: Rs. 48,000 x 3 = 6,000 12

= 5,000

c) Rent & Royalties: : Rs. 10,000 x 6 12

d) Clerical staff : Rs. 62,400 x 1 = 12 e) Managerâ&#x20AC;&#x2122;s salary: Rs.

2,600

2 1 2

x 4,800

= 200

12 27,300

f) Miscellaneous expenses : Rs. 48,000 x 3 12

= 6,000

25,950

Networking capital

2.590

Add 10% contingencies

28,545

Net working capital

Problem.No.5 A Proforma cost sheet of a company provides the following particulars. Elements of cost

Amount per unit

Raw materials

50%

Direct Labour

15%

Overheads

15%

The following particulars are available: a) It is proposed to maintain a level of activity of 3,00,000 units. b) Selling price is Rs.20 per unit. c) Raw materials are expected to be in the stores for an average of 2 months. d) Materials will be in the process an average of one month. e) Finished goods are required to be in stock for an average of 2 months. f)

Credit allowed to debtors is 3 months

g) Credit allowed by suppliers is 2 months. You may assume that sales and production follow a consistent pattern.

Solution: Statement showing the details of net working capital

Rs.

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Current assets: Raw materials(two month) 3,00,000 x 20 x 50 x 100

500,000

Work-in-progress (one month) Raw materials 3,00,000 x 20 x 50 x 100

2,50,000

Direct Labour 3,00,000 x 20 x 15 x 100

75,000

Overheads 3,00,000 x 20 x 15 x 100

75,000

Finished goods( two month) Raw materials 3,00,000 x 20 x 50 x 100

5,00,000

Direct Labour 3,00,000 x 20 x 15 x 100

1,50,000

Overheads 3,00,000 x 20 x 15 x 100

1,50,000

Debtors (Two months) Raw materials 3,00,000 x 20 x 50 x 100

5,00,000

Direct Labour 3,00,000 x 20 x 15 x 100

1,50,000

Overheads 3,00,000 x 20 x 15 x 100

1,50,000

25,00,000

Total current assets Current liabilities Raw materials

5,00,000

3,00,000 x 20 x 50 x 100 Net working capital

2 12 20,00,000

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UNIT-IV MANAGEMENT OF CASH, RECEIVABLES AND INVENTORIES MANAGEMENT OF CASH Q. GIVE THE MEANING AND NATURE OF CASH. Meaning of cashCash is one of the current assets of a business. It is needed at all times to keep the business going. A business concern should always keep sufficient cash for meeting its obligations. Any shortage of cash will hamper the operations of a concern and any excess of it will be unproductive.The term ‘cash’ with reference to cash management is used in 2 senses. In a narrower sense it includes coins, currency notes, cheque, bank draft held by a firm with it and the demand deposits held by it in banks. In a broader sense it also includes “near-cash assets” such as, marketable securities and time deposits with banks.

Such

securities or deposits can immediately be sold or converted into cash if the circumstances requiring. The term cash management is generally used for management of both cash and near-cash assets.

Nature of cashCash itself does not produce goods or service. It is used as a medium to acquire other assets. It is the other assets which are used in manufacturing goods improving services. The idle cash can be deposited in bank to earn interest.A business has to keep required cash for meeting various needs. The assets acquired by cash again help the business in producing cash. The goods manufactured or services produced re sold to acquire cash. A firm will have to maintain a critical level of cash .it at a time it does not have sufficient cash with it, it will have to borrow from the market for reaching the required level. There remains a gap between cash inflows and cash outflows. Sometimes cash receipts are more than the payments or it may be vice-versa at another time. A financial manager tries to synchronize the cash inflows and cash outflows. But this situation is seldom found in real world. Perfect synchronization of receipts and payments of cash is only an ideal situation. PLANNING OF CASH REQUIREMENTS In planning its cash requirements and proper use of the funds subsequently generated through its operations A management should use two tools. (i) A long-range cash projection and (ii) A short-range forecast of cash position.

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In making its long range projection of case , a management should first difine in goals it intends to accomplish Over the period under consideration-usually a period which is longer than one year. The managing of the cash is not simple in the corporate world of cash managers (treasures) and accountants (controllers). Determining How much cash a corporation has, is a task that is not easy. Dictionary definitions of cash are not particularly Helpful because they do not take into account the dynamic of entire modern case management are the current accounting practices. All corporation do not use the same accounting treatment of cash the problem of measuring corporate cash in further compounded by the fact that corporate treasure and controllers used different of the cash. Different definitions and accounting results and misunderstanding

and problem and

corporation as well as for uses of published and financial statements to key objective of modern corporate cash management are maximization of the written on liquid and assets and maintenance of the cost financing the assets used by corporations. The minimization of idle cash balance based to the achievement of these objectives. The corporation should either invest all available cash to produce investment income are used cash to reduce debit and the cost of borrowings.

Q WRITE SHORT NOTES ON MOTIVES FOR HOLDING CASH. A distinguishing feature of cash as an asset, irrespective of the firm in which it is held, is that it does not earn any substantial return for the business. In spite of this fact cash is held by the firm with the following motives. Transaction motiveA firm enters into a variety of business transaction, resulting in both inflows and outflows. In order to meet the business obligations in such a situation, it is necessary to maintain adequate cash balance. Thus, cash balance is kept by the firms with the motive of meeting routine business payments. Precautionary motiveA firm keeps cash balance to meet unexpected cash needs arising out of unexpected contingencies such as floods, strikes, presentment of bills for payment earlier than the expected date, unexpected slowing down of collection of accounts receivable, sharp increase in price of raw material etc., the more is the possibility of such contingencies, more is the amount of cash kept by the firm for meeting them. Speculative motiveA firm also keeps each balance to take advantages of unexpected opportunities typically outside the normal course of the business. Such motive is, therefore of purely a speculative nature. Compensation motive-

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Banks provide certain services to their clients free of charge. They, therefore usually require clients to keep a minimum cash balance with them, which help them to earn interest and thus compensate them for the free services so provided. Business firms normally, do not enter into speculative activities and, therefore, out of the four motive of holding cash balance, the two most important motives are the transaction motive and the compensation motive.

Q. EXPLAIN THE OBJECTIVES OF CASH MANAGEMENT. Meeting cash disbursementsThe first basic objective of cash management is to meet the payments schedules. In other words, the firm should have sufficient cash to meet the various requirements of the firm at different period of times. The business has to make payment for purchase of raw material, wages, taxes, purchase of plant etc. The business activity may come to a grinding halt if the payment schedule is not maintained. Cash has, therefore, been aptly described as the “oil to lubricate the ever-turning wheels of the business, without it the process grinds to a stop”. Minimizing funds locked up a cash balanceThe second objective of cash management is to minimize the amount locked up as cash balances.

In the process of minimizing the cash balance, the finance manager is

confronted with two conflicting aspects. A higher cash balance ensures proper payment with all its advantages. But this will result in a large balance of cash remaining idle. Low level of cash balance may result in failure of the firm to meet the payment schedule. The finance manager should, therefore, try to have an optimum amount of cash of balance keeping the above facts in view.

Q.ENUMERATE THE FACTORS DETERMINING CASH NEEDS. The amount of cash for transaction requirements is predictable and depends upon a variety of factors which are as follows: 1. Credit position of the firm: The credit position influences the amount of cash required in two distinct ways. First, if a firm’s credit position is sound, it is not necessary to carry a large cash reserve for emergencies. Second, if a firm finances its inventory requirements with trade credit, its cash requirements are considerably smaller, since the firm can synchronize the credit terms it gives to its customers with the terms it receives. 2. Status of firm’s receivable: The amount of time required for a firm to convert its receivable into cash also affects amount of cash needed and of course, reduces total working capital employed. In other words, the longer the credit terms, the slower the turnover.

When out flow is not

synchronized with turn over, a firm must carry amounts of cash relatively larger than would otherwise be required.

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3. Status of firm’s inventory account: The status of a firm’s inventory account also affects the amount of cash tied up at any one time. For example, if one business firm carries two months’ inventory on hand and another firm carries only one month’s supply, the former has twice as much investment in inventory and will normally be called upon to maintain a larger investment in cash in order to finance its acquisition. 4. The nature of business enterprise: The nature of firm’s demand definitely affects the volume of cash required.

illustrate, a firm whose demand is volatile, needs a relatively larger cash reserve than one whose demand is stable. Public utility firms exhibit stable demand where as firms that deal with high fashion merchandise or goods that tend to be ‘faddish’ are subject to high degrees of volatility. 5. Management’s attitude towards risk: A more conservative management will hold a larger cash reserve than one that is less conservative. The former usually demands more liquidity than the latter and consequently does not experience the same degree of efficiency. A generalization is made that the firm that effectively plans its working capital policies is less conservative than one that does little or no planning. The obvious conclusion is that planning allows the firm to predict its requirements more accurately, there by eliminating uncertainty, which is the basis for large cash reserves. 6. Amount of sales in relation to assets: Another characteristic affecting the level of cash is the amount of sales in relation to assets.

Firms with large scale relative to fixed assets are required to carry larger cash

reserves. This is the result of having larger sums of invested in inventories however, that cash requirements do not increase in the same proportion as sales. The rule is that as sales increase, cash also increases but at a decreasing rate, it is impossible to determine to what extent each characteristic affects the total volume of cash, but these examples indicate that different types of businesses have different cash requirements.

Q.LIST OUT THE ADVANTAGES OF CASH MANAGEMENT 1. The availability of cash may be a matter of life or death. A sufficiently of cash can keep an unsuccessful firm going despite losses. Conversely, this insufficiency can bring failure in the face of actual or prospective earnings. 2. An efficient cash management through a relevant and timely cash budget may enable a firm to obtain optimum working capital and ease the strains of cash shortage, facilitating temporary investment of cash and providing funds for normal growth 3. Cash may be said to be like the blood stream in a living body, for it is very much the life blood of business. It must be kept circulating around the arteries of the business because if the circulation gets clogged, sickness and death may occur, as they do when a clot forms in an artery.

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4. The first priority of any business is survival and this cannot be assured, even in the short run, unless a company remains both liquid and solvent, that is, unless it is able to pay its debts as and when they fall due, both immediately and in the foreseeable future. 5. Cash management involves balance sheet changes and other cash flows that do not appear in the profit and loss account such as capital expenses. 6. It gives an inventory of the financial reserves which are available in the event of a recession. 7. It yields a plan as an integral part of the procedure. 8. It views problems in a dynamic context over a period of time. 9. It yields a number of additional insights into the crucial task of framing a sound debt policy. The focus is on the solvency of the firm in adverse circumstances rather than on the effects of leverage in normal circumstances. 10. While a regularization of cash flows enables a management to achieve a more effective planning, sophistication in handling cash enables a firm to cut down on the amount that it must keep in order to sustain any given level of operations.

Q.EXPLAIN THE DISADVANTAGES OF CASH MANAGEMENT 1. It may offer a solution of compensation which is not justified on the basis of a concrete notion, particularly when the business economy operates in an uncertain world. 2. It considers economic recession as the main source of uncertainty but ignores technological developments, shifts in consumer preferences, political changes etc. Moreover, recessions are not the only source of economic unhappiness. 3. The cost of holding cash is the profit that could have been earned had the funds been put to another use. 4. Financial distress usually is a matter of degree, while the declaration of the bankruptcy is an indication of this distress in an extreme form.

Middle firms of

financial distress occur when a firmâ&#x20AC;&#x2122;s cash flows falls below expectations. Costs of financial distress are thus related to modifications in investment and financial strategic made necessary by the conditions of distress.

Firms often encounter

conditions of financial distress which are sometimes mild and sometimes rather severe.

Q. EXPLAIN THE VARIOUS METHODS OF INVESTING SURPLUS FUNDS. WHAT CRITERIA SHOULD A FIRM USE IN INVESTING IN MARKETABLE SECURITIES? There are, sometimes surplus funds with the companies which are required after sometime. These funds can be employed in liquid and risk free securities to earn some income. There are a number of avenues where these funds can be invested. The selection

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FINANCE MANAGEMENT of securities or method of investment is very important.

98 Some of these methods are

discussed here with: 1. Treasury bills: The treasury bills are issued by RBI on behalf of the central government. Earlier they were issued on the basis of tender floated regularly but now are available on tap system, i.e., on rates announced by RBI every week. These bills are issued only in bearer form. Name of the purchaser is not mentioned on the bills, rather they are easily transferable from one investor to another. No interest is paid on the bills but the return is the difference between the purchase price and face (par) value of the bill. Since there is a backing of the central government, these are risk free securities. 2. Negotiable certificates of deposit (CDâ&#x20AC;&#x2122;s): The money is deposited in a bank for a fixed period of time and marketable receipt is issued. On maturity, the amount deposited and interest are paid. The CDâ&#x20AC;&#x2122;s are different from the treasury bills which are issued on discount. The short term surplus funds can be used to earn interest in this method. 3. Unit 1964 scheme: The Unit Trust of Indiaâ&#x20AC;&#x2122;s unit 1964 scheme is very popular for making short term investments. It is an open ended scheme which allows investors to withdraw their funds on a continuing basis. The units have a face value of Rs.10. The purchase and sale value of units is not based on net assets value but it is determined administratively in such a manner and they give rise gradually over time. 4. Ready forward: A commercial bank or some other organization may enter into a ready forward deal with a company willing to invest funds for a short period of time. Under this system the bank sells and repurchases the same security (that means that company purchases and sells securities in turn) at pre-determined prices. The difference between the purchase and sale price is the income of the company. Ready forwards are generally done in units, public sector bonds or government securities. 5. Badla financing: Badla financing is used in stock exchange transactions when a broker wants to carry forward his transactions from one settlement period to another.

Badla financing is done

through operators in stock exchange. It is the financing of transactions of a broker who wants to carry forward this deal to the other settlement period. The badla rates are decided on the day of settlement. Badla transactions are financed on the security of shares purchased whose settlement is to be carried forward. Sometime this financing facility may be extended for a particular share only. 6. Inter-Corporate deposits:

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FINANCE MANAGEMENT These are short term deposits with other companies which attracts a good rate of return. Inter-corporate deposits are of three types: 7. Call deposits: It is a deposit which a lender can withdraw on one day’s notice. In practice it takes three days to get this money. The rate of interest at present is 14 percent on these deposits. 8. Three months deposits: These deposits are popular and are used by borrowers to tide over short-term inadequacy of funds. The interest rate on such deposits is influenced by bank overdraft interest rate and at present the borrowing rate is 22 percent per annum. 9. Six month deposits: The lenders may not have surplus funds for a very long period. Six-month period is normally the maximum which lenders may prefer. The current interest rate on these deposits is 24 percent per annum. Since inter-corporate deposits are unsecured loans, the creditworthiness of the borrower should be ascertained. 10. Bill discounting: A bill arises out of credit sales. The buyer will accept a bill drawn on him by the seller. In order to raise funds the seller may get the bill discounted with his bank. The bank will charge discount and release the balance amount to the drawer. These bills normally do not exceed 90 days. 11. Investment in marketable securities: A firm has to maintain a reasonable balance of cash. This is necessary because there is no perfect balancing of inflows and outflows of cash. Instead of keeping the surplus cash as idle, the firms tries to invest it in marketable securities. It will bring some income to the business. The cash surpluses will be available during slack seasons and will be required when demand picks up again.

The investment of this cash in securities needs a prudent and

cautious approach. The selection of securities for investment should be carefully made so that the amount is raised quickly on demand. 12. Money market mutual funds (MMMF): ‘Money market mutual fund’ means a scheme of a mutual and which has been set up with the objective of investing exclusively in money market instruments. These instruments include treasury bills, dated government securities with an expired maturity of upto one year, call and notice money, commercial paper, commercial bills accepted by banks and certificates of deposits. Till recently, only commercial banks and public financial institutions were allowed to set up MMMFs. But in November 1995, the government has permitted private sector mutual funds also to set up money market mutual fund. MMMFs are wholesale markets for low risk, high liquidity and short term securities. The main feature of this fund is the access to persons of small savings.

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RECEIVABLES MANAGEMENT Q.GIVE THE MEANING OF RECEIVABLESReceivable represent amount owed to the firm as a result of sale of goods or services in the ordinary course of business. These are claims of the firm against its customers and form part of its current assets. Receivables are also known as accounts receivables, trade receivables, customer receivables or book debts.

The receivables are carried for the

customer. The period of credit and extent of receivables depends upon the credit policy followed by the firm.

The purpose of maintaining or investing in receivables is to meet

competition, and to increase the sales and profits.

Q.GIVE THE MEANING AND OBJECTIVES OF RECEIVABLE MANAGEMENT Receivable management is the process of making decisions relating to investment in trade debtors. Certain investment in receivable is necessary to increase the sales and the profits of a firm. But at the same time investment in this asset involves cost considerations also. Further, there is always a risk of bad debts too. Objectives of receivables managementTo take a sound decision as regards investment in debtors It is to promote sales and profits until that point is reached where the return on investment in further funding of receivable is less than the cost of funds raised to finance that additional credit.

CREDIT POLICIES FOR MANAGING RECEIVABLES Q.DISCUSS

THE

VARIOUS

ASPECTS

DIMENSIONS

RECEIVABLES

MANAGEMENT Receivables management involves the careful consideration of the following aspects: 1. Forming of credit policy 2. Executing the credit policy 3. Formulating and executing collection policy

1.Forming of credit policy: a)Quality of trade accounts or credit standards: The volume of sales will be influenced by the credit policy of a concern.

liberalizing credit policy the volume of sales can be increased resulting into increased profits. The increased volume of sales is associated with certain risks too. It will result in enhanced costs and risks of bad debts and delayed receipts. There may be more bad debt losses due to extension of credit to less worthy customers. These customers may also take more time than normally allowed in making the payments resulting into tying up of additional capital in receivables. On the other hand, extending credit to only credit worthy customers will save costs like bad debt losses,

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collection costs, investigation costs etc. The restriction of credit to such customers only will certainly reduce sales volume, thus resulting in reduced profits.

b)Length of credit period: Credit terms or length of credit period means the period allowed to the customers for making the payment. The customers paying well in time may also be allowed certain cash discount. There is no binding on fixing the terms of credit. A concern fixes its own terms of credit depending upon its customers and the volume of sales. The customs of industry act as constraints on credit terms of individual concerns. A firm may allow liberal credit terms to increase the volume of sales. The lengthening of this period will mean blocking of more money in receivables which could have been invested somewhere else to earn income. A finance manager should determine the period where additional revenue equates the additional costs and should not extend credit beyond this period as the increase in cost will be more than the increase in revenue.

c)Cash discount: Cash discount is allowed to expedite the collection of receivables. The funds tied up in receivables are released. The concern will be able to use the additional funds received from expedited collections due to cash discount. The discount allowed involves cost. The financial manager should compare the earnings resulting from released funds and the cost of discount.

d)Discount period: The collection of receivables is influenced by the period allowed for availing the discount. The additional period allowed for this facility may prompt some more customers to avail discount and make payments. This will mean additional funds released from receivables which may be alternatively used.

2.Executing credit policy: After formulating the credit policy, its proper execution is very important.

The

evaluation of credit applications and finding the credit worthiness of customers should be undertaken.

a)Collecting credit information: The first step in implementing credit policy will be to gather credit information about the customers. This information should be adequate enough so that proper analysis about the financial position of the customers is possible. This type of investigation can be undertaken only upon a certain limit because it will involve cost. The cost incurred in collecting this information and the benefit from reduced bad

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debts losses will be compared. The credit information will certainly help in improving the quality of receivables but the cost of collecting information should not increase the reduction of bad debt losses. The proper analysis of financial statements will be helpful in determining the credit worthiness of customers. There are credit rating agencies which can supply information about various concerns. These agencies regularly collect information about business units from various sources and keep this information upto date. The interpreted information can be had from these agencies. These agencies supply this information to their subscribers on a regular basis through circulars, periodicals etc. The information is kept in confidence and may be used when required. Such agencies are not available in India at present, but countries like America have so many agencies in this field. Credit information may be available with banks too. The banks have their credit departments to analyse the financial position of the customer. In case of old customers, businessâ&#x20AC;&#x2122; own records may help to know their credit worthiness. The sales men of the business may also be asked to collect information about the customers.

b)Credit analysis: After gathering the required information, the finance manager should analyse it to find out the credit worthiness of potential customers and also to see whether they satisfy the standards of the concern or not.

The credit analysis will determine the degree of risk

associated with the account, the capacity of the customer to borrow and his ability and willingness to pay.

c) Credit decision: After analyzing the credit worthiness of the customer, the finance manager has to take a decision whether the credit is to be extended and if yes, then, upto what level. He will match the credit worthiness of the customer with the credit standards of the company. If customersâ&#x20AC;&#x2122; credit worthiness is above the credit standards, then there is no problem in taking decision. It is only in the managerial cases that such decisions are difficult to be made. In such cases, the benefit of extending credit should be compared to the likely bad debt losses and then a decision should be taken.

d)Financing investments in receivables and factoring: Account receivables block a part of working capital. Efforts should be made that funds are not tied up in receivables for longer periods. The finance manager should make efforts to get receivables financed so that working capital needs are met in time. The banks allow raising of loans against security of receivables. Generally, banks supply between 60 to 80 percent of the amount of receivables as loans against their security.

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The quality of receivables will determine the amount of loan. The banks will accept receivables of dependable parties only. Another method of getting funds against receivables is their outright sale to the bank. The bank will credit the amount to the party after deducting discount and will collect the money from the customers later. Here too, the bank will insist on quality receivables only. Besides banks, there may be other agencies which can buy receivables and pay cash for them. This facility is known as factoring. The factoring service varies from bill discounting facilities offered by commercial banks to a total take over of administration of the sales ledger and credit control functions.

3) Formulating and executing collection policy: The collection of amounts due to the customers is very important.

The concern

should devise procedures to be followed when accounts become due after the expiry of credit period. The collection policy be termed as strict and lenient. A strict policy of collection will involve more efforts on collection. Such a policy has both plus and negative effects. The policy will enable early collection of dues and will reduce bad debt losses. The money collected will be used for other purposes and the profits of the concern will go up. On the other hand a rigorous collection policy will involve increased collection costs. It may also reduce the volume of sales. The collection policy should weigh various aspects associated with it, the gains and losses of such policy and its effect on the finances of the concern. The collection policy should also device the steps to be followed in collecting over due amounts. The objective is to collect the dues and not to annoy the customer. The steps should be like Sending a reminder for payments Personal request through telephone etc. Personal visits to the customers Taking help of collecting agencies and lastly Taking legal action. The last step should be taken only after exhausting all other means because it will have a bad impact on relations with customers. The genuine problems of customers should never be ignored while making collections. The aim should be to make collections and keep amiable relations with customers.

Q. DISCUSS THE ADVANATGES/BENEFITS OF RECEIVABLES MANAGEMENT. 1. It is an interesting fact that business enterprise have little or no understanding of this method of borrowing or of how simply their accounts receivables may be employed as a source of borrowing cash. 2. The assignment of accounts receivables furnishes additional operating cash, and there is no need for diluting the equity and control of owners. Moreover, small and

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medium size corporations find it difficult to raise additional to raise additional cash through security issues. 3. Small, medium size and even large corporations find it expensive to raise funds through long term debt. The accounts receivables financing arrangement provides a business firm with an established source of funds which may be used for long as well as short term purposes, and which does not obligate it to pay to money when it is not needed. 4. Accounts receivables financing is of a revolving nature and provides a continuous source of operating cash 5. It is flexible because borrowing under it may be continued throughout its life or used only temporarily to meet a constant need. 6. If a firm makes use of accounts receivables financing, it does not have to wait to get back the money it has invested in the goods it sells. It simply assigns the credit sales of its financing source. 7. With a wise use of debt capacity, as in the employment of accounts receivables, a firm will have more cash with which to take advantage of any profitable opportunities which may develop. 8. By using accounts receivables financing to release the money which has been invested in its receivables, a firm will have more cash with which to take advantage of any profitable opportunities which may develop. 9. It enables businessmen to protect and improve a firmâ&#x20AC;&#x2122;s credit rating, for the latter is in a position to pay bills on due dates. 10. A firm receives experienced business counsel and technical guidance, for it has to approach a specialized financing institution to obtain accounts receivables financing. 11. To obtain funds from accounts receivables financing, a businessman does not need to be one of the established customers.

Q.WRITE A NOTE ON THE COST OF MAINTAINING RECEIVABLES. The allowing of credit to customers means giving of funds for the customerâ&#x20AC;&#x2122;s use. The concern incurs the following cost on maintaining receivables: Cost of financing receivablesWhen goods and services are provided on credit then concerns capital is allowed to be used by the customers. The receivables are financed from the funds supplied by shareholders for long term financing and through retained earnings.

The concern incurs some cost for

collecting funds which finance receivable. Cost of collectionsA proper collection of receivable is essential for receivable management. The customers who do not pay the money during a stipulated credit period are sent reminders for early payments. Some persons may have to be sending for collecting these amounts. In some cases legal

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resources may have to be taken for collection receivables. All these costs are known as collection costs which a concern is generally required to incur. Bad debtsSome customers may fail to pay the amount due towards them. The amounts which the customers fail to pay are known as bad debts. Though a concern may be able to reduce bad debts through efficient collection machinery but one cannot altogether rule out this cost. FACTORS INFLUENCING THE SIZE OF RECEIVABLES Q. DISCUSS THE FACTORS WHICH INFLUENCING THE SIZE OF RECEIVABLES. Besides sales, a number of other factors also influence the size of receivables. The following factors directly and indirectly affect the size of receivables. Size of credit salesThe volume of credit sales is the first factor which increases or decreases the size of receivables. If a concern sells only on cash basis, as in the case of Bata Shoe Company then there will be no receivables. The higher part of credit sales out of total sales, figures of receivables will also be more or vice versa. Credit policiesA firm with conservative credit policy will have a low size of receivables while a firm with liberal credit policy will be increasing this figure. The vigour with which the concern collects the receivables also affects its receivables. If collections are prompt then even if credit is liberally extended the size of receivables will remain under control. In case receivables remain outstanding for a longer period, there is always a possibility of bad debts.

Terms of tradeThe size of receivables also depends upon the terms of trade. The period of credit allowed and rates of discount given are linked with receivables. If credit period allowed is more than receivables will also be more.

Expansion plansWhen a concern wants to expand its activities it will have to enter new markets. To attract customers it will give incentives in the form of credit facilities. The period of credit can be reduced when the firm is able to get permanent customers. In the early stage of expansion more credit becomes essential and size of receivables will be more. Relation with profitsThe credit policy is followed with a view to increase sales. When sales increase beyond a certain level the additional costs incurred are less than the increase in revenues. It will be beneficial to increase sales beyond a point because it will bring more profits. The increase in profits will be followed by an increase in the size of receivables or vice-versa Credit collection efforts-

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FINANCE MANAGEMENT The collection of credit should be streamlined.

106 The customers should be sent

periodical reminders if they fail to pay in time. On the other hand, if adequate attention is not paid towards credit collection then the concern can land itself in a serious financial problem. An efficient credit collection machinery will reduce the size of receivables. If these efforts are slower then outstanding amounts will be more. Habits of customersThe paying habits of customers also have a bearing on the size of receivables.

The

customers may be in the habit of delaying payments even though they are financially sound. The concern should remain in touch with such customer and should make them realize the urgency of their needs.

FORECASTING OF RECEIVABLES Q.â&#x20AC;&#x153;RECEIVABLE FORECASTING IS IMPORTANT FOR THE PROPER MANAGEMENT OF RECEIVABLESâ&#x20AC;?- DISCUSS. (OR) Q. EXPLAIN THE FACTORS WHICH HELPS IN FORECASTING THE RECEIVABLES. The following factors will help in forecasting receivables Credit period allowedThe Aging of Receivables is helpful in forecasting. The longer the amounts remain due, the higher will be the size of receivables. The increase in receivables will result in more profits as well as higher costs too. The collection expenses and bad debts will also be more. If credit period is less, then the size of receivables will also be less. Effect of cost of goods soldSometimes an increase in sales results in decrease in cost of goods sold. It this is so then sales should be increased to that extent where costs are low. The increase in sales will also increase that amount of receivable. The estimate for sales will enable the estimation of receivables too. Forecasting expensesThe receivable are associated with a number of expenses. These expenses are administration expenses on collection of amounts, cost of funds tied down in receivables, bad debts, etc., at the same time the increase in receivables will bring in more profits by increasing sales. If the costs of receivables are more than the increase in income, further credit sales should not be allowed. On the other hand, if revenue earned by the increase in sales is more than the costs of receivables, then sales should be expanded. Forecasting average collection period and discountThe credit collection policies will spell out the time allowed for making payments and the time allowed for availing discounts. If average collection period is more, then the size of receivable will be more. Average collection period is calculated as follows: Average collection period = Trade debtors x No. of working days

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107 Net sales

Average size receivableThe determination of average size of receivables will also be helpful in forecasting receivables. Average size of receivables is calculated as:

Average size of receivables =

Estimated annual sales x Average collection period. Problem .No.6 From the following information, calculate average collection period: Rs. Total sales

1,00,000

Cash sales

20,000

Sales returns

7,000

Debtors at the end of the year Bills receivables

11,000 4,000

Creditors

15,000

Solutions Average collection period = Trade debtors x No. of working days Net credit sales

Trade debtors

= Rs.11,000 + 4,000 = Rs.15,000

Net credit sales

= Rs.1,00,000 â&#x20AC;&#x201C; 20,000 â&#x20AC;&#x201C; 7,000 = Rs.73,000

Hence, Average Collection Period = 15,000 x 365 73,000 Or A.C.P = 75 days.

Problem .No.7 Bharat Ltd. decides to liberate credit to increase its sales. The liberalized credit policy will bring additional sales of Rs.3,00,000. The variable costs will be 60% of sales and there will be 10% risk for non-payment and 5% collection costs. Will the company benefit from the new credit policy? Solutions Rs. Additional sales revenue

3,00,000

Less: variable cost (60%)

1,80,000

Incremental revenue

1,20,000

Less: 10% for non-payment risk

30,000 90,000

Less: 50% for costs of collection

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15,000

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Additional revenue from increased sales due to liberal credit policy

75,000

INVENTORY MANAGEMENT Q.GIVE THE MEANING AND NATURE OF INVENTORY: The dictionary meaning of inventory is ‘stock of goods, or a list of goods’. The word ‘Inventory’ is understood differently by various authors. In accounting language it may means stock of finished goods only. In a manufacturing concern, it may include raw materials, workin-progress and stores etc. To understand the exact meaning of the word ‘Inventory’ we may study it from the usage side or from the ‘side of point of entry’ in the operations. Inventory includes the following things. a)Raw material: Raw material form a major input into the organization. They are required to carry out production activities uninterruptedly.

The quantity of raw materials required will be

determined by the rate of consumption and the time required for replenishing the supplies. b)Work-in-progress: The work-in-progress is that stage of stocks which are in between raw materials and finished goods. The raw materials enter the process of manufacture but they are yet to attain a final shape of finished goods. c)Consumables: These are the materials which are needed to smoothen the process of production. These materials do not directly enter production but they act as catalysts etc. Consumables may be classified according to their consumption and criticality.

d)Finished goods: These are the goods which are ready for the consumers. The stock of finished goods provides a buffer between production and market. The purpose of maintaining inventory is to ensure proper supply of goods to customers. e)Spares: Spares also form a part of inventory.

The consumption pattern of raw materials

consumables, finished goods are different from that of spares.

The stocking policies of

spares are different from industry to industry. Some industries like transport will require more spares than the other concerns. The costly spare parts like engines, maintenance spares etc are not discarded after use, rather they are kept in ready position for further use.

Q.DISCUSS THE PURPOSE OF HOLDING INVENTORIES. Although holding inventories involves blocking of a firm’s funds and the costs of storage and handling, every business enterprise has to maintain a certain level of inventories to facilitate uninterrupted production and smooth running of business.

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In absence of inventories a firm will have to make purchase as soon as it receives orders. it will mean loss of time and delays in execution of orders which sometimes may cause loss of customers and business. A firm also needs to maintain inventories to reduce ordering costs and avail quantity discounts etc. Generally speaking, there are three main purposes or motives of holding inventories. i) Transaction motive- The transaction motive which facilitates continuous production and timely execution of sales orders. ii) Precautionary motive-The Precautionary motive which necessitates the holding of inventories for meeting the unpredictable changes in demand and supplies of materials. iii) Speculative motive-The speculative motive which induces to keep inventories for taking advantages of price fluctuations, saving in re-ordering costs and quantity discounts, etc.

Q.DISCUSS THE RISK AND COSTS OF HOLDING INVENTORIES: The holding of inventories involves blocking of a firm’s funds and incurrence of capital and other costs.

It also exposes the firm to certain risks.

The various costs and risks

involved in holding inventories are as below: a)Capital costs: Maintaining of inventories results in blocking of the firm’s financial resources. The firm has therefore to arrange for additional funds to meet the cost of inventories. The funds may be arranged from own resources or from outsiders. But in both the cases, the firm incurs a cost. In the former case, there is an opportunity cost of investment while in the latter case, the firm has to pay interest to the outsiders. b)Storage and handling costs: Holding of inventories also involves costs on storage as well as handling of materials. The storage costs include the rental of the godown, insurance charges etc. c)Risk of price decline: There is always a risk of reduction in the prices of inventories by the suppliers in holding inventories. This may be due to increased market supplies. Competition or general depression in the market. d)Risk of obsolescence: The inventories may become obsolete due to improved technology, changes in requirements, changes in customer’s tastes etc. e)Risk deterioration in quality: The quality of the materials may also deteriorate while the inventories are kept in stores.

Q. GIVE THE MEANING OF INVENTORY MANAGEMENT. Inventories often constitute a major element of the total working capital and hence it has been correctly observed, “Good inventory management is good financial management”.

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Inventory management covers a large number of issues including fixation of minimum and maximum levels; determining the size of the inventory to be carried; deciding about the issue price policy setting up receipt and inspection procedure; determining the EOQ; providing proper storage facilities, keeping check on obsolescence and setting up effective information system with regard to the inventories.

Q.EXPLAIN THE OBJECTS OF INVENTORY MANAGEMENT. The main objectives of inventory management are operational and financial. The operational objectives mean that the materials and spares should be available in sufficient quantity so that work is not disrupted for want of inventory. The financial objective means that the investments in inventories should not remain idle and minimum working capital should be locked in it. The following are the objectives of inventory management. 1. To ensure continuous supply of materials, spares and finished goods so that productions should not suffer at any time and the customers demand should also be met. 2. To avoid both over stocking and under stocking of inventory 3. To maintain investments in inventories at the optimum level as required by the operational and sales activities 4. To keep material cost under control so that they contribute in reducing cost of production and overall costs. 5. To eliminate duplication in ordering or replenishing stocks. This is possible with the help of centralizing purchases. 6. To minimize the losses through deterioration, pilferage, wastages and damages. 7. To design proper organization for inventory management. A clear cut accountability should be fixed at various levels of the organization. 8. To ensure perpetual inventory control so that materials shown in stock ledgers should be actually lying in the stores. 9. To ensure right quantity goods at reasonable prices. Suitable quality standards will ensure proper quality of stocks. The price analysis, the cost analysis and value analysis will ensure payment of proper prices. 10. To facilitate furnishing of data for short term and long term planning and control of inventory.

Q.EXPLAIN THE VARIOUS INVENTORY CONTROL TECHNIQUES? Q.EXPLAIN IN DETAIL THE VARIOUS TOOLS AND TECHNIQUES OF INVENTORY MANAGEMENT. 1. DEMAND AND SUPPLY METHOD OF STOCK CONTROL: Levels of Stock & EOQ

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This method of inventory control utilizes the principles of planning the demand and supply of each item of inventory. The various levels of stock used in demand and supply method are explained in detail below: The purpose of inventory control is to maintain the stocks of raw materials as low as possible. At the same time, they must be made available as and when required by the production department. There may be overstocking or under stocking of materials if there is no proper planning. Proper maintenance of stock level of each type of material is the main function of the stores department. Following are the different levels of stock to be fixed by the store keeper for the purpose of material control. MAXIMUM LEVEL: This is the level above which the stock should not be allowed to exceed at any time. This is fixed by taking into account the following factors: 1) Availability of capital. 2) Storage space available. 3) Rate of consumption of material. 4) Seasonal price fluctuations. 5) EOQ 6) Possibility of change in fashion. 7) Government restrictions as in the case of explosive materials. 8) The cost of maintenance. 9) Time required to obtain fresh supply of material. Formula: Maximum level= Reorder Level + Reorder Quantity â&#x20AC;&#x201C; (Minimum Consumption x Minimum Reorder Period) MINIMUM LEVEL (SAFETY STOCK) This is the level below which stock should not be allowed to fall at any time. If the stock goes below this level, there is a danger of stoppage of production for want of materials. This level is fixed by taking into account the following factors: 1. Rate of consumption of material 2. Time required to obtain fresh supply of material 3. Re-order level Formula: Minimum level = Reorder Level â&#x20AC;&#x201C; (Normal Consumption x Normal Reorder Period) REORDER LEVEL /ORDERING LEVEL (= WHEN TO ORDER) This is the level at which a new order for material is to be placed by the store keeper. In other words, this is the level at which a purchase requisition is made out. It is fixed in between maximum level and minimum level to ensure that the stock on hand does not fall below the minimum level before the receipt of order material. This level is fixed by taking into account the following factors:

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1. Rate of consumption of material 2. Minimum level 3. Delivery time 4. Variation in delivery time Formula: Re-order Level = Maximum Consumption x Maximum Reorder Period DANGER LEVEL: This is fixed below Minimum level. When the stock reaches this level, urgent action for purchase of material is taken. Formula: Danger level = Minimum Rate of Consumption x Emergency Delivery Time. AVERAGE STOCK LEVEL: This level indicates the average stock held by the firm. It is calculated as follows: Formula: Minimum Level + Â˝ of Reorder Quantity (or) (Maximum Level + Minimum Level) 2 Economic Order Quantity (EOQ) It is not a stock level. It is the ideal quantity of materials to be purchased at any time. If purchases are made in large quantities, the cost of holding the stock will be higher but the cost of purchasing would be less.

On the other hand, if purchases are made in small

quantities the cost of holding the stock will be less while the cost of purchasing would be high. Therefore the most economical size of order is that the costs of purchasing as well as the costs of holding will be at the minimum.

The EOQ is fixed in such a manner as to minimize the cost of ordering and carrying stock Ordering cost: These arise out of the following factors. a) Rent for the purchasing department. b) The salaries and wages of the staff in the department. c) The depreciation on the equipment and furniture. d) Postage and telephone bills. e) Stationery, travelling expenses and other consumables required by the staff. Inventory carrying cost: These arise out of the following factors: a) Loss of interest on the capital invested in materials. b) Rent for the storage space. c) Salaries of the store keeping department. d) Any loss due to pilferage and deterioration. e) Stores insurance charges. f)

Stationary etc used by the stores.

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g) Taxes on inventories. EOQ is also known as standard order quantity, optimum quantity or economic lot size. As number of units per order is increased, ordering costs are reduced but at the same time carrying costs are increased as quantity of material kept in stores increases. With the equalization of ordering and carrying costs, the EOQ will be ascertained where the total cost of inventory will be minimum.

EOQ =

2AB CS

A=Annual Consumption or usage of Materials in Units B=Buying Cost per order C=Cost per unit S=Storage and Carrying Cost per Annum

Problem.No.8 From the following particulars calculate (a) Re-order level (b) Minimum level (c) Maximum level Normal usage 100 units per day Minimum usage-50 units per day Maximum usage-150 units per day Reorder quantity 400 units Re-order period-6 to 8 days Solution: Re-order Level = Maximum Consumption x Maximum Reorder Period = 150 x 8 = 1200 units

Minimum level = Reorder Level – (Normal Consumption x Normal Reorder Period) =1200 – ( 100 x 7 ) = 1200 – 700 = 500 units

Maximum level= Reorder Level + Reorder Quantity – (Minimum Consumption x Minimum Reorder

Period)

= 1200 +400 – (50 x 6) = 1600 – 300 = 1300 units

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Problem.No.9 The cost of goods sold of E.S.P limited is Rs.5,00,000. The opening inventory id Rs.40,000 and the closing inventory id Rs.60,000. Find out inventory turnover ratio. Solution: Inventory Turnover Ratio =

Cost of goods sold Average inventory at cost

= .

5,00,000

40,000 + 60,000 2

= 5,00,000

= 10 times

50,000

Problem.No.8 Calculate EOQ: Annual consumption 600 units Ordering cost Rs.12 per order Carrying cost 20% Price per unit Rs.20. Solution:

EOQ =

2AB CS

EOQ =

2 x 600 x 12 20 x 20%

3,600

EOQ = 60 units ABC Analysis (control according to values) ABC analysis is also known a proportional parts value analysis. Under this method (Always Better Control) efficient control of store is required to give more care on costlier items. As such, on the basis of the value of different materials, items are grouped into three categories a) High Priced Materials (A)

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b) Medium Priced Materials (B) c) Low Priced Materials (C) The materials which are costlier and form a small part of the total inventory can be grouped under A. Greater degree of care should be taken in storing and in the case of such items marked ‘A’. For these category materials, high price has to be paid and the number of such items is usually large, marked ‘C’. The materials which have moderate value may be marked ‘B’.

JUST IN TIME INVENTORY (JIT) Business concerns are giving maximum attention to reducing stock levels by establishing cordial relationship with suppliers to arrange for frequent delivery of quantities. This is called just in time purchasing. The objective of JIT purchasing is to obtain delivery of materials immediately before their use.

VED Analysis: Vital, Essential and Desirable analysis is done mainly for control of spare parts. Spares are controlled on the basis of their importance. Vital spares are crucial for production. Non availability may stop production. The ‘stock out cost’ of these spares is very high. Essential spares are spares the ‘stock out’ of which cannot be sustained for more than a few hours and cost of loss of production is high. Desirable spares are needed, but their absence for a short time may not lead to stoppage of production. Some items of spares though negligible in value may be vital for production. Such items may not be given importance under ABC analysis method which operates on value based control. Automatic Order System: This method of inventory control is done with the help of computers. Orders for fresh purchases are automatically placed when the inventory reaches ‘Order Point Quantity’ (OPQ). For each type of material, records are maintained by data processing in the form of receipts and issues. This system ensures that materials are always promptly replaced. Ordering Cycle Method: In this method, the review of materials held in stock is done in a regular cycle. The length of cycle depends on the nature of material. Materials which are expensive and essential have a shorter review cycle and Non Vital Materials have longer review cycle. At the time of review order is placed to bring the inventory to the desired level. Min-Max Method: The demand and supply method is an improvisation of Min-Max method. In the MinMax method, each item of material is fixed with its Maximum and Minimum levels. When the quantity reaches Minimum level, an order is placed for such a quantity as would make the inventory reach its Maximum level.

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Inventory Turnover Ratio: Kohler defines inventory turnover ratio as “a ratio which measures the number of times a firm’s average inventory is sold during a year”. In his view the ratio is an indicator of a firm’s inventory management efficiency.

A high inventory turn over ratio indicates fast

movement of material. A low ratio on the other hand indicates over investment and blocking up of working capital.

Input Output Ratio Analysis: This is yet another method of inventory control. Input output ratio is the ratio of the quantity of material to production and standard material content of the actual output. This is possible in industries where the product and raw material are being expressed in same quantitative measurement such as kilograms, metric tonnes, etc. The input output ratio analysis indicates whether the consumption of actual material when compared with standards is favourable or adverse. Perpetual Inventory System: The ICMA defines Perpetual Inventory as “a system of records maintained by the control department which reflects the physical movement of stocks and their correct balance”. It is clear from the above definitions that perpetual inventory system: a) Is a method or system of recording materials b) Reflects the physical movement of materials and records the balance of material after every receipt and issue c) Facilitates regular checking and avoids the need for closing down for stock taking. The records forming part of the system are: (1) Bin Card maintained by the store keeper in which all the physical quantities of receipts, issues and balances are recorded; (2) Stores Ledger Cards maintained by the costing department in which quantities as well as values of receipts, issues and balance are recorded. Physical verification of the stores is also made by a programme of ‘continuous stock taking’.

VALUATION OF INVENTORIES Q.DESCRIBE THE DIFFERENT METHODS OF PRICING OF MATERIAL ISSUES/WRITE SHORT NOTES ON FIFO, LIFO, AND WEIGHTED AVERAGE/SIMPLE AVERAGE. The purchase prices of materials fluctuate on account of changes in the product prices, buying from different suppliers and on account of quantity and discounts. Because of price fluctuations, the stock may include several lots of the same material purchased at different prices. When these materials are issued to production. It is important to consider the correct price at which these materials are changed to production. The following are the different methods of pricing the material issues: First In First Out Method (FIFO):

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Under this method, materials are issued in the order in which they are received in the store. It means that the material received first will be issued first. Advantages: 1. This method is simple to understand and easy to operate. 2. The closing stock is valued at the current market price. 3. Since issues are priced at cost, no profit or loss arises from pricing. 4. This method is made suitable in time of falling prices. 5. Deterioration and obsolescence can be avoided. Disadvantages: 1. When prices fluctuate, calculation becomes complicated; this increases the possibility of clerical error. 2. During the period of price fluctuations, material charged to jobs vary. Therefore, comparison between jobs is difficult. 3. During the period of rising prices, product costs are understated and profits are overstated. This may result in payment of higher dividend out of capital.

Last In First Out Method (LIFO): This method is opposite to FIFO.

Here materials received last are issued first.

Issues are made from the latest purchases. Advantages: 1. Issues are based on actual cost. 2. Issue price reflects current market price 3. Product cost will be based on current market price and hence will be more realistic. 4. There is no unrealistic profit or loss 5. Simple to operate if purchases are not many and prices are steadily on rising. 6. When prices are rising, this method is helpful in preparation of quotation on estimates. Disadvantages: 1. This method involves considerable clerical work 2. Under falling prices, issues are priced at lower prices and stocks are valued at higher rates. 3. Stock of material shown in the balance sheet will not reflect market price 4. Due to variation in prices, comparison of cost of similar jobs is difficult. 5. This method is not accepted by the income tax authorities.

Base Stock Method: Each business concern usually maintains a minimum quantity of material in stock. This minimum quantity is known as Base Stock. This stock will be used only when an emergency arises. This base stock is considered to be a fixed asset valued at cost price

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irrespective of the price fluctuations. The quantity in excess of this stock may be valued either by using FIFO or LIFO method. Base stock method is not an independent method. It operates in conjunction with either FIFO or LIFO. Hence the advantages and disadvantages relating to FIFO or LIFO are applicable.

Simple Average Method: The simple average is determined by adding different prices of materials in stock and dividing the total by number of prices. Quantity purchased in each lot is ignored. Advantages: 1. This method is simple to understand and easy to operate. 2. It reduces clerical work. 3. It is suitable when prices are stable. Disadvantages: 1. It does not take into account the quantities purchased. 2. The value of closing stock becomes unrealistic. 3. Material cost does not represent actual cost price. 4. When prices fluctuate, this method will give incorrect result.

Weighted Average Method: This is an improvement over the simple average method. This method takes into account both quantity and price for arriving at the average price. The weighted average is obtained by dividing the total cost of material in the stock by total quantity of material in the stock.

Advantages: 1. It gives more accurate results than simple average prices, because it considers both quantity as well as price. 2. It evens out the effect of price fluctuations. All jobs are charged at average prices. So, comparison between jobs is more easy and realistic 3. It is suitable in the case of materials subject to wide price fluctuations. 4. It is acceptable to income tax authorities Disadvantages: 1. Stock on hand does not represent current market prices 2. When large number of purchases are made at different rates, the calculation is tedious. So there are more chances of clerical error. 3. With some approximation in average price, there will be profit or loss due to over or under charging of material cost to jobs.

Highest In First Out Method (HIFO)

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Under this method, materials of the highest price are issued first. According to this method, the closing stock will be of the minimum price or as low as possible. In short, after materials purchases at highest prices are exhausted, materials purchased at the next higher price are issued. This method is suitable for cost plus contracts, but is not common.

Standard Price Method The issue price of materials is predetermined or estimated in this method. The standard price is based on market conditions, usage rate, handling facilities, storage facilities etc. the materials are priced at standard price irrespective of price paid for various purchases.

Market price method In this method the prices charged to production are not costs incurred on the materials but latest market prices. The market prices may either be replacement prices or realizable prices. The replacement prices are used for the materials which are kept in stock for use in production and realizable prices are used for the goods kept for resale. The prices of issue for materials are always the replacement prices. The actual prices paid for acquiring the materials are not considered at the time of issue of materials.

Every issue is made at

the replacement price of that day. It reflects the latest price charged to production.This methjod is a check on the efficiency of the purchasing department

Q. ENUMERATE THE ADVANTAGES/BENEFITS OF INVENTORY MANAGEMENT. a) Elimination of waste in the use of materials. b) Reduction of risk of loss on account of theft, loss, fraud etc. c) Availability of the right quality of material in time. d) Avoidance of overstocking. e) Possibility of economic buying. f)

Reviewing and revising of product design and savings in material.

g) Quick and accurate availability of data relating to stores. h) Preventions of production delays.

Q. EXPLAIN THE SIGNIFICANT PROBLEMS OF INVENTORY MANAGEMENT. The inventory theory deals with the determination of optimal procedures for the procurement of the stocks of commodities to meet future demand there are different inventory problems, each varying from situation to situation which may be summed up as under: a) Knowledge of demand, certainty ,risk and uncertainty; b) Method of obtaining a commodity; c) The decision process; d) Analytical conveniences; fixed demand distribution over a period of time or varying demand distribution; e) Time lag in receiving an order; constant time lag or probability distribution.

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An analysis of inventory problems is fundamentally based on very simple, common sense observations-that in any genuine inventory problem whatsoever, there must be opposing costs. By this, we may think simply that there is a cost associated with doing “too large “and there is a cost associated with doing “too little”. Sometimes, there are several such costs; but there must always be at least one in each direction.

REGULATION OF BANK FINANCE Traditionally, industrial borrowers enjoyed a relatively easy access to bank finance for meeting their working Capital needs. Further , the case credit arrangement, the arrangement, the principal device through which such finance has been provided is quite advantageous from the point of view of borrowers Ready availability of finance in a fairly convenient form led to, in the opinion of many informed observes of the Indian banking scene, over borrowing by industry and deprivation of other sectors. Concerned about such a distortion in credit allocation, the Reserve Bank of India(RBI) has been trying, particularly from the mid-sixties onwards. To bring a measure of discipline among industrial borrowers and to redirect credit to the priority sectors of the economy. From time to time. The RBI has been issuing guidelines and directives to the banking sector towards this end. Important guidelines and directives have stemmed from the recommendations of certain specially constituted groups entrusted with the task of examining various aspects of bank finance to industry. In particular, the following committees have

significant shaped the

regulation of bank finance for working capital in India. The Dahejia committee, the Tandon committee, the Chore Committee, and the Marathe committee. The key elements of regulation are discussed below Norms for inventory and Receivables In the Mid-seventies, the RBI accepted the norms for raw materials, stock-in-progress, finished goods and receivables that were suggested by the Tandon committee for fifteen major industries. These norms were based inter alia on company finance studies made by the Reserve

Bank of India, the process periods in different industries, discussions with

industry exports and feed back received on the interim reports. These norms represented in maximum level for holding inventory and receivable in each period From the mid-eighties onwards, special comities were set up the RBI to prescribe norms for several other industries and revise norms for some industries covered by the Tandon committee. The presently, the RBI Has a standing committee which revises norms on an on going basis. However these norms are now regarded as guidelines. Banks have a discretion to discretion to deviate from the norms, taking into account the past holding levels and other factors. Maximum Premissible Bank Finance

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The Tandon Committee had suggested three methods for determining the maximum permissible bank finance (MPBF). To describe these methods, the following notation is used.

CA = Current assets as per the norms laid down CL

= Non bank current liabilities trade credit and provision

CCA= Core current assets-this represents the permanents component of the working capital.

The methods for determining the MPBF are described below Method1

MPBF =0.75(CA-CL)

Method2

MPBF =0.75 (CA)-CL

Method3

MPBF =0.75 (CA-CCA) â&#x20AC;&#x201C; CL

To illustrate the calculation of the MPBF under three method consider the data for Ambex company Current assets

Rs (in millions)

Raw materials

Work-in-process

Finished Goods

Receivable (including bills discounted)

15 2

Other current assets Total

Calculated on the basis of the study group norms or past level, whichever are lower. Current liabilities Trade creditors

Other current liabilities

Bank borrowings (including bills discounted)

25 Total 40

The MPBF of Ambex as per the three methods is as follows. Method1

=0.75(CA-CL) =0.75(50-15) =Rs 26/25Million

Method 2

= 0.75(CA)-CL =0.75(50)-15 Rs.22.5 million

Method3

0.75(CA-CCA)-CL =0.75(50-20)-15 =Rs 7.5 million

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The second method has been adopted. Note that this method the minimum current ratio works out to be 1.33. An example will illustrate this point suppose the current assets and current liabilities(excluding banks finance)for a firm are 100 and 50 respectively. The MPBF will be. 0.75 (CL)-CA=0.75 (100) -50=25

This means that the current liabilities including MPBF will be: 50+25=75. Hence the current ratio works out to 100/75 =1.33 Forms of assistance Traditionally, banks credit to industry has been mainly in the forms of cash credit which was introduced by the Scottish bankers. Under the cash credit system, the bank barriers the responsibility of the cash management because the borrowers have the freedom determine their drawls within cash credit limit provided the bank. With a view to bringing about better discipline in the utilization of bank credit, in 1995 a ‘loan’system for delivery of bank credit was introduced. Under the new dispensation, with in the MPBF so arrived at in terms of the extant guidelines, bank/consortia/syndicates are required to restrict sanction of the cash credit limits to borrowers up to certain portion(which is currently 60 per Cent )2 of the MPBF. Where borrowers desire to avail of bank credit for the balance portion(which is currently 40 per cent) of MPBF. Or any part thereof this will be considered on merit by banks consortia/syndicates in the form of short-term loan (or loans) repayable on demand working capital purpose for a stipulated period. Banks consortia/syndicates will have the discretion to stipulate repayment of the short-term loan for working capital purpose by a borrower in instalments or by way of a “bullet” or “baloon” payment. In case the loan is repaid before the due date it will be credited the case credit account.

Information and reporting systems The current information and reporting system followed by banks has been shaped largely by the chore committed recommendations. Its key components are as follows. 1. Quarterly information system –form1 this gives (I) the estimates of production and sales for the current year and the ensuing quarter, and (II) the estimates of current assets and liabilities for the ensuing quarter. 2. Quarterly information system –form2 this gives (I) the actual production and sales during the current year and for the latest completed year and (II) the actual current assets and liabilities for the latest completed quarter. 3. Half-yearly operating systems- Form III This gives natural operating performance for the of year ended against the estimates the for the same. 4. Half yearly funds flow statements – Form III B this give the sources and uses of funds for the half year ended against the estimates for the same.

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The thrust of the information and reporting system is (I) to strengthen the partnership between borrowers and banker, (II) to give the banker a deeper insight into operations and funds requirements of the borrower, and

(III) To enable the banker to monitor closely the

performance and efficiency for the borrower. Credit Monitoring Based largely on the recommendations of the marathe Commmittee the RBI replaced its credit Authorisation Scheme by its credit monitoring arrangement in 1988. under this, RBI does post-sanction scrutiny of working capitals limits provides by the banks beyond the prescribed cut-off levels. The key issues examined in his scrutiny are •

Whether the minimum current ratio is 1.33 ?

•

Whether the estimates of sales production profit, current assets and current liabilities are in Line with past trends? If any differ, what is the justification for the deviation

•

Whether units has complied with the Chore Committee information system requirements ?

•

Whether the renewal of limits is in time.

•

Whether the bank is following the for inventory and receivable prescribed by the RBI standing committee? If the banks of the different set of norms what is the justification the same?

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UNIT-V BUDGET & BUDGETARY CONTROL INTRODUCTION:A budget is a written plan covering projected activities of a firm for a definite period of time. It is a monetary & quantitative expression of business plans & policies to be pursued in the future period of time. A budget is prepared to have effective utilization of funds & for the realization of objective as efficiently as possible.

Q.GIVE THE MEANING & DEFINITION OF i. Budget ii. Budgeting iii. Budgetary control BUDGET A Budget is a numerical statement expressing the plans, policies & goals for a definite future period. A budget is a blue print of a plan expressed in quantitative terms. It forms the basis for the budgetary control. Definition I.C.M.A. defines a budget is “A financial and / or quantitative statement, prepared prior to a defined period of time, of the policy to be pursued during that period for the purpose of attaining a given objective”.

BUDGETING Budgeting means the process of preparing budgets. In other words, it is the technique of formulating budgets or it is an art of planning. Definition “The entire process of preparing the budget is known as budgeting”.

BUDGETARY CONTROL Budgetary control is the process of preparation of budgets for various activities & comparing the budgets figures for arriving at deviations if any, which are to be eliminated in future. Thus budget is a means & budgetary control is the end result. Budgetary control is a continuous process which helps in planning & coordination. It also provides a method of control. Definition I.C.M.A. defines budgetary control as “the establishment of budgets, relating the responsibilities of executives to the requirements of a policy, & the continuous comparison of

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actual with budgets results either to secure by individual action the objectives of that policy or to provide a basis for its revision”.

Q.WHAT ARE THE ESSENTIAL FEATURES OF A BUDGET. ☺ A budget is a financial statement but it can be a statement of quantities also with or without monetary data. ☺ Budget is prepared for a particular period & it is prepared in advance. ☺ Budget is a detailed plan of the policy to be pursued during the period for which the budget is prepared. ☺ The function of the budget is to attain a specific objective.

Q. EXPLAIN THE OBJECTIVE OF BUDGETARY CONTROL. To define the goal of the enterprise. To provide long & short period plan for attaining these goals. To co-ordinate the activities of different departments. To operate various cost centres & department with efficiency & economy. To eliminate waste & increase the profitability. To estimate capital expenditure requirements of the future. To centralize the control system. To correct deviations from established standards. To fix the responsibility of various individuals in the organization. To ensure that adequate working capital is available for the efficient operation of the business. To indicate to the management as to where action is needed to solve problems without delay.

Q. DISTINGUISH BETWEEN ESTIMATES, FORECASTS & BUDGETS. An ‘estimate’ is predetermination of future events either on the basis of guess work or following scientific procedure. ‘Forecast’ is an assessment of possible future events. ‘Budget’ is planning of future events. Forecasting precedes budgeting. Effective budgeting is based on efficient forecasting. In order to prepare a budget it is essential to forecast various important variables like Sales, Selling prices, availability of materials, prices of materials, wage rates etc.

Q. DISTINGUISH BETWEEN FORECAST & BUDGET:Both budgets & forecast are foreseeing the future events. Still there are number of difference between budgets & forecast.

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FINANCE MANAGEMENT Forecasts

126 Budgets.

1. Forecasts are mostly concerned with

1. Budgets are concerned with planned

expected or probable events.

Events.

2. Generally forecasting is done for a long

2. Budgets are for a shorter, specification of

duration of time.

Time

3. Result of forecasting is planning.

3. Result of planning is budgeting.

4. Forecasting is a mere estimation.

4. Budget is a target fixed for a period.

5. Forecasting does not act are as tool of

5. Budgets are the target against which

measurement.

actuals are compared.

6. Forecasting refers to events over which

6. Purpose of budget is to control the

there is no control.

Activities.

Q. WHAT ARE THE MAIN STEPS IN BUDGETARY CONTROL? 1. Establishment of budget for each section of the organization. 2. Recording of actual performance. 3. Continuous comparison of the actual performance with the budget. 4. In case there is a difference between actual & budgeted performance, taking suitable remedial action. 5. Revision of budgets if necessary.

Q. WHAT ARE THE ESSENTIALS OF A GOOD BUDGETARY CONTROL SYSTEM? A business budget is a detailed plan covering phases of operations for a definite future period. It is laying down of policies, plans, objectives & goals set in advance by the top management for the enterprises are a whole & for each segment.

The following are the essential requisite for implementary budgetary control successfully . Top management support The budgetary control system have continuous support of top management which can ensure its all round acceptance. Clearly defined organizational structure The authority and responsibility are to be properly defined to pin point the responsibility of specific individuals in key positions. Efficient Accounting System The accounting system should provide the required information in time. Reporting of deviations Efficient system has to be devised to reduce the difference between the budgets and actual performance . Motivation

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Staffs are to be appraised of the budgets and benefits they are going to derive directly or indirectly Realistic targets The targets set should be realistic so that they are achievable and budgets should not frustrate the workers by fixing unrealistic targets. Participation of all departments concerned Budgets are to be set for all the departments so that their participation in implementation will be effective. Flexibility Budgets are prepared on the basis of certain conditions. If there is change in the conditions budgets also should be adjusted to accommodate the changes.

Q. BRIEFLY DISCUSS THE STEPS IN THE INSTALLATION OF A SYSTEM OF BUDGETARY CONTROL. The following steps should be taken in a sound system of budgetary control.

1. Organization Chart: There should be a well defined organization chart for budgetary control. This will show the authority & responsibility of each executive.

2. Budget Centre: A budget centre is that a part of the organization for which the budget is prepared. A budget centre may be a department or a section of a department. (e.g., Production department or Purchase section). The establishment of budget centre is essential for covering all Parts of the Organization. The budget centre are also necessary for cost control purpose. The evaluation of performance becomes easy when different centres are established. 3. Budget Committee: In small companies, the budget is prepared by cost accountant. But in big companies the budget is prepared by the committee. The budget committee consists of a chief executive or managing director, budget officer & the managers of various departments. The managers of various departments prepare their budgets & submit them to their committee. The committee will make their necessary adjustments, co-ordinates all the budgets & prepare a Master budget. The main functions of the committee are 1. To receive & scrutinize all budgets. 2. To decide the policy to be followed. 3. To suggest revision of functional budgets wherever necessary. 4. To approve the finally revised budget. 5. To prepare the Master Budget after functional Budgets are approved. 6. To coordinate the budget programme.

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7. To study variations of actual performance from the Budget. 8. To recommend corrective action if and when required. 4. Budget Manual:Budget manual is a book which contains the procedure to be followed by the executives concerned with the budget. It guides the executive in preparing various budgets. It is the responsibility of the budget officer to prepare and maintain the manual. The budget manual may contain the following particulars:A Brief explanation of the objectives and principles of budgetary control. Duties and powers of the budget officer. Functions and duties of the budget committee. Budget period. Accounts classification. Reports, Statements, Forms and Charts to be used. Procedure to be followed for obtaining approval. 5. Budget Period:Budget period is the length of time for which a budget is prepared and employed. It may be different in the same Industry or business. The budget period depends upon the following factors. 1. The type of Budget, whether it is a sales Budget, Production Budget, Raw Material Budget or Capital expenditure Budget. A Capital Budget may be for a long period. i.e. 3 to 5 years. Purchase & sales Budget may be for one year. 2. The nature of the demand for the product. 3. The timing for the availability of finance. 4. .The length of the trade cycle. All the above factors are taken into account by fixing the budget period. 6. Key Factor:It is also known as limiting factor or governing factor or principal factor . Key factor is one which restricts the volume of production. It may arise due to the shortage of material, labour, capital, plant capacity or sales.

It is a factor which affects all other Budgets.

Therefore the budget relating to the key factor is prepared before the other budgets are framed.

Q. WHAT ARE THE ADVANTAGES OF BUDGETARY CONTROL? Budgetary control system defines the policies & objectives of the undertaking as a whole. It co-ordinates the activities of different departments. It develops the systematic organization by establishing responsibilities & authorities to departments & executives. It leads to planned allocation of scarce resources & production facilities.

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It sets out plans of action & targets to be achieved by the departments as well as individuals. Therefore everyone knows for what he is responsible & how mush he should do for it, for which a team spirit will be developed. It promotes efficiency of & economy by creating cost conscious among employees. It helps in measuring the efficiency of departments & individuals in achieving the budget targets. It facilitates centralized control with decentralized activity. It facilitates introduction of standard costing. It acts as an internal audit by continuous scrutiny of departmental results & leads to introduction of intensive remuneration system based on performance. It reveals whether the things are moving in right direction or not by pin pointing deviation of actual results from budgets.

Q. DISCUSS THE LIMITATIONS OF BUDGETARY CONTROL. The preparation of a budget under inflationary conditions & changing government policies is really difficult.

Thus, the accurate position of the business cannot be

estimated. Accuracy in budgeting comes through experience. Hence it should not be relied on too much in the initial stages. Budget is only a management tool. It is not a substitute for management in decisionmaking. Budgeting involves heavy expenditure, which small concerns cannot afford. There will be active & passive resistance to budgetary control as it points out the efficiency or inefficiency of individuals. The success of budgetary control depends upon willing co-operation & team work. This is often lacking.

Classification and preparation of various budgets Q. BRIEFLY EXPLAIN THE DIFFERENT TYPES OF BUDGETS. A. CLASSIFICATION ACCORDING TO TIME:1. Short period budget:Long term budgets are prepared to reflect long term planning of the business. Generally, the long-term period varies between 5 to 10 years. They are prepared by top level Management. Example-Capital expenditure, R&D budgets. 2. Short term budgets:These budgets are generally for a duration of one year and are expressed in Monetary terms. 3. Current Budgets:The duration of current budgets is generally in months and weeks. These budgets are prepared for the current operation of the business.

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130 FUNCTIONAL BUDGETS

B. CLASSIFICATION ACCORDING TO FUNCTION:A functional budget is a budget which relates to any of the functions of an organization. The following are commonly used functional budgets. 1. Sales Budget:A Sales Budget is an estimate of expected sales during a budget period. It is expressed either in monetary or in quantitative terms. A Sales budget is known as a nerve centre or backbone of the enterprise. It contains information relating to sales, month wise, product wise, and area wise. This Budget is prepared by the Sales manager with the help of some top Management Staff and Executives. The Sales Budget may be classified in the following manner. 1. Products. 2. Area of Territories. 3. Salesmen or Agent. 4. Types of customers and 5. Periods (Example weekly, monthly, quarterly, half yearly, & annually)

This Budget is prepared by the sales manager taking into account by the following:1. Past sales figures 2. Salesmen estimates 3. Plant capacity 4. Availabilty of raw materials 5. Seasonal Fluctuation. 6. Availability of finance. 7. Competiton. 8. Orders on Hands. 9. Other factors like political conditions government policies, etc.,

2. Production Budget:It is a Budget prepared by the production manager showing the forecast of output. The objective is to determine the quantity of production for a budgeted period. It is in quantity of units to be produced during the budget period. It is based on the sales budget. Apart from the sales budget, optimum utilization, of plant, availability of raw materials, labour are to be considered. It must avoid over work in rush seasons. It must maintain stock of finished goods.

3. Material Budget:To carry out the production satisfactorily regular supply of materials during the budget period is ensured by preparing by a Budget. In this, the decision regarding the quantity of

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materials as shown at different time during that period is followed. Only direct materials are taken into account, indirect materials are not taken into account and they are considered under overheads. The material budget helps proper planning of purchases. It shows the estimated quantities as well as the cost of raw materials required for production budget.

4. Labour Budget:It is a part of the Production budget.

The budget is prepared by the personnel

department and it shows an estimate of the requirements of labour to meet the production target on the basis of previous records and budgeted production. This budget gives detailed information relating to the number of workers, rates of wages and cost of labour hours to be employed.

5. Worker overhead budget:It sets out the estimated cost of indirect materials, indirect labour, and indirect factory expenses during the budget period in order to achieve the target. This is classified into fixed, variable and semi variable. This facilitates preparation of budgets and further department wise and subdivision to have effective control.

6. Administrative expenses budget:The budget is an estimate of administrative expenses to be incurred in the budget period. Eg. Rent, salaries, insurance etc.,

7. Selling and distribution overhead budget:This budget relates to selling and distribution of products for the budget period and is based on sales budget. It is generally prepared territory wise by the sales manager of each territory. The costs are divided into fixed, variable and semi variable and estimate is taken on the basis of past records.

8. Capital Expenditure Budget:This budget shows the estimated budget on fixed assets, land, building, plant, and machinery etc. It is a long term budget. The capital expenditure is necessitated on account of replacement of old machines, increased demand of products, expansion of industry adoption of new technological progress etc., 9. Cash Budget:This budget represents the amount of cash receipts and payments and balance during the budgeted period. It is prepared after all the functional budgets are prepared by the chief accountant either monthly or weekly giving the following hints

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It ensures sufficient cash for business requirements

It proposes arrangements to be made over draft to meet any shortage of cash.

It reveals the surplus amount and the effect of the seasonal fluctuations on cash

positions. The objective of cash budget is proper coordination of total working capital sales, investment and credit. 10. Master Budget:Finally, master budget is prepared incorporating all functional budgets. It is defined as “the summary budget incorporating the functional budget which is finally approved, adopted and employed”. The budget may take the form of budgeted profit and loss account & balance sheet. It contains Sales, production cost, cash position, debtors, fixed assets, bills payable etc. It also shows the gross and the net profits and the important accounting ratios. It has to be approved by the board of directions before it is put into operation.

C. CLASSIFICATION ACCORDING TO FLEXIBILITY:1. Fixed Budget:Fixed Budget is also called static budget. It may be defined as “a budget designed to remain unchanged irrespective of the level of activity actually attained”. This budget is most suitable for fixed expenses, which have no relation to the volume of output. It is useful for comparison with actual performance when the level of activity changes. 2. Flexible Budget:Flexible budget is also called variable budget. It may be defined as “A budget designed to change in accordance with the level of activity actually attained”. It shows estimated costs and profit at different levels of output. It facilitates comparison of actual performance with the budget at any level of output. To prepare flexible budget, all costs should be classified into fixed, variable and semi-variable.

This budget is used in the following cases:o

Where sales cannot be accurately predicted because of the nature of business.

Where the concern is suffering from shortage of materials, labour, plant capacity etc.,

Where production during the year varies from period to period, due to the seasonal nature of the industry.

Where it is difficult to forecast the demand accurately.

ZERO BASE BUDGETING Q. WHAT IS ZERO-BASE BUDGETING (ZBB) ? Zero Base Budgeting is a management technique aimed at cost reduction and optimum utilization of resource. This technique was introduced by the US department of agriculture in 1961. Peter.A. Phyrr designed its basic frame work in 1970 and popularized its

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wider use in the private sector. In 1979, President Jimmy Carter issued a mandate asking for the use of ZBB throughout the federal government agencies for controlling state expenditure. The technique has become quite popular in the US.

Meaning:The traditional technique of budgeting is to take previous year’s cost levels as a base for preparing this year’s budget. This type of budgeting assumes that allocation of funds in the past was correct. In most cases, an addition is made to the previous years figure to allow for an increase in cost. Because of this, budgets (particularly government budgets) take an upward direction inspite of declining efficiency year after year. Thus, the inefficiency of a previous year are carried forward in formulating the subsequent year’s budget. Managers tend to inflate their budget requests resulting more demand for funds. ZBB is starting from scratch. Every year is taken as a new year and previous year is not taken as the base in the preparation of budget. Rather Zero is taken as base. Something will not be allowed simply because it was allowed in the past. A manager has to justify why he wants to spend. The manager proposing an expenditure or activity has to prove that it is essential and the amounts asked for are reasonable.

Definition:Zero based budgeting is defined as “a planning and budgeting process which requires each manager to justify his entire budget required in detail from scratch (hence Zero base) and shifts the burden of proof to each manager to justify why he should spend money at all. The approach requires that all activities be analyzed in decision packages which are evaluated by systematic analysis and ranked in the order of importance.”

-Peter.A.Phyrr.

Q. ENUMERATE THE STEPS IN ZERO BASE BUDGETING. The objective of zero base budgeting should be well defined. When the objective is clear, efforts will be made to achieve that objective. A cost benefit analysis should be undertaken. The extent to which zero base budgeting is to be applied should be designed. Only those projects should be taken first where the net benefit is more compared to other projects. It helps in fixing priority on the basis of benefits and then utility.

Q. WHAT ARE THE USES OF ZBB. It enables management to allocate funds according to the jurisdiction of the programme. Priority can be fixed for various activities & funds can be allocated accordingly. It does not perpetuate inefficiency by carrying it forward to the next budgeting period.

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It improves the efficiency of the management as each manager has to justify the demand for resources. Only those activities will be undertaken which will have justification & will be essential for the business. It brings to light inflated budget allotment requests. It is well suited to such activities such as marketing, administration, servicing etc. It helps in identifying economic & uneconomic areas. Management will be able to make optimum use to resources. A list of priorities will be prepared & cost benefit analysis will be the guiding principle in fixing the priority. It is the most effective technique as it aims at finding out the best alternative use of the scarce resources of the concern.

Q. DISCUSS THE LIMITATIONS OF ZBB. 1. Time consumingZBB requires more time than the traditional budgeting as there is no basis on which estimates are to be made. Moreover the process of ZBB is lengthy & time consuming as it involves classification of decision formulation of decision packages & ranking of decision units. 2. Lack of skilled managerial personnelIt requires skilled managers at all levels of the organization. In practice, skilled managerial personnel may not be available. 3. Limited applicationIt cannot be directly applied to direct material, direct wages & overheads associated with production function. Problem.No.1 BPL Ltd. Wishes to arrange overdraft facilities with its bankers during the period April to June 2000 when it will be manufacturing mostly for stock. (a) Prepare a cash budget for the above period from the following data, indicating the extent of the bank facilities the company will require at the end of each month: Credit sales

Purchases

Wages

Rs.

February 2000

1,80,000

1,24,000

12,000

March

1,92,000

1,44,000

14,000

April

1,08,000

2,43,000

11,000

May

1,74,000

2,46,000

10,000

June

1,26,000

2,48,000

15,000

(b) 50 percent of credit sales are realized in the month following the sales and the remaining 50 per cent in the second month following. Creditors are paid in the month following the month of purchase. Wages are paid at the end of the respective month.

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Solution: BPL Ltd. Cash Budget for 3 months ending June 2000 April

May

June

Rs.

Opening balance

25,000

53,000

-----

90,000

96,000

54,000

96,000

54,000

87,000

2,11,000

2,03,000

1,41,000

14,000

11,000

10,000

1,44,000

2,43,000

2,46,000

1,58,000

2,54,000

2,56,000

53,000

(51,000)

(1,15,000)

51,000

1,15,000

Receipts: Realization from Debtors

Total

Payments: Wages Purchases

Total

Surplus or (Deficit)

------

Estimated overdraft (assumed)

53,000

-----

Closing balance

Note: It is assumed that payment of wages and for purchases are made in the following month.

Problem.No.2 Summarized below are the income and expenditure forecasts of Gemini ltd. For the month of March to August,2000. Month

Sales

Purchases

(credit)

(all credit)

March

60,000

36,000

April

62,000

May

Wages

Manufacturing

Office

Selling

expenses

9,000

4,000

2,000

4,000

38,000

8,000

3,000

1,500

5,000

64,000

33,000

10,000

4,500

2,500

4,500

June

58,000

35,000

8,500

3,500

2,000

3,500

July

56,000

39,000

9,500

4,000

1,000

4,500

August

60,000

34,000

8,000

3,000

1,500

4,500

You are given the following further information:

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(a) Plant costing Rs.16,000 is due for delivery in July payable 10% on delivery and the balance after three months. (b) Advance tax of Rs.8,000 is payable in march and June each. (c) Period of credit allowed(i) by suppliers 2 months and (ii) to customers 1 month. (d) Lag in payment of manufacturing expenses Â˝ month. (e) Lag in payment of all other expenses 1 month. st

You are required to prepare a cash budget for three months starting on 1 May, 2000 when there was a cash balance of Rs.8,000. Solution:

GEMINI LIMITED Cash budget for the quarter ended 31 July, 2000 May

June

July

Rs.

Receipts : Opening Balance

8,000

15,750

12,750

62,000

64,000

58,000

70,000

79,750

70,750

36,000

38,000

33,000

Wages

8,000

10,000

8,500

Manufacturing Expenses

3,750

4,000

3,750

Office Expenses

1,500

2,500

2,000

Selling Expenses

5,000

4,500

3,500

Debtors Total

Payments: Creditors

Advance Tax

------

8,000

------

Delivery of plant (10% payment of delivery) Total Closing Balance

------

1,600

54,250

67,000

52,350

15,750

12,750

18,400

Problem.No.3 Draw up a flexible budget for overhead expenses on the basis of the following data and determine the overhead rates at 70%, 80% and 90% plant capacity.

particulars

At 70%

At 80%

At 90%

capacity

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Variable overheads Indirect labour

12,000

Stores including spares

4,000

Power (30%, 70% variable)

20,000

Repairs and maintenance(60%fixed,40%variable)

2,000

Depreciation

11,000

Insurance

3,000

Salaries

10,000

Semi variable overheads

Fixed overhead

Total overheads

62,000

Estimated direct labour hours: 1,24,000 hrs. Solution: Flexible Budget for the period -------

At 70%

At 80%

At 90%

Capacity

Rs.

Variable Overheads: Indirect labour Stores including spares

10,500

12,000

13,500

3,500

4,000

4,500

6,000

12,250

14,000

15,750

1,200

700

800

900

11,000

3,000

10,000

-------------

------------

58,150

62,000

65,850

-------------

------------

1,08,500

1,24,000

1,39,500

Rs. 0.536

Rs. 0.500

Rs. 0472

Semi – Variable Overheads: Power – Fixed Variable Repairs and Maintenance Fixed Variable Fixed Overheads: Depreciation Insurance Salaries

Total Overheads

Estimated direct labour hours Direct labour hour rate

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Working:

Direct labour rates have been computed as follows: At 70% capacity =

Rs. 58,150 =

Re. 0.536

1,08,500 hrs. At 80% capacity =

Rs. 62,000 =

Re. 0.500

1,24,000 hrs. At 90% capacity =

Rs. 65,850

= Re. 0.472

1,39,500 hrs.

Problem.No.4 The expenses for budgeted production of 10,000 units in a factory are furnished below: Per unit(Rs) Material

Labour

Variable overheads

Fixed overheads(Rs. 1,00,000)

Variable expenses(direct)

Selling expenses(10% fixed)

Distribution expenses(20% fixed)

Administration expenses

Total cost per unit

155

Prepare a budget for production of: a)8,000 units b)6,000 units c) Indicate cost per unit at both the levels. Assume that administration expenses are fixed for all levels of production. Solution

Per

Total

Per

Total

Per

Total

Unit

Amount

Unit

Amount

Unit

Amount

Production expenses:

Rs.

Materials

70.00

7,00,000

70.00

5,60,000

70.00

4,20,000

Labour

25.00

2,50,000

25.00

2,00,000

25.00

1,50,000

Overheads

20.00

2,00,000

20.00

1,60,000

20.00

1,20,000

5.00

50,000

5.00

40,000

5.00

30,000

10.00

1,00,000

12.50

1,00,000

16.667

1,00,000

1.30

13,000

1.625

13,000

2.167

13,000

11.70

1,17,000

11.70

93,600

11.70

70,200

1.40

14,000

1.750

14,000

2.334

14,000

Direct variable exp Fixed Overheads: Selling expenses: Fixed Variable Distribution expenses: Fixed Variable

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139

5.60

56,000

5.600

44,800

5.600

33,600

5.00

50,000

6.250

50,000

8.333

50,000

155.00

15,50,000

159.425

12,75,400

166.801

10,00,800

Working:

Fixed expenses remain fixed irrespective of the level of output. Selling expenses Rs.13; Variable expenses per unit is constant. Fixed 10% (i.e., 13 x 10/100) = Rs. 1.30

For 10,000 units = 10,000 x 1.30 = Rs.13,000

Variable 90% (i.e., 13 x 90/100 )= Rs.11.70 Fixed Budget Problem.No.5 A company which supplies its output on contract basis as component to an assembling firm has a contract to supply 10,000 units of its only product during 1999. The following were the budgeted expenses and revenue. Material

Rs. 15 per unit

Wages

Rs. 10 per unit

Works expenses – (Fixed)

Rs. 40,000

Variable General expenses (all fixed)

Rs. 4 per unit Rs. 60,000, Profit is 20% on sale price. Prepare

the budget for 1999 showing the costs and profit. Master Budget Particulars

Output 10,000 units Total Rs.

Per unit

Materials

1,50,000

15.00

Wages

1,00,000

10.00

2,50,000

25.00

40,000

4.00

40,000

4.00

3,30,000

33.00

60,000

6.00

3,90,000

39.00

97,500

9.75

4,87,500

48.75

Prime cost Add: Works expenses : Fixed Variable

Works cost Add: General expenses Total cost Add: Profit 3,90,000 x 20/(100 – 20) Sales

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PERFORMANCE BUDGETING The main emphasis of budgeting is to control organizational activities and related expenditure. Budgets are mainly used in government administrative activities to control financial expenditure and much significance is laid on financial aspects. Traditional budgeting does not relate financial input and physical output. Performance budgeting is designed to overcome this limitation of traditional budgeting. The term â&#x20AC;&#x2DC;performanceâ&#x20AC;&#x2122; was originally used in the U.S.A by the first Hoover Commission in 1949 when it recommended the utilization of budgets function wise for specific programmes and different activities the emphasis of performance budgeting is incorporation of financial and physical activities. The financial and physical aspects are correlated by establishing relationship between outputs and inputs. Performance budgeting results in a budget which presents the operations of an enterprise in terms of functions, programmes, activities and projects. Performance budgeting determines targets in respect of various responsibility levels. The measurement of actual performance both in terms of physical and financial terms in relation to budgets is the main feature of performance budgeting. The important features of performance budgeting are as follows: a) Specific job or work to be executed is predetermined. b) Function wise estimation of targets both in terms of financial as well as physical aspects. c) Determination of techniques of measurement of output in relation to input.

Important elements of performance budgeting 1. Laying down of objectives: Performance budgeting involves evaluation of performance of an enterprise in the context of both specific and overall objectives of an organization. The prerequisites of the performance budgeting is to define the objectives of the enterprise. This sets the frame work for the specification of objectives for individual activities and projects. 2. Classification of activitiesAppropriate classification of activities is to be incorporated in performance budgeting. The classification is done by functions and subdivision is done into programmes, activities and projects. This classification is done to integrate physical and financial aspects of each activity and programme. 3. Fixation of standards For objective working of performance budgeting, physical targets are set for each programmes or activity and incorporation of financial estimation is also done. Efficiency of performance budgeting depends on evolving suitable work measurement units, norms, yardsticks, standards and other performance indicators. 4. Accounting systemThe performance of different activities in financial terms will be revalued by good accounting system as the accounting structure reveals function wise financial details of activities.

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5. Decentralized responsibility structure and delegationThe decentralized style of management is the essence of performance budgeting. Decentralized responsibility structure necessitates the delegation of financial power down the line commensurate with the responsibilities with the responsibilities to be carried out at different levels. 6. Performance reportingEffective reporting system is very much essential in performance budgeting. Meaningful information reporting down the line is essential for decision and control. It is also essential for performance evaluation. effective reporting helps in comparison of targets with actuals and spotting of variances. On receipt of reporting of variances decisions at various levels are exercised to pin point the responsibility and taking of remedial measures. Purposes of performance budgeting: the main purposes of performance budgeting are as under: 1. To integrate physical and financial aspects of each activity and programme. 2. To improve the budgeting at various levels. 3. To facilitate performance audit and to make it more effective. 4. To compare the performance against short-term and long-term objectives.

ETHIC IN FINANCE Ethics in general is concerned with human behavior that is acceptable or "right" and that is not acceptable or "wrong" based on conventional morality. General ethical norms encompass truthfulness, honesty, integrity, respect for others, fairness, and justice. They relate to all aspects of life, including business and finance. Financial ethics is, therefore, a subset of general ethics. Ethical norms are essential for maintaining stability and harmony in social life, where people interact with one another. Recognition of others' needs and aspirations, fairness, and cooperative efforts to deal with common issues are, for example, aspects of social behavior that contribute to social stability. In the process of social evolution, we have developed not only an instinct to care for ourselves but also a conscience to care for others. There may arise situations in which the need to care for ourselves runs into conflict with the need to care for others. In such situations, ethical norms are needed to guide our behavior. "Ethics represents the attempt to resolve the conflict between selfishness and selflessness; between our material needs and our conscience." Ethical dilemmas and ethical violations in finance can be attributed to an inconsistency in the conceptual framework of modern financial-economic theory and the widespread use of a principal-agent model of relationship in financial transactions. The financial-economic theory that underlies the modern capitalist system is based on the rationalmaximizer paradigm, which holds that individuals are self-seeking (egoistic) and that they behave rationally when they seek to maximize their own interests. The principal-agent model of relationships refers to an arrangement whereby one party, acting as an agent for another,

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carries out certain functions on behalf of that other. Such arrangements are an integral part of the modern economic and financial system, and it is difficult to imagine it functioning without them. The behavioral assumption of the modern financial-economic theory runs counter to the ideas of trustworthiness, loyalty, fidelity, stewardship, and concern for others that underlie the traditional principal-agent relationship. The traditional concept of agency is based on moral values. But if human beings are rational maximizers, then agency on behalf of others in the traditional sense is impossible. The ethical dilemma presented by the problem of conflicting interests has been addressed in some areas of finance, such as corporate governance, by converting the agency relationship into a purely contractual relationship that uses a carrot-and-stick approach to ensure ethical behavior by agents. In corporate governance, the problem of conflict between management (agent) and stockholders (principal) is described as an agency problem. Economists have developed an agency theory to deal with this problem. The agency theory assumes that both the agent and the principal are self-interested and aim to maximize their gain in their relationship. A simple example would be the case of a store manager acting as an agent for the owner of the store. The store manager wants as much pay as possible for as little work as possible, and the store owner wants as much work from the manager for as little pay as possible. This theory is value-free because it does not pass judgment on whether the maximization behavior is good or bad and is not concerned with what a just pay for the manager might be. It drops the ideas of honesty and loyalty from the agency relationship because of their incompatibility with the fundamental assumption of rational maximization. Most of our needs for financial servicesâ&#x20AC;&#x201D; management of retirement savings, stock and bond investing, and protection against unfore-seen events, to name a fewâ&#x20AC;&#x201D;are such that they are better entrusted to others because we have neither the ability nor the time to carry them out effectively. The corporate device of contractualization of the agency relationship is, however, too difficult to apply to the multitude of financial dealings between individuals and institutions that take place in the financial market every day. Individuals are not as well organized as stockholders, and they are often unaware of the agency problem. Lack of information also limits their ability to monitor an agent's behavior. Therefore, what we have in our complex modern economic system is a paradoxical situation: the ever-increasing need for getting things done by others on the one hand, and the description of human nature that emphasizes selfish behavior on the other. This paradoxical situation, or the inconsistency in the foundation of the modern capitalist system, can explain most of the ethical problems and declining morality in the modern business and finance arena.

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