Unit 01

Introduction
Financial Management:
This stream of knowledge is concerned with financial decision making within a
business entity. Financial management decisions include maintaining optimum
cash balance, extending credit, mergers and acquisitions, raising of funds and the
instruments to be used for raising funds and the instruments to be used for raising
funds etc. Financial management is broadly concerned with the acquisition and
use of funds by a business firm. The scope of financial management has grown in
recent years, but traditionally it is concerned with the following:
How large should a firm be and how fast should it grow?
What should be the composition of the firms assets?
What should be the mix of the firms financing?
How should the firm analyze, plan and control its financial affairs?
Significance:
The significance of financial management is discussed as follows:
Determination of Business Success: Sound financial management leads to
optimum utilization of resources which is the key factor for successful
enterprises. If we analyze the factors which lead to an enterprise turning sick
one of the main factors would be mismanagement of financial resources.
Financial Management helps in preparation of plans for growth, development,
diversification and expansion and their successful execution.
Optimum Utilization of Resources: One of the basic objectives of financial
management is to measure the input and output in monetary terms. Since
finance managers are responsible for the allocation of resources, they are also
responsible to ensure that resources are used in an optimum manner. In fact,
the failure of business enterprise is not due to inadequacy of financial
resources, but is the result of defective management of financial resources. In
a country like India, where capital is scarce effective utilization of financial
resources is of great significance.
Focal Point of Decision Making: Financial management is the focal point of
decision-making as it provides various tools and techniques for scientific
 financial analysis. Some of the techniques of financial management are
comparative financial statement, budgets, ratio analysis, variance analysis,
cost- volume, profit analysis, etc. These tools help in evaluating the
profitability of the project.
Measurement of Performance: The performance of the firm is measured by
its financial results. The value of the firm is determined by the quantum of
earnings and the associated risk with these earnings. A financial decision
which increases earnings and reduces risk will enhance the value of the firm.
Basis of Planning, Co-ordination and Control: Each and every activity of
the firm requires resource outlays which are ultimately measured in monetary
terms. The finance department being the nodal department is closely
associated with the planning of most of the activities of the various
departments. Since most of the activities of the firm require co-ordination
among various departments, the finance department facilitates this co-
ordination by supplying the requisite information. Since the result of various
activities is measured in monetary terms, again the finance department is
closely involved in control and monitoring activities.
Advisory Role: The finance manager plays an important role in the success of
any organizations.
Information Generator for Various Stakeholders: In this modern era where
business managers are trustees of public money, it is expected that the firm
provides information to the various stakeholders about the functioning of the
firm. One of the major objectives of financial management is to provide
timely information to various stakeholders.
Objectives:
Financial management of an organization may seek to achieve the following
objectives:
Ensure adequate and regular supply of funds to the business.
Provide a fair rate of return to the suppliers of capital.
Ensure efficient utilization of capital according to the principles of
profitability, liquidity and safety.
 Devise a definite system for internal investment and financing.
Minimize cost of capital by developing a sound and economical
combination of corporate securities.
Co-ordinate the activities of the finance department with the activities of
other departments of the organization.
Generally, maximization of economic welfare of its owners is accepted as the
financial objective of the firm.
Functions:
Profit Maximization
The basic objective of every business enterprise is the welfare of its owners. It
can be achieved by the maximization of profits. Therefore, according to this
criterion, the financial decisions (investment, financing and dividend) of a
firm should be oriented to the maximization of profits (i.e. select those assets,
projects and decisions which are profitable and reject those which are not
profitable). In other words, actions that increase profits are undertaken and
those that decrease profits are to be avoided. Profit maximization as an
objective of financial management can be justified on the following grounds:
Rational.
Test of Business Performance.
Main Source of Inspiration.
Maximum Social Welfare.
Basis of Decision-Making
Drawbacks of Profit Maximization Concept:
It is vague.
It ignores time value of money.
It ignores risks.
It ignores social responsibility.
From the above description, it can be easily concluded that profit maximization
criterion is inappropriate and unsuitable as an operational objective of financial
management. In imperfect competition, the profit maximization criterion will
certainly encourage concentration of economic power and monopolistic
tendencies. That is why, the objective of wealth maximization is considered as
the appropriate and feasible objective as against the objective of profit
maximization. We shall discuss these criteria in detail and arrive at a satisfactory
conclusion to determine the goals or objectives of financial management.
Wealth Maximization
The objective of profit maximization, as discussed above, is not only vague
and ambiguous, but it also ignores the two basic criteria of financial
management i.e.
Risk and,
Time value of money.
Therefore, wealth maximization is taken as the basic objective of financial
management, rather than profit maximization. It is also known as Value
Maximization or Net Present Value Maximization. According to Ezra
Soloman of Stanford University, the ultimate objective of financial
management should be the maximization of wealth.
Prof. Irwin Friend has also supported this view. Wealth Maximization means
to maximize the net present value (or wealth) (NPV) of a course of action. It
NPV is the difference between the gross present value of the benefits of that
action and the amount of investment required to achieve those benefits. The
gross present value of a course of action is calculated by discounting or
capitalizing its benefits at a rate which reflects their timings and uncertainty.
In present day changed circumstances, wealth maximization is a better
objective because it has the following points in its favour:
It measures income in terms of cash flows, and avoids the ambiguity now
associated with accounting profits as; income from investments is
measured on the basis of cash flows rather than on accounting profits.
It recognizes time value of money by discounting the expected income of
different years at a certain discount rate (cost of capital).
It analyses risk and uncertainty so that the best course of action can be
selected from different alternatives.
 It is not in conflict with other motives like maximization of sales or market
value of shares. It helps rather in the achievement of all these other
objectives.
Therefore, maximization of wealth is the operating objective by which financial
decisions should be guided.
Basic Financial Decisions
Investment Decision
The firm has scarce resources that must be allocated among competing uses.
On the one hand the funds may be used to create additional capacity which in
turn generates additional revenue and profits and on the other hand some
investments results in lower costs. In financial management the returns, from a
proposed investment are compared to a minimum acceptable hurdle rate in
order to accept or reject a project. The hurdle rate is the minimum rate of
return below which no investment proposal would be accepted. In financial
management we measure (estimate) the return on a proposed investment and
compare it to minimum acceptable hurdle rate in order to decide whether or
not the project is acceptable. The hurdle rate is a function of riskiness of the
project, riskier the project higher the hurdle rate. There is a broad argument
that the correct hurdle rate is the opportunity cost of capital. The opportunity
cost of capital is the rate of return that an investor could earn by investing in
financial assets of equivalent risk.
Financing Decision:
Another important area where financial management plays an important role
is in deciding when, where, from and how to acquire funds to meet the firms
investment needs. These aspects of financial management have acquired
greater importance in recent times due to the multiple avenues from which
funds can be raised. Some of the widely used instruments for raising finds are
ADRs, GDRs, ECBs Equity Bonds and Debentures etc. The core issue in
financing decision is to maintain the optimum capital structure of the firm that
is in other words, to have a right mix of debt and equity in the firms capital
structure. In case of pure equity firm (Zero debt firms) the shareholders
 returns should be equal to the firms returns. The use of debt affects the risk
and return of shareholders. In case, cost of debt is used the firms rate of
return the shareholders return is going to increase and vice versa. The change
in shareholders return caused by change in profit due to use of debt is called
the financial leverage.
Dividend Decision:
A Dividend decisions is the third major financial decision. The share price of
a firm is a function of the cash flows associated with the share. The share
price at a given point of time is the present value of future cash flows
associated with the holding of share. These cash flows are dividends. The
finance manager has to decide what proportion of profits has to be distributed
to the shareholders. The proportion of profits distributed as dividends is called
the dividend payout ratio and the retained proportion of profits is known as
retention ratio. The dividend policy must be designed in a way, that it
maximizes the market value of the firms share. The retention ratio depends
upon a host of factors the main factor being the existence of investment
opportunities. The investors would be indifferent to dividends if the firm is
able to earn a rate or return which is higher than the cost of the capital.
Dividends are generally paid in cash, but a firm may also issue bonus shares.
Bonus share are shares issued to the existing shareholders without any charge.
As far as dividend decisions are concerned the finance manager has to decide
on the question of dividend stability, bonus shares, retention ratio and cash
dividend.
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Unit 02
Analysis of Financial Statement
Ratio Analysis:
To evaluate the financial performance of a company, the financial ratios are used
as a very sophisticate tool. But, the type of analysis varies according to the
specific interests of the party involved. External members and creditors are
interested primarily in the liquidity of a firm. Their claims are short term, and the
ability of a firm to pay these claims is best judged by means of a thorough
analysis of its liquidity. The claims of bondholders, on the other hand, are long
term. Accordingly, they are more interested in the cash-flow ability of the
company to service debt over the long run. The bondholder may evaluate this
ability by analyzing the capital structure of the firm, the major sources and uses
of funds, its profitability over time, and projections of future profitability.
Types of Ratios:
Financial ratios can be grouped into five types: liquidity, debt, profitability,
coverage, and market-value ratios. No one ratio gives us sufficient information by
which to judge the financial condition and performance of the firm. Only when
we analyze a group of ratios we are able to make reasonable judgments. We must
be sure to take into account any seasonal character of a business. Underlying
trends may be assessed only through a comparison of raw figures and ratios at the
same time of year.
Financial ratios can be broadly classified into three groups:
Liquidity ratios,
Turnover Ratios
Leverage/Capital structure ratio, and
Profitability ratios.
Liquidity Ratios:
Liquidity refers to the ability of a firm to meet its financial obligations in the
short-term which is less than a year. Certain ratios, which indicate the liquidity of
a firm, are;
Current Ratio,
Acid Test Ratio,
It is based upon the relationship between current assets and current liabilities.

The current ratio measures the ability of the firm to meet its current liabilities
from the current assets. Higher the current ratio, greater the short-term solvency
(i.e. larger is the amount of rupees available per rupee of liability).
Quick assets are defined as current assets excluding inventories and prepaid
expenses. The acid-test ratio is a measurement of firms ability to convert its
current assets quickly into cash in order to meet its current liabilities. Generally
speaking 1:1 ratio is considered to be satisfactory.
Turnover Ratios:
Turnover ratios measure how quickly certain current assets are converted into
cash or how efficiently the assets are employed by a firm. The important turnover
ratios are:
Inventory Turnover Ratio,

Where, the cost of goods sold means sales minus gross profit. Average
Inventory refers to simple average of opening and closing inventory. The
inventory turnover ratio tells the efficiency of inventory management, higher the
ratio, much the efficiency of inventory management.
Debtors Turnover Ratio,

The ratio shows how many times accounts receivables (debtors) turn over during
the year. If the figure for net credit sales is not available, then net sales figure is
to be used, higher the debtors turnover, the greater the efficiency of credit
management.
Average Collection Period,

Average Collection Period represents the number of days worth credit sales that
is locked in debtors (accounts receivable). Please note that the Average
Collection Period and the accounts Receivable (Debtors) Turnover are related as
follows:

Fixed Assets Turnover Ratio:

Fixed Assets turnover ratio measures sales per rupee of investment in fixed
assets. In other words, how efficiently fixed assets are employed. Higher ratio is
preferred. It is calculated as follows:
Net Sales or Net Sales
Fixed Assets Total Assets
Leverage/Capital structure ratio:
Long term financial strength or soundness of a firm is measured in terms of its
ability to pay interest regularly or repay principal on due dates or at the time of
maturity. Such long term solvency of a firm can be judged by using leverage or
capital structure ratios.
Broadly there are two sets of ratios:
First, the ratios based on the relationship between borrowed funds and owners
capital which are computed from the balance sheet. Some such ratios are: Debt to
Equity and Debt to Asset ratios.
Second set of ratios which are calculated from Profit and Loss Account is: The
interest coverage ratio and debt service coverage ratio are coverage ratio to
leverage risk.
Debt-Equity ratio reflects relative contributions of creditors and owners to
finance the business.
Total Debt or Long Term Debt
Total Equity Shareholders Fund
Interest Cover Ratio:
Interest
Earnings before interest and tax
Higher the interest coverage ratio better is the firms ability to meet its interest
burden. The lenders use this ratio to assess debt servicing capacity of a firm.
Profitability Ratio:
Profitability and operating/management efficiency of a firm is judged mainly by
the following profitability ratios:
Gross Profit and Net Profit
Net Sales Net Sales
Return on Capital Employed:
Net Profit after Tax
Capital Employed
Capital Employed = Total Assets Current Liabilities.
Return on Capital Shareholders Fund/ Net Worth:
Net Profit after Tax
Shareholders Fund
Shareholders Fund= Share Capital + Reserves and Surplus.
Earnings per Share (EPS):
EPS measures the profit available to the equity shareholders per share, that is, the
amount that they can get on every share held. It is calculated by dividing the
profits available to the shareholders by number of outstanding shares. The profits
available to the ordinary shareholders are arrived at as net profits after taxes
minus preference dividend. It indicates the value of equity in the market.
E.P.S. = Profit after Tax and Dividend
No. of Equity Shares
P/E (Price Earnings Ratio):
The lower the ratio the cheaper the stock and vice versa theoretically, there may
be other practical aspects as well which may be necessary before final analysis.
P/E = Market Price per Share
Earnings per Share

Cash Flow Analysis:

Cash plays a very important role in the economic life of a business. A firm needs
cash to make payment to its suppliers, to incur day-to-day expenses and to pay
salaries, wages, interest and dividends etc. In fact, it is the life blood for an
enterprise. Thus, it is very essential for a business to maintain an adequate
balance of cash. Cash Flow Statement deals with flow of cash which includes
cash equivalents as well as cash. This statement is additional information to the
users of Financial Statements. The statement shows the incoming and outgoing of
cash. The statement assesses the capability of the enterprise to generate cash and
utilize it. A Cash-Flow statement may be defined as a summary of receipts and
disbursements of cash for a particular period of time. It also explains reasons for
the changes in cash position of the firm. Cash Flows are inflows and outflows of
cash and cash equivalents.
The statement of cash flow shows three main categories/ components of cash
inflows and cash outflows, namely: operating, investing and financing activities.
1. Operating activities are the principal revenue generating activities of the
enterprise.
2. Investing activities include the acquisition and disposal of long-term assets
and other investments not included in cash equivalents.
3. Financing activities are activities that result in change in the size and
composition of the owners capital (including Preference share capital in the
case of a company) and borrowings of the enterprise.
Objectives:
The statement of cash flow serves a number of objectives which are as follows:
Cash flow statement aims at highlighting the cash generated from
operating activities.
Cash flow statement helps in planning the repayment of loan schedule and
replacement of fixed assets, etc.
Cash is the centre of all financial decisions. It is used as the basis for the
projection of future investing and financing plans of the enterprise.
Cash flow statement helps to ascertain the liquid position of the firm in a
better manner. Banks and financial institutions mostly prefer cash flow
statement to analyze liquidity of the borrowing firm.
Cash flow Statement helps in efficient and effective management of cash.
The management generally looks into cash flow statements to understand
the internally generated cash which is best utilized for payment of
dividends.
Cash Flow Statement based on AS-3 (revised) presents separately cash
generated and used in operating, investing and financing activities.
It is very useful in the evaluation of cash position of a firm.
Unit 03
Leverage Analysis
LEVERAGES
The term Leverage in general refers to a relationship between two interrelated
variables. In financial analysis it represents the influence of one financial variable
over some other related financial variable. Variables may be costs, output, sales,
EBIT, EPS, etc.
Commonly used measures of leverage in Financial Analysis are:
1. Operating Leverage
2. Financial Leverage
3. Combined Leverage
Leverage provides the framework for financing decisions of a firm. It may be
defined as the employment of an asset or source of funds for which the firm has
to pay a fixed cost, or fixed return.
The best mixture of source of funds decides about the capital structure of the
firm. The desired structure of the funds influences the shareholders return and
risk.
Leverage analysis is the technique used by business firms to quantify a risk-
return relationship of different alternative capital structure.
Impact of Leverage:
An increase in sales improves net profit ratio, raising ROI to a higher level. Raise
in Capital Turnover must be supported by adequate capital base. Normally, as
Capital Turnover ratio increases, Working Capital ratio deteriorates.
When turnover/activity increases without corresponding rise in Working Capital,
the Working Capital becomes tight.
Operating Leverage:
Refers to the extent to which the firm has fixed operating costs. A firm with high
operating leverage will have relatively high fixed costs in comparison with a firm
with low operating leverage.

DOL = %Change in EBIT Or Increase in EBIT

% Change in Sales EBIT Increase in Sales
= (Sales V)
EBIT
Firms ability to use fixed operating costs to magnify effects of changes in sales
on its earnings before increase and taxes.
Increase or Decrease in sales level effects change EBIT. The effect of change in
sales on the level of EBIT is measured by operating leverage.
Operating Leverage occurs when a firm has fixed costs, which must be met
regardless of volume of sales, When the firm, has fixed costs, the % change in
profits due to change in sales level in greater than the % change in sales.
The operating Leverage of 1.2 means that 1% increase in sales would result into
1.2% increase in operating profit.
Percent increase in EBIT is (48%) and percent increase in sales in (40%). It
means that for every increase of 1% in sales level, the % increase in EBIT would
be 1.2 times 48/40.
If no fixed costs TC is VC. EBIT varies in direct proportion to sales.
Significance of Operating Leverage:
It tells the impact of changes in sales on operating Income. A concern having
higher D.O.L. can experience a magnified effect on EBIT, for even a small
change in Sales level can dramatically change / effect operating profit. If
operating leverage is high, it means that break -even point will be reached at a
higher level of sales and the margin safety is low.
Financial Leverage:
Finance Leverage is related to the financing activities of the firm. It results from
the presence of fixed financial charge.
Financial leverage is defined as the ability of a firm to use fixed financial changes
to magnify the effect of changes in EBIT/Operating profits, on the firms EPS.
Financial leverage refers to the extent to which the firm has fixed financing costs
arising from the use of debt capital.
A firm with high financial leverage will have relatively high fixed financing costs
compared to a firm with low financial leverage.
Fixed finance changes do not vary with EBIT. Have to be paid regardless of
amount of EBIT available. Balance belongs to shareholders.
The effect of changes is operating profit. EBIT on the level of EPS is measured
by FL.
 % changes in EPS or Increase in EPS/EPS
% change in EBIT Increase in EBIT/EBIT.
The FL is favorable when the firms earn more on the investment/assets financed
by the sources having fixed charges. Shareholders gain in a situation where the
company earns a high rate of return and pays a lower rate of return to the supplier
of long-term funds. FL is such easer is also called Trading on Equity.
Combined Leverage:
The Combined Leverage measures the effect of a % change in sales on % change
in EPS.
C.L = OL x FL
= % Change in EBIT X % Change in EPS
% Change in Sales % Change in EBIT
= % Change in E.P.S.
% Change in Sales
It indicates the effect that sales changes will have on EPS.
Significance:
The ratio of contribution to EBT, given by CL shows the combined effect of FL
and OL.
A high Operating and Financial Leverage Combination is very risky. If the
company is producing and selling at a high level, it will make extremely high
profit for it and shareholders. But even a small fall in the level of operation would
result in tremendous fall in EPS. Proper Balance should be maintained.
A high OL and low FL indicate that management is careful since the higher
amount of risk involved in high OL has been sought to be balanced by low
FL. Preferable situation will be low OL and high FL. Low FL results in
equivalent B-E sales.
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Unit 04
Investment Decisions

Time Value of Money:

A finance manager is required to make decisions on investment, financing and
dividend in view of the company's objectives. The decisions as purchase of assets
or procurement of funds i.e. the investment/financing decisions affect the cash
flow in different time periods. Cash outflows would be at one point of time and
inflow at some other point of time; hence, they are not comparable due to the
change in rupee value of money. They can be made comparable by introducing
the interest factor. In the theory of finance, the interest factor is one of the crucial
and exclusive concepts, known as the time value of money.
Time value of money means that worth of a rupee received today is different
from the same received in future. The preference for money now as compared to
future is known as time preference of money. The concept is applicable to both
individuals and business houses.
Reasons of time preference of money:
Risk:
There is uncertainty about the receipt of money in future.
Preference for present consumption:
Most of the persons and companies have a preference for present consumption
may be due to urgency of need.
Investment opportunities:
Most of the persons and companies have preference for present money because of
availabilities of opportunities of investment for earning additional cash flows.
Importance of time value of money:
The concept of time value of money helps in arriving at the comparable value of
the different rupee amount arising at different points of time into equivalent
values of a particular point of time, present or future. The cash flows arising at
different points of time can be made comparable by using any one of the
following:
By compounding the present money to a future date i.e. by finding out the
value of present money.
By discounting the future money to present date i.e. by finding out the
present value (PV) of future money.
Techniques of compounding:
Future value (FV) of a single cash flow:
The future value of a single cash flow is defined as:
FV = PV (1 + r)n
Where, FV = future value
PV = Present value
r = rate of interest per annum
n = number of years for which compounding is done.
If any variable, i.e. PV, r, or n varies, then FV also varies. It is very tedious to
calculate the value of (1 + r)n, so, different combinations are published in the
form of tables. These may be referred for computation; otherwise one should use
the knowledge of logarithms.
Future value of an annuity:
An annuity is a series of periodic cash flows, payments or receipts, of equal
amount. The premium payments of a life insurance policy, for instance are an
annuity. In general terms the future value of an annuity is given as:
FVAn = A * ([(1 + r)n - 1]/r) Where,
FVAn = Future value of an annuity which has duration of n years.
A = Constant periodic flow
r = Interest rate per period
n = Duration of the annuity
Thus, future value of an annuity is dependent on 3 variables, they being, the
annual amount, and rate of interest and the time period, if any of these variable
changes it will change the future value of the annuity. A published table is
available for various combination of the rate of interest 'r' and the time period 'n'.
Techniques of discounting:
Present value of a single cash flow:
The present value of a single cash flow is given as:
PV = FVn (1) n
1+r
Where,
FVn = Future value n years hence
r = rate of interest per annum
n = number of years for which discounting is done.
From above, it is clear that present value of a future money depends upon 3
variables i.e. FV, the rate of interest and time period. The published tables for
various combinations of (1) n are available.
1+r
Present value of an annuity:
Sometimes instead of a single cash flow, cash flows of same amount is received
for a number of years. The present value of an annuity may be expressed as
below:
PVAn = A/(1 + r)1 + A/(1 + r)2 + ................ + A/(1 + r)n-1 + A/(1 + r)n
= A [1/(1 + r)1 + 1/(1 + r)2 + ................ + 1/(1 + r)n-1 + 1/(1 + r)n ]
= A [ (1 + r)n - 1]
r(1 + r)n
Where,
PVAn = Present value of annuity which has duration of n years
A = Constant periodic flow
r = Discount rate.
Meaning of Capital Budgeting
Capital expenditure budget or capital budgeting is a process of making decisions
regarding investments in fixed assets which are not meant for sale such as land,
building, machinery or furniture.
The word investment refers to the expenditure which is required to be made in
connection with the acquisition and the development of long-term facilities
including fixed assets. It refers to process by which management selects those
investment proposals which are worthwhile for investing available funds. For this
purpose, management is to decide whether or not to acquire, or add to or replace
fixed assets in the light of overall objectives of the firm.
What is capital expenditure is a very difficult question to answer. The terms
capital expenditure are associated with accounting. Normally capital expenditure
is one which is intended to benefit future period i.e., in more than one year as
opposed to revenue expenditure, the benefit of which is supposed to be exhausted
within the year concerned.
Nature of Capital Budgeting
Capital expenditure plans involve a huge investment in fixed assets.
Capital expenditure once approved represents long-term investment that
cannot be reserved or withdrawn without sustaining a loss.
Preparation of capital budget plans involve forecasting of several years
profits in advance in order to judge the profitability of projects.
It may be asserted here that decision regarding capital investment should
be taken very carefully so that the future plans of the company are not
affected adversely.
Procedure of Capital Budgeting
Capital investment decision of the firm have a pervasive influence on the entire
spectrum of entrepreneurial activities so the careful consideration should be
regarded to all aspects of financial management.
In capital budgeting process, main points to be borne in mind how much money
will be needed of implementing immediate plans, how much money is available
for its completion and how are the available funds going to be assigned tote
various capital projects under consideration. The financial policy and risk policy
of the management should be clear in mind before proceeding to the capital
budgeting process.
The following procedure may be adopted in preparing capital budget:-
Organization of Investment Proposal:
The first step in capital budgeting process is the conception of a profit making
idea. The proposals may come from rank and file worker of any department or
from any line officer. The department head collects all the investment proposals
and reviews them in the light of financial and risk policies of the organisation in
order to send them to the capital expenditure planning committee for
consideration.
Screening the Proposals:
In large organizations, a capital expenditure planning committee is established for
the screening of various proposals received by it from the heads of various
departments and the line officers of the company. The committee screens the
various proposals within the long-range policy-frame work of the organization. It
is to be ascertained by the committee whether the proposals are within the
selection criterion of the firm, or they do no lead to department imbalances or
they are profitable.
Evaluation of Projects:
The next step in capital budgeting process is to evaluate the different proposals in
term of the cost of capital, the expected returns from alternative investment
opportunities and the life of the assets with any of the following evaluation
techniques:-
Degree of Urgency Method (Accounting Rate of return Method)
Pay-back Method
Return on investment Method
Discounted Cash Flow Method.
Establishing Priorities:
After proper screening of the proposals, uneconomic or unprofitable proposals
are dropped. The profitable projects or in other words accepted projects are then
put in priority. It facilitates their acquisition or construction according to the
sources available and avoids unnecessary and costly delays and serious cot-
overruns. Generally, priority is fixed in the following order.
Current and incomplete projects are given first priority.
Safety projects ad projects necessary to carry on the legislative
requirements.
Projects of maintaining the present efficiency of the firm.
Projects for supplementing the income
Projects for the expansion of new product.
Final Approval:
Proposals finally recommended by the committee are sent to the top management
along with the detailed report, both o the capital expenditure and of sources of
funds to meet them. The management affirms its final seal to proposals taking in
view the urgency, profitability of the projects and the available financial
resources. Projects are then sent to the budget committee for incorporating them
in the capital budget.
Evaluation:
Last but not the least important step in the capital budgeting process is an
evaluation of the programme after it has been fully implemented. Budget
proposals and the net investment in the projects are compared periodically and on
the basis of such evaluation, the budget figures may be reviewer and presented in
a more realistic way.

Significance of capital budgeting

The key function of the financial management is the selection of the most
profitable assortment of capital investment and it is the most important area of
decision-making of the financial manger because any action taken by the manger
in this area affects the working and the profitability of the firm for many years to
come.
The need of capital budgeting can be emphasized taking into consideration the
very nature of the capital expenditure such as heavy investment in capital
projects, long-term implications for the firm, irreversible decisions and
complicates of the decision making. Its importance can be illustrated well on the
following other grounds:-
Indirect Forecast of Sales:
The investment in fixed assets is related to future sales of the firm during the life
time of the assets purchased. It shows the possibility of expanding the production
facilities to cover additional sales shown in the sales budget. Any failure to make
the sales forecast accurately would result in over investment or under investment
in fixed assets and any erroneous forecast of asset needs may lead the firm to
serious economic results.
Comparative Study:
Alternative Projects Capital budgeting makes a comparative study of the
alternative projects for the replacement of assets which are wearing out or are in
danger of becoming obsolete so as to make the best possible investment in the
replacement of assets. For this purpose, the profitability of each project is
estimated.
Timing of Assets-Acquisition:
Proper capital budgeting leads to proper timing of assets-acquisition and
improvement in quality of assets purchased. It is due to ht nature of demand and
supply of capital goods. The demand of capital goods does not arise until sales
impinge on productive capacity and such situation occurs only intermittently. On
the other hand, supply of capital goods with their availability is one of the
functions of capital budgeting.
Cash Forecast:
Capital investment requires substantial funds which can only be arranged by
making determined efforts to ensure their availability at the right time. Thus it
facilitates cash forecast.
Wealth-Maximization of Shareholders:
The impact of long-term capital investment decisions is far reaching. It protects
the interests of the shareholders and of the enterprise because it avoids over-
investment and under-investment in fixed assets. By selecting the most profitable
projects, the management facilitates the wealth maximization of equity share-
holders.
Other Factors:
It assists in formulating a sound depreciation and assets replacement policy. It
may be useful n considering methods of coast reduction. A reduction campaign
may necessitate the consideration of purchasing most up to date and modern
equipment. The feasibility of replacing manual work by machinery may be seen
from the capital forecast be comparing the manual cost and the capital cost. The
capital cost of improving working conditions or safety can be obtained through
capital expenditure forecasting. It facilitates the management in making of the
long-term plans an assists in the formulation of general policy. It studies the
impact of capital investment on the revenue expenditure of the firm such as
depreciation, insure and there fixed assets.
Capital Budgeting Techniques:
Capital budgeting is the process most companies use to authorize capital
spending on long-term projects and on other projects requiring significant
investments of capital. Because capital is usually limited in its availability, capital
projects are individually evaluated using both quantitative analysis and
qualitative information. Most capital budgeting analysis uses cash inflows and
cash outflows rather than net income calculated using the accrual basis. Some
companies simplify the cash flow calculation to net income plus depreciation and
amortization. Others look more specifically at estimated cash inflows from
customers, reduced costs, and proceeds from the sale of assets and salvage value,
and cash outflows for the capital investment, operating costs, interest, and future
repairs or overhauls of equipment.
The Cottage Gang is considering the purchase of Rs150, 000 of equipment for its
boat rentals. The equipment is expected to last seven years and has an Rs5, 000
salvage value at the end of its life. The annual cash inflows are expected to be
Rs250, 000 and the annual cash outflows are estimated to be Rs200, 000.
Payback technique
The payback measures the length of time it takes a company to recover in cash its
initial investment. This concept can also be explained as the length of time it
takes the project to generate cash equal to the investment and pay the company
back. It is calculated by dividing the capital investment by the net annual cash
flow. If the net annual cash flow is not expected to be the same, the average of
the net annual cash flows may be used.

For the Cottage Gang, the cash payback period is three years. It was calculated by
dividing the Rs150, 000 capital investment by the Rs50, 000 net annual cash flow
(Rs250, 000 inflows - Rs200, 000 outflows)
The shorter the payback period, the sooner the company recovers its cash
investment. Whether a cash payback period is good or poor depends on the
company's criteria for evaluating projects. Some companies have specific
guidelines for number of years, such as two years, while others simply require the
payback period to be less than the asset's useful life.
When net annual cash flows are different, the cumulative net annual cash flows
are used to determine the payback period. If the Turtles Co. has a project with a
cost of Rs150, 000, and net annual cash inflows for the first seven years of the
project are: Rs30, 000 in year one, Rs50, 000 in year two, Rs55, 000 in year
three, Rs60, 000 in year four, Rs60, 000 in year five, Rs60, 000 in year six, and
Rs40, 000 in year seven, then its cash payback period would be 3.25 years. See
the example that follows.

The cash payback period is easy to calculate but is actually not the only criteria
for choosing capital projects. This method ignores differences in the timing of
cash flows during the project and differences in the length of the project. The
cash flows of two projects may be the same in total but the timing of the cash
flows could be very different.
Discounted Payback Period:
One of the limitations in using payback period is that it does not take into account
the time value of money. Thus, future cash inflows are not discounted or adjusted
for debt/equity used to undertake the project, inflation, etc. However, the
discounted payback period solves this problem. It considers the time value of
money; it shows the breakeven after covering such costs. This technique is
somewhat similar to payback period except that the expected future cash flows
are discounted for computing payback period.
Discounted payback period is how long an investments cash flows, discounted at
projects cost of capital, will take to cover the initial cost of the project. In this
approach, the PV of future cash inflows is cumulated up to time they cover the
initial cost of the project. Discounted payback period is generally higher than
payback period because it is money you will get in the future and will be less
valuable than money today.
Net Present Value:
Considering the time value of money is important when evaluating projects with
different costs, different cash flows, and different service lives. Discounted cash
flow techniques, such as the net present value method, consider the timing and
amount of cash flows. To use the net present value method, we need to know the
cash inflows, the cash outflows, and the company's required rate of return on its
investments. The required rate of return becomes the discount rate used in the net
present value calculation.
For the following examples, it is assumed that cash flows are received at the end
of the period.
The difference between the NPV under the equal cash flows example (Rs50, 000
per year for seven years or Rs350, 000) and the unequal cash flows (Rs350, 000
spread unevenly over seven years) is the timing of the cash flows.
Most companies' required rate of return is their cost of capital. Cost of capital is
the rate at which the company could obtain capital (funds) from its creditors and
investors. If there is risk involved when cash flows are estimated into the future,
some companies add a risk factor to their cost of capital to compensate for
uncertainty in the project and, therefore, in the cash flows.
Most companies have more project proposals than they do funds available for
projects. They also have projects requiring different amounts of capital and with
different NPVs. In comparing projects for possible authorization, companies use
a profitability index. The index divides the present value of the cash flows by the
required investment.

Decision Criteria
 If the NPV is greater than 0 (zero), accept the project.
If the NPV is lesser than 0 (zero), reject the project.
Profitability Index
Profitability index (PI) is the ratio of investment to payoff of a suggested project.
It is a useful capital budgeting technique for grading projects because it measures
the value created by per unit of investment made by the investor.
This technique is also known as profit investment ratio (PIR), benefit-cost ratio
and value investment ratio (VIR).
The ratio is calculated as follows:

If project has positive NPV, then the PV of future cash flows must be higher than
the initial investment. Thus the Profitability Index for a project with positive
NPV is greater than 1 and less than 1 for a project with negative NPV. This
technique may be useful when available capital is limited and we can allocate
funds to projects with the highest PIs.
Decision Rule:
Rules for the selection or rejection of a proposed project:
If Profit Index is greater than 1, then project should be accepted.
If Profit Index is less than 1, then reject the project
Internal rate of return
The internal rate of return also uses the present value concepts. The internal rate
of return (IRR) determines the interest yield of the proposed capital project at
which the net present value equals zero, which is where the present value of the
net cash inflows equals the investment. If the IRR is greater than the company's
required rate of return, the project may be accepted. To determine the internal
rate of return requires two steps. First, the internal rate of return factor is
calculated by dividing the proposed capital investment amount by the net annual
cash inflow. Then, the factor is found in the Present Value of an Annuity of 1
table using the service life of the project for the number of periods. Discount rate
that the factor is the closest to is the internal rate of return.
A project for Bridge, Inc., has equal net cash inflows of Rs50,000 over its seven-
year life and a project cost of Rs200,000. By dividing the cash flows into the
project investment cost, the factor of 4.00 (Rs200,000 Rs50,000) is found. The
4.00 is looked up in the Present Value of an Annuity of 1 table on the seven-
period line (it has a seven-year life), and the internal rate of return of 16% is
determined.

where P0, P1, . . . Pn equals the cash flows in periods 1, 2, . . . n, respectively; and
IRR equals the project's internal rate of return.
Decision Criteria
If the IRR is greater than the cost of capital , accept the project
If the IRR is less than the cost of capital , reject the project
These criteria guarantee that the firm earns at least its required return. Such an
outcome should enhance the market value of the firm and therefore the wealth of
its owners.
Annual Rate of Return Method:
The three previous capital budgeting methods were based on cash flows. The
annual rate of return uses accrual-based net income to calculate a project's
expected profitability. The annual rate of return is compared to the company's
required rate of return. If the annual rate of return is greater than the required rate
of return, the project may be accepted. The higher the rate of return, the higher
the project would be ranked.
The annual rate of return is a percentage calculated by dividing the expected
annual net income by the average investment. Average investment is usually
calculated by adding the beginning and ending project book values and dividing
by two.

Assume the Cottage Gang has expected annual net income of Rs5, 572 with an
investment of Rs150, 000 and a salvage value of Rs5, 000. This proposed project
has a 7.2% annual rate of return (Rs5, 572 net income Rs77, 500 average
investments).
________
Unit 05
Working Capital Management
Introduction:
Effective financial management is concerned with the efficient use of important
economic resources, namely, capital funds. The capital funds can be used to
invest in two forms like,
Fixed assets: A major portion of the capital funds used for investing in
purchase of fixed assets for permanent or long-term purposes, for the purpose
of diversification, expansion of business, renovation or modernization of plant
and machinery and research and development and
Current assets: Rest of the portion of funds needed for short-term purposes like
investing into assets for current operations of business is called working capital.
For example, one who is managing a trading business has to arrange funds
regularly for, purchase of finished stock and keeping it in storeroom, and also
find suitable customer to go for sales. On the other hand if it is a
manufacturing firm he has to arrange for funds continuously for, buying raw
materials, keeping it for some time in store, then taking it for the process of
converting into finished goods, and ultimately selling it to consumers.
Fixed asset investments Vs current asset investments:
Out of the two types of investments, investing in the current operations of the
business is more difficult and is a continuous process with more components of
assets rather than the first case where the investment is one time or long-term in
the business process. Further, purchase of fixed assets can only be by long-term
sources of funds. But both long-term as well as short-term sources of funds are
used to finance current assets.
It is flexible on the basis of season like operational cycle, production policy,
credit term, growth and expansion, price level changes, etc. Improper working
capital management can lead to business failure. Many profitable
companies fail because their management team fails to manage the working
capital properly. They may be profitable, but they are not able to pay the bills.
Therefore management of working capital is not very easy and the financial
manager takes very important role in it. Hence, the following guidelines
regarding concepts, components, types and determinants will be very useful to a
financial manager.
Concepts of Working Capital
There are two concepts of working capital namely gross concepts and net
concepts:
Gross Working Capital:
According to this concept, whatever funds are invested are only in the current
assets. This concept expresses that working capital is an aggregate of current
assets. The amount of current liabilities is not deducted from the total current
assets. This concept is also referred to as Current Capital or Circulating
Capital.
Net Working Capital:
The term net working capital can be defined in two ways:
The most common definition of net working capital is the capital required for
running day-to-day operations of a business. It may be expressed as excess of
current assets over current liabilities.
Net working capital can alternatively be defined as a part of the current assets,
which are financed with long-term funds.
Net Working Capital = Current assets Current liabilities.
Types of working capital:
Working capital can be divided into two categories on the basis of time:
1. Permanent, fixed or regular working capital,
2. Temporary, variable, fluctuating, seasonal or specified working capital.
Permanent working capital:
This refers to minimum amount of investment required in all current assets at all
times to carryout minimum level of activity. In other words, it represents the
current assets required over the entire life of the business. Tandon committee has
referred to this type of working capital as Core current assets or Hard-core
working capital.
The need for investment in current assets may increase or decrease over a period
of time according to the level of production. Some amount of permanent
working capital remains in the business in one form or another. This is
particularly important from the point of view of financing. Tandon Committee
has pointed out that this type of core current assets should be financed through
long-term sources like capital, reserves and surplus, preference share capital, term
loans, debentures, etc.
Leader in two-wheelers Hero Honda Ltd. and in four-wheelers Maruthi Udyog
Ltd. keeping their model in each type in their showrooms are typical examples of
permanent working capital.
Working capital fluctuating over time:
Depending upon the production and sales, the need for working capital over and
above permanent working capital will change. The changing working capital may
also vary on account of seasonal changes or price level changes or unanticipated
conditions. For example, raising the prices of materials, labour rate and other
expenses may lead to an increase in the amount of funds invested in the stock of
raw materials, work-in-progress as well as in finished goods. Sometimes
additional working capital may be required to face the cut-throat competition in
the market. Sometimes when the company is planning for special advertisement
campaigns organized for promotional activities or increasing the sales, additional
working capital may have to be financed. All these extra capital needed to
support the changing business activities are called temporary, fluctuating or
variable working capital.
Determination of working capital requirements:
There are no uniform rules or formulae to determine the working capital
requirements in a firm. A firm should not plan its working capital neither too
much nor too low. If it is too high it will affect profits. On the other hand if it is
too low, it will have liquidity problems. The total working capital requirements
is determined by a wide variety of factors. They also vary from time to time.
Among the various factors, the following are necessary.
1. Nature of business:
The working capital requirements of an organization are basically influenced
by the nature of its business. The trading and financial institutions require more
working capital rather than fixed assets because these firms usually keep more
varieties of stock to satisfy the varied demands of their customers. The public
utility service organizations require more fixed assets rather than working capital
because they have cash sales only and they supply only services and not products.
Thus, the amounts tied up with stock and debtors are almost nil. Generally,
manufacturing business needs, more fixed assets rather than working capital.
Further, the working capital requirements also depend on the seasonal products.
2. Size of the business: Another important factor is the size of the business.
Size of the business means scale of operation. If the operation is on a large
scale, it will need more working capital than a firm that has a small-scale
operation
3.Operating cycle: The term production cycle or manufacturing cycle
refers to the time involvement from cash to purchase of raw materials and
completion of finished goods and receipt of cash from sales. If the operating
cycle requires a longer time span between cash to cash, the requirement of
working capital will be more because of larger tie up of funds in all the
processes. If there is any delay in a particular process of sales or collection there
will be further increase in the working capital requirements. A distillery is to
make a relatively heavy investment in working capital. A bakery will have a low
working capital.
4. Production policy: The requirements of working capital are also determined
by production policy. When the demand for the product is seasonal, inventory
must be accumulated during the off-season period and this leads to more cost and
risks. These firms, which manufacture variety of goods, will have
advantages of keeping low working capital by adjusting the production
according to season.
5. Turnover of Working capital: The speed of working capital is also
influenced by the requirements of working capital. If the turnover is high, the
requirement of working capital is low and vice versa.
Working Capital Turnover = Cost of goods sold
 Working capital
6. Credit Terms: The level of working capital is also determined by credit
terms, which is granted to customers as well as available from its creditors. More
credit period allowed to debtors will result in high book debts, which leads to
high working capital and more bad debts. On the other hand liberal credit terms
available from creditors will lead to less working capital.
7. Growth and Expansion: As a company grows and expands logically, it
requires a larger amount of working capital. Other things remaining same,
growing industries need more working capital than those that are static.
8. Price level changes: Rising prices would necessitate the organization to
have more funds for maintaining the same level of activities. Raising the prices in
material, labour and expenses without proportionate changes in selling price will
require more working capital. When a company raises its selling prices
proportionally there will be no serious problem in the working capital.
9. Operating efficiency: Though the company cannot control the rising price in
material, labour and expenses, it can make use of the assets at a maximum
utilization with reduced wastage and better coordination so that the requirement
of working capital is minimized.
10. Other factors:
Level of taxes: In this respect the management has no option. If the
Government increases the tax liability very often, taxes have to be paid in
advance on the basis of the profit on the current year and this will need more
working capital.
Dividend policy: Availability of working capital will decrease if it has a high
dividend payout ratio. Conversely, if the firm retains all the profits without
dividend, the availability of working capital will increase. In practice, although
many firms earn profit, they do not declare dividend to augment the working
capital.
Significance of working capital:
The basic objective of financial management is to maximize the shareholders
wealth. This is possible only when the company increases the profit. Higher
profits are possible only by way of increasing sales. However sales do not
convert into cash instantaneously. So some amount of funds is required to meet
the time gap arrangement in order to sustain the sales activity, which is known as
working capital. In case adequate working capital is not available for this period,
the company will not be in a position to sustain stocks as it is not in a position to
purchase raw materials, pay wages and other expenses required for
manufacturing goods to be sold. Working capital, thus, is a life-blood of a
business. As a matter of fact, any organization, whether profit oriented or
otherwise, will not be able to carry on day-to-day activities without adequate
working capital.
Problems of inadequate working capital:
Proper management of working capital is very important for the success of an
enterprise. It should be neither large nor small, but at the optimum level. In
case of inadequate working capital, a business may suffer the following
problems.
1. Purchase of raw materials: Availing the cash discount from the suppliers
(creditors) or on favorable credit terms may not be available from creditors due to
shortage of funds.
For e.g. This situation arises when the suppliers supply the goods on two months
credit allowing 5% cash discount, if it is payable within the 30 days.
In the above situation, if a person buys material for Rs. 10,000 by availing the
cash discount, he has to pay only Rs 9500 [10,000 500]. This is possible only
with the help of adequate working capital.
2. Credit rating: When the financial crisis continues due to shortage of
funds , the credit worthiness of the company may be lost, resulting in poor
credit rating. E.g. a company is having the liquid assets of Rs 20,000, current
assets of Rs 30,000 and current liabilities of Rs 40,000. From the above data we
can determine the short-term solvency with the help of the following ratios 1.
Liquid ratio 0.50 and 2, Current ratio 0.75, standard ratios are 1:1 and 2:1 for
liquidity ratio and current ratio respectively. But seeing the above ratios, it shows
that the short-term solvency is very poor. This clearly shows that the company is
not in a position to repay the short-term debt. This is due to inadequate working
capital.
3. Seizing business opportunity: Due to lack of adequate working capital, the
company is not in a position to avail business opportunity during boom
period by increasing the production. This will result in loss of opportunity
profit.
4. Duration of operating Cycle: The duration of operating cycle is to be
extended due to inadequate working capital. E.g. If the companys duration of
operating cycle is 45 days when a company is having sufficient amount of
working capital, due to delay in getting the material from the suppliers and delay
in the production process, it will have to extend the duration of operating cycle.
Consequently, this results in low turnover and low profit.
5. Maintenance of plant and machinery: Due to lack of adequate working
capital, plant and machinery and fixed assets cannot be repaired, renovated,
maintained or modernized in an appropriate time. This results in non-utilization
of fixed assets. Moreover, inadequate cash and bank balances will curtail
production facilities. Consequently, it leads to low fixed assets turnover ratio.
E.g. Cost of goods sold is Rs 2,40,000 fixed assets is Rs 60,000 and average
industrial fixed assets turnover ratio is 10 times.
Fixed assets turnover ratio= Cost of sales = 2, 40,000 = 4 times
Fixed assets 60,000
When industrial average ratio is 10 times and the actual turnover ratio is 4 times,
it is understood that the fixed assets are not utilized to the maximum.
6. Higher interest: In order to account for the emergency working capital
fund, the company has to pay higher rate of interest for arranging either short-
term or long-term lo
7. Low Return on Investment (ROI): Inadequate working capital will reduce
the working capital turnover, which results in low return on investment.
8. Liquidity verses profitability: Inadequate working capital may result in
stock out of cost, reduced sales, loss of future sales, loss of customers, loss of
goodwill, down time cost, idle labour, idle production and finally results in
lower profitability.
9. Dividend policy: A study of dividend policy cannot be possible unless and
otherwise the organization has sufficient available funds. In the absence of proper
planning and control, the companys inadequate working capital will cause the
above said problems.
Working capital management under inflation:
One of the most important areas in the day-to-day management of working
capital includes all the short term assets (current assets) used in daily operations.
Such management will have more significance during the time of inflation. The
following measures can be applied to control the working capital during the
period of inflation.
Cost control: Cost control aims at maintaining the costs in accordance with the
predetermined cost. According to this concept, the management aims at
material, labour and other expenses.
Cost reduction: Cost reduction aims at exploring the possibilities of using
alternative raw materials without affecting the quality of the products by
adoptions of new technology for the improved quality of products and reducing
the cost.
Large-scale production: Within the given capacities the management can
increase the productivity by proper cost control strategy. Increased price due to
inflation may compensate with reduction in fixed cost when production is
increased.
Management cost: Since management cost is a fixed, period cost, the
maximum possible use of facilities already created must be ensured.
Operating cycle: The time gap between purchase of inventory and converting
the material into cash is known as operating cycle. The management attempts to
decrease the duration of operating cycle during inflation.
Turnover: Turnover ratio indicates how the capitals are effectively used in order
to increase the sales during the purchase period. By increasing the rate of rotation
there will be an increase in sales which in turn will increase the profit.
Turnover ratio = Sales
Capital employed
Improvement of turnover includes improvement in fixed assets turnover ratio
and working capital turnover ratio, which are elements of the capital
employed.
Capital employed = Fixed assets + working capital.
Creditors turnover ratio: It indicates the speed with which the payments are
made to credit purchases. This can be computed as follows:
Creditors payment period = Average Creditors x 365
Credit purchase
Higher creditors turnover ratio with a lower payment period shows that the
creditors are paid promptly or even earlier. During inflation the company with
help of bargaining power and good relation they can ask to increase the payment
period, trade discount, cash discount, etc.
Stock turnover ratio: A low stock turnover ratio may indicate a slow moving
inventory suffering from low sales force. On the contrary, higher stock turnover
ratio shows better performance of the company. Under this situation the
company may keep relatively small amount of funds as resources. Thus
during inflation the company tries to keep high stock turnover ratio.
Stock turnover ratio = Cost of goods sold
Average stock
This should be more during inflation than the ordinary period.
Debtors turnover: Debtors constitute an important component of the working
capital and therefore the quality of debtors to a great extent determines the
liquidity position during inflation. A higher ratio gives a lower collection period
and a low ratio gives a longer collection period. During inflation, the
management tries to keep a high turnover ratio.
Other factors: The management can try to decrease the overhead expenses like
administrative, selling and distributing expenses. Further the management
should be very careful in sanctioning any new expenditure belonging to the
cost areas. The managers should match the cash inflow with cash outflow
for future period through cash budgeting.
Negative working capital
Negative working capital is where the organization uses supplier credit or
customer prepayment to fund their day-to-day needs. Organization with negative
working capital uses the money from their customer with which to invest and to
pay suppliers. Banks and financial services, retailers, distributors, industries with
cash sales or advance payments on signature of contract are some of the firms
which may have low or negative working capital / sales % figures.
Competition is fiercest among industries with low or negative working capital /
sales % figures. Financial entry barriers are lower and these industries are easier
to expand. However, profit margins are often lower because of the competition
(but not always!) and the failure rate among such industries in developed
countries is usually higher. Banks are attracted to industries with low or
negative working capital/ sales % figure s cash and profits are more quickly.
Entrepreneurs are attracted to industries with low or negative working
capital % figures. The customers, suppliers and authors of books publishers
also want to operate to a low or negative working capital/ sales %.
OPERATING CYCLE:
This is the chronological sequence of events in a manufacturing company in
regard to working capital. We know that working capital is the excess of current
assets over current liabilities. In reality such excess of current assets over current
liabilities may be either more or less than the working capital requirement of the
company. Accordingly it is necessary to calculate the working capital of the
company. This is illustrated with an example. Such computation of working
capital requirement may also be necessary for planning increase of sales from
existing level.
The operating cycle is the length of time for a company to acquire
materials, produce the products, sell the products, and collect the proceeds from
customers. The normal operating cycle is the average length of time for a
company to acquire materials, produce the products and collect the proceeds
from customers.
Working capital is required to meet the time-gap between the raw materials and
actual realization of stocks. This time gap is technically termed as operating cycle
or working capital cycle. The operating cycle can be sub-divided into two on the
basis of the nature of the business namely trading cycle and manufacturing cycle.
Trading business does not involve any manufacturing activities. Their activities
are limited to buying finished goods and selling the same to consumers.
Therefore operating cycle requires a short time span behavior cash to cash, the
requirement of working capital will be low because very less number of
processes in the operation is given below:
In the case of trading firm the operating cycle includes time required to convert
(1) Cash into inventories
(2) Inventories into debtors
(3) Debtors into cash.
In the case of financing firm, the operating cycle is still less when
compared to trading business. Its operating cycle includes time taken for
(1) Conversion of cash into suitable borrowers
(2) Borrowers into cash.
Importance of operating cycle:
If a company can shorten the operating cycle, cash can accumulate more
quickly, and due to the time value of money, there should be a positive impact on
the share value. Holding everything else constant, an investor would prefer a
company with a short operating cycle to a similar company with a longer
operational cycle.
The formula to calculate operating cycle:
Operating cycle = Age of inventory + collection period
Net operating cycle = Age of inventory + collection period deferred payments
For calculating net operating cycle, various conversion periods may be
calculated as follows:
Raw material cycle period (RMCP)
= (Average Raw material stock/Total raw material Consumable) x 365
Working progress cycle period (WPCP)
= (Average work in progress/Total cost of Production) x 365
Finished goods cycle period (FGCP)
= (Average finished goods/Total cost of goods Sold) x 365
Accounts receivable cycle period (ARCP)
= (Average Account receivable/Total of sales) x 365
Accounts payable cycle period (APCP)
= (Average account payable/Total credit purchase) x 365
Where, Total credit purchase = cost of goods sold + ending inventory beginning
of inventory
For above calculations, the following points are essential:
1. The average value is the average of opening balance and closing balance of
the respective items. In case the opening balance is not available, only the closing
balance is taken as the average.
2. The figure 365 represents number of days in a year. Sometimes even 360
days are considered.
3. The calculation of RMCP, WPCP and FGCP the denomination is taken as the
total cost raw material consumable, total cost of production total, cost of goods
sold respectively since they form respective end products.
On the basis of the above, the operating cycle period:
Total operating cycle period (TOCP) = RMCP + WPCP + FGCP + ARCP Net
operating cycle period (NOCP) = TOCP-DP(deferred payment)(APCP)
The operating cycle for individual components are not constant in the
growth of the business. They keep on changing from time to time, particularly the
Receivable Cycle Period and the Deferred Payment. But the company tries to
retain the Net Operating Cycle Period as constant or even less by applying some
requirements such as inventory control and latest technology in
production. Therefore regular attention on the firms operating cycle for a period
with the previous period and with that of the industrial average cycle period may
help in maintaining and controlling the length of the operating cycle.
Manufacturing Cycle:
In the case of manufacturing company the operating cycle refers to the time
involvement from cash through the following events and again leading to
collection of cash.
Operating cycle of a manufacturing concern starts from cash to purchase of raw
materials, conversion of work in progress into finished goods, conversion of
finished goods into Bills Receivable and conversion of Bills Receivable into
cash. In the other words the operating cycle is the number of days from cash to
inventory to accounts receivable back to cash. The operating cycle denotes how
long cash is tied up in inventories and receivables. If the operating cycle requires
a longer time span between cash to cash, the requirement of working capital will
be more because of the huge funds required in all the process. If there is any
delay in a particular process there will be further increase in the working capital
requirement. A long operating cycle means that less cash is available to meet
short-term allegations. A distillery has to make a heavy investment in working
capital rather than a bakery, which has a low working capital.
Forecasting/estimate of working capital requirement
Working capital is the life-blood and the controlling nerve centre of a business.
No business can run successfully without adequate amount of working capital.
To avoid the shortage in working capital, an estimate of working capital
requirements should be made in advance so that arrangements can be made to
procure adequate working capital.