National Institute of Business Management

Chennai - 020

FIRST SEMESTER EMBA/ MBA

Subject : Financial Management

Attend any 4 questions. Each question carries 25 marks

(Each answer should be of minimum 2 pages / of 300 words)

1. Explain the objectives of financial management, interphase between

finance and other functions.

2. Explain the Indian Financial Systems.

3. Explain debentures as instruments for raising long-term debt capital.

4. What are Inventories? Explain.

5. Explain the different sources of cash.

6. What is cash budget and proforma balance sheet? Explain.

25 4=100 marks
1.Explain the objectives of financial management, interphase between
finance and other functions.

Meaning of Financial Management

Financial Management means planning, organizing, directing and

controlling the financial activities such as procurement and utilization of
funds of the enterprise. It means applying general management principles to
financial resources of the enterprise.
Objectives of Financial Management

The financial management is generally concerned with procurement,

allocation and control of financial resources of a concern. The objectives can
be-
1. To ensure regular and adequate supply of funds to the concern.
2. To ensure adequate returns to the shareholders which will depend
upon the earning capacity, market price of the share, expectations of
the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured,
they should be utilized in maximum possible way at least cost.
4. To ensure safety on investment, i.e, funds should be invested in safe
ventures so that adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair
composition of capital so that a balance is maintained between debt
and equity capital.

Functions of Financial Management

1. Estimation of capital requirements: A finance manager has to make
estimation with regards to capital requirements of the company. This
will depend upon expected costs and profits and future programmes
and policies of a concern. Estimations have to be made in an adequate
manner which increases earning capacity of enterprise.
 2. Determination of capital composition: Once the estimation have
been made, the capital structure have to be decided. This involves
short- term and long- term debt equity analysis. This will depend upon
the proportion of equity capital a company is possessing and
additional funds which have to be raised from outside parties.
3. Choice of sources of funds: For additional funds to be procured, a
company has many choices like-
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.

Choice of factor will depend on relative merits and demerits of each

source and period of financing.

4. Investment of funds: The finance manager has to decide to allocate

funds into profitable ventures so that there is safety on investment and
regular returns is possible.
5. Disposal of surplus: The net profits decision have to be made by the
finance manager. This can be done in two ways:
a. Dividend declaration - It includes identifying the rate of
dividends and other benefits like bonus.
b. Retained profits - The volume has to be decided which will
depend upon expansional, innovational, diversification plans of
the company.
6. Management of cash: Finance manager has to make decisions with
regards to cash management. Cash is required for many purposes like
payment of wages and salaries, payment of electricity and water bills,
payment to creditors, meeting current liabilities, maintainance of
enough stock, purchase of raw materials, etc.
7. Financial controls: The finance manager has not only to plan,
procure and utilize the funds but he also has to exercise control over
finances. This can be done through many techniques like ratio
analysis, financial forecasting, cost and profit control, etc.

Marketing-Finance Interface

There are many decisions, which the Marketing Manager takes which have a
significant location, etc. In all these matters assessment of financial
implications is inescapable impact on the profitability of the firm. For
example, he should have a clear understanding of the impact the credit
extended to the customers is going to have on the profits of the company.
Otherwise in his eagerness to meet the sales targets he is liable to extend
liberal terms of credit, which is likely to put the profit plans out of gear.
Similarly, he should weigh the benefits of keeping a large inventory of
finished goods in anticipation of sales against the costs of maintaining that
inventory. Other key decisions of the Marketing Manager, which have
financial implications, are:

 Pricing
 Product promotion and advertisement
 Choice of product mix
 Distribution policy.

Production-Finance Interface

As we all know in any manufacturing firm, the Production Manager controls

a major part of the investment in the form of equipment, materials and men.
He should so organize his department that the equipments under his control
are used most productively, the inventory of work-in-process or unfinished
goods and stores and spares is optimized and the idle time and work
stoppages are minimized. If the production manager can achieve this, he
would be holding the cost of the output under control and thereby help in
maximizing profits. He has to appreciate the fact that whereas the price at
which the output can be sold is largely determined by factors external to the
firm like competition, government regulations, etc. the cost of production is
more amenable to his control. Similarly, he would have to make decisions
regarding make or buy, buy or lease etc. for which he has to evaluate the
financial implications before arriving at a decision.

Top Management-Finance Interface

The top management, which is interested in ensuring that the firm’s long-
term goals are met, finds it convenient to use the financial statements as a
means for keeping itself informed of the overall effectiveness of the
organization. We have so far briefly reviewed the interface of finance with
the non-finance functional disciplines like production, marketing etc.
Besides these, the finance function also has a strong linkage with the
functions of the top management. Strategic planning and management
control are two important functions of the top management. Finance
function provides the basic inputs needed for undertaking these activities.

Economics – Finance Interface

The field of finance is closely related to economics. Financial managers

must understand the economic framework and be alert to the consequences
of varying levels of economic activity and changes in economic policy. They
must also be able to use economic theories as guidelines for efficient
business operation. The primary economic principle used in managerial
finance is marginal analysis, the principle that financial decisions should be
made and actions taken only when the added benefits exceed the added
costs. Nearly all-financial decisions ultimately come down to an assessment
of their marginal benefits and marginal costs.

Accounting – Finance Interface

The firm’s finance (treasurer) and accounting (controller) activities are

typically within the control of the financial vice president (CFO). These
functions are closely related and generally overlap; indeed, managerial
finance and accounting are often not easily distinguishable. In small firms
the controller often carries out the finance function, and in large firms many
accountants are closely involved in various finance activities. However,
there are two basic differences between finance and accounting; one relates
to the emphasis on cash flows and the other to decision making.
2. Explain the Indian Financial Systems.

A financial system (within the scope of finance) is a system that

allows the exchange of funds between lenders, investors, and borrowers. ...
They consist of complex, closely related services, markets, and institutions
intended to provide an efficient and regular linkage between investors and
depositors.

Functions of Financial System:

The financial system helps production, capital accumulation, and growth by

(i) encouraging savings, (ii) mobilising them, and (iii) allocating them
among alternative uses and users. Each of these functions is important and
the efficiency of a given financial system depends on how well it performs
each of these functions.

(i) Encourage Savings:

Financial system promotes savings by providing a wide array of financial
assets as stores of value aided by the services of financial markets and
intermediaries of various kinds. For wealth holders, all this offers ample
choice of portfolios with attractive combinations of income, safety and yield.

With financial progress and innovations in financial technology, the scope of

portfolio choice has also improved. Therefore, it is widely held that the
savings-income ratio is directly related to both financial assets and financial
institutions. That is, financial progress generally insures larger savings out of
the same level of real income.

As stores of value, financial assets command certain advantages over

tangible assets (physical capital, inventories of goods, etc.) they are
convenient to hold, or easily storable, more liquid, that is more easily
encashable, more easily divisible, and less risky.

A very important property of financial assets is that they do not require

regular management of the kind most tangible assets do. The financial assets
have made possible the separation of ultimate ownership and management of
tangible assets. The separation of savings from management has encouraged
savings greatly.

Savings are done by households, businesses, and government. Following the

official classification adopted by the Central Statistical Organization (CSO),
Government of India, we reclassify savers into— household sector, domestic
private corporate sector, and the public sector.

The household sector is defined to comprise individuals, non-Government,

non-corporate entities in agriculture, trade and industry, and non-profit
making organisations like trusts and charitable and religious institutions.

The public sector comprises Central and state governments, departmental

and non departmental undertakings, the RBI, etc. The domestic private
corporate sector comprises non-government public and private limited
companies (whether financial or non-financial) and corrective institutions.

Of these three sectors, the dominant saver is the household sector, followed
by the domestic private corporate sector. The contribution of the public
sector to total net domestic savings is relatively small.

(ii) Mobilisation of Savings:

Financial system is a highly efficient mechanism for mobilising savings. In a
fully-monetised economy this is done automatically when, in the first
instance, the public holds its savings in the form of money. However, this is
not the only way of instantaneous mobilisation of savings.

Other financial methods used are deductions at source of the contributions to

provident fund and other savings schemes. More generally, mobilisation of
savings taken place when savers move into financial assets, whether
currency, bank deposits, post office savings deposits, life insurance policies,
bill, bonds, equity shares, etc.

(iii) Allocation of Funds:

Another important function of a financial system is to arrange smooth,
efficient, and socially equitable allocation of credit. With modem financial
development and new financial assets, institutions and markets have come to
be organised, which are replaying an increasingly important role in the
provision of credit.

In the allocative functions of financial institutions lies their main source of

power. By granting easy and cheap credit to particular firms, they can shift
outward the resource constraint of these firms and make them grow faster.

On the other hand, by denying adequate credit on reasonable terms to other

firms, financial institutions can restrict the growth or even normal working
of these other firms substantially. Thus, the power of credit can be used
highly discriminately to favour some and to hinder others.
Structure of Indian Financial System:
Financial system operates through financial markets and institutions.

The Indian Financial system (financial markets) is broadly divided

under two heads:
(i) Indian Money Market

(ii) Indian Capital Market

The Indian money market is the market in which short-term funds are
borrowed and lent. The money market does not deal in cash, or money but in
bills of exchange, grade bills and treasury bills and other instruments. The
capital market in India on the other hand is the market for the medium term
and long term funds.
3.Explain debentures as instruments for raising long-term debt capital.

1. Introduction: Debt Capital

Debt capital is funds supplied by lender that is part of a company’s capital
structure. Debt capital usually refers to long-term capital, specifically bonds,
rather than short-term loans to be paid off within one year.
Debt capital differs from equity or share capital because subscribers to debt
capital do not become part owners of the business, but are merely creditors,
and the suppliers of debt capital usually receive a contractually fixed annual
percentage return on their loan, and this is known as the coupon rate. Debt
refers to capital that is loaned by a lender to a borrower, who is in turn
obligated (1) to repay the original amount loaned–or the principal–within a
specified time period, and (2) to pay interest on the principal.
Debt capital ranks higher than equity capital for the repayment of annual
returns. This means that legally, the interest on debt capital must be repaid in
full before any dividends are paid to any suppliers of equity.
The main source of debt capital for Indian corporate expansion has
traditionally been the strong domestic bank loan market. The existence of a
vibrant debt capital market is important from a macro-economic perspective
to provide mechanisms for greater sources of financing and liquidity and for
risk minimization in any economy. In India, while equity capital markets
have developed significantly in terms of liquidity, infrastructure and
regulatory framework, the debt capital markets have traditionally lagged
behind.
The various instruments of debt can be classified into long term, medium
term and short term debt depending on the tenure for which the amount has
been raised or the period of repayment. Apart from term loan and credit
facilities, the various instruments of debt are mentioned below.
(i) Bonds
(ii) Debenture
(iii) Equipment Financing
(iv) Deposit (including Public Deposit)
(v) Commercial Paper
(vi) Inter-corporate Debt
Mezzanine Debt is a different type of debt that typically has both debt and
equity characteristics. Mezzanine Debt carries a higher interest rate and
some form of equity options (an equity interest in the company‐ typically in
the form of stock or warrants) to drive acceptable risk‐adjusted returns.
In this article we would be discussing the legal framework for issue of
Debenture specifically and debt instrument in general.

2. Debenture

2.1 Debentures – meaning and characteristics

The Companies Act, 1956 (“Companies Act”) defines ‘debenture’ as
follows :
“debenture” includes debenture stock, bonds and any other securities of a
company, whether constituting a charge on the assets of the company or not;
In modern commercial usage, a debenture denotes an instrument issued by
the company, normally but not necessarily, called on the face of it a
debenture, and providing for the payment of, or acknowledging the
indebtedness in a specified sum, at a fixed rate, with interest thereon. It
usually, but not necessarily, gives a charge by way of security, and is often,
though not invariably, expressed to be one of a series of like debentures. But
the term as used in the modern commercial parlance is of extremely elastic
character. Following are the basic characteristics of debentures.
(i) It is a document containing an acknowledgement of indebtedness.
(ii) Debentures are issued in form of certificates.
(iii) Debenture may be secured or unsecured. Debentures need not
necessarily create a charge on the company’s assets. Section 2(12) provides
that debenture may or may not constitute a charge on the assets of the
company.
(iv) Debentures are generally issued under the common seal of the company.
(v) Debenture holders do not have any right to vote at any meeting of the
company. In terms of provisions of section 117 of the Act, no company shall,
after the commencement of this Act, issue any debentures carrying voting
rights at any meeting of the company, whether generally or in respect of
particular classes of business.
(vi) Debentures may be convertible or non-convertible.
(vii) Debentures may or may not be one of a series.
(viii) Debentures carry interest at a fixed rate.
2.2 Classification of Debenture
Debentures are classified into various types. These are redeemable,
irredeemable, perpetual, convertible, non convertible, fully, partly, secured,
mortgage, unsecured, naked, first mortgaged, second mortgaged, bearer,
fixed, floating rate, coupon rate, zero coupon, secured premium notes,
callable, puttable, etc.
Debentures are classified into different types based on their tenure,
redemption, mode of redemption, convertibility, security, transferability, type
of interest rate, coupon rate, etc. Following are the various types of
debentures vis-a-vis their basis of classification
Redemption / Tenure
Redeemable and Irredeemable (Perpetual) Debentures: Redeemable
debentures carry a specific date of redemption on the certificate. The
company is legally bound to repay the principal amount to the debenture
holders on that date. On the other hand, irredeemable debentures, also
known as perpetual debentures, do not carry any date of redemption. This
means that there is no specific time of redemption of these debentures. They
are redeemed either on the liquidation of the company or when the company
chooses to pay them off to reduce their liability by issues a due notice to the
debenture holders beforehand.
Convertibility
Convertible and Non Convertible Debentures: Convertible debenture holders
have an option of converting their holdings into equity shares. The rate of
conversion and the period after which the conversion will take effect are
declared in the terms and conditions of the agreement of debentures at the
time of issue. On the contrary, non convertible debentures are simple
debentures with no such option of getting converted into equity. Their state
will always remain of a debt and will not become equity at any point of time.
Fully and Partly Convertible Debentures: Convertible Debentures are further
classified into two – Fully and Partly Convertible. Fully convertible
debentures are completely converted into equity whereas the partly
convertible debentures have two parts. Convertible part is converted into
equity as per agreed rate of exchange based on agreement. Non convertible
part becomes as good as redeemable debenture which is repaid after the
expiry of the agreed period.
Security
Secured (Mortgage) and Unsecured (Naked) Debentures: Debentures are
secured in two ways. One when the debenture is secured by charge on some
asset or set of assets which is known as secured or mortgage debenture and
another when it is issued solely on the credibility of the issuer is known as
naked or unsecured debenture. A trustee is appointed for holding the secured
asset which is quite obvious as the title cannot be assigned to each and every
debenture holder.
First Mortgaged and Second Mortgaged Debentures: Secured / Mortgaged
debentures are further classified into two types – first and second mortgaged
debentures. There is no restriction on issuing different types of debentures
provided there is clarity on claims of those debenture holders on the profits
and assets of the company at the time of liquidation. First mortgaged
debentures have the first charge over the assets of the company whereas the
second mortgage has the secondary charge which means the realization from
the assets will first fulfill obligation of first mortgage debentures and then
will do for second ones.
Transferability / Registration
Registered Unregistered Debentures (Bearer) Debenture: In the case of
registered debentures, the name, address, and other holding details are
registered with the issuing company and whenever such debenture is
transferred by the holder; it has to be informed to the issuing company for
updating in its records. Otherwise the interest and principal will go the
previous holder because company will pay to the one who is registered.
Whereas, the unregistered commonly known as bearer debenture. can be
transferred by mere delivery to the new holder. They are considered as good
as currency notes due to their easy transferability. The interest and principal
is paid to the person who produces the coupons, which are attached to the
debenture certificate. and the certificate respectively.
Type of Interest Rates
Fixed and Floating Rate Debentures: Fixed rate debentures have fixed
interest rate over the life of the debentures. Contrarily, the floating rate
debentures have floating rate of interest which is dependent on some
benchmark rate say LIBOR etc.
No Coupon Rate
Zero Coupon and Specific Rate Debentures: Zero coupon debentures do not
carry any coupon rate or we can say that there is zero coupon rate. The
debenture holder will not get any interest on these types of debentures. Need
not to get surprised, for compensating against no interest, companies issue
them at a discounted price which is very less compared to the face value of
it. The implicit interest or benefit is the difference between the issue price
and the face value of that debenture. These are also known as ‘Deep
Discount Bonds’ .All other debentures with specified rate of interest are
specific rate debentures which are just like a normal debenture.
Secured Premium Notes / Debentures: These are secured debentures which
are redeemed at a premium over the face value of the debentures. They are
similar to zero coupon bonds. The only difference is that the discount and
premium. Zero coupon bonds are issued at discount and redeemed at par
whereas the secured premium notes are issued at par and redeemed at
premium.
Mode of Redemption
Callable and Puttable Debentures / Bonds: Callable debentures have an
option for the company to buyback and repay to the investors whereas in
case of puttable debentures, the option lies with the investors. Puttable
debenture holders can ask the company to redeem their debenture and ask
for principal repayment.
3. Legal Framework regulating Debentures in India
Primarily, debentures in India are regulated by Government of India
(“Central Govt.”), Securities Exchange Board of India (“SEBI”) and
Reserve Bank of India (“RBI”) under various legislation like, the
Companies Act, Securities Exchange Board of India Act, 1992 (“SEBI
Act”), Securities Contract Regulation Act, 1956 (“SCRA”), Reserve Bank
of India Act, 1934 (“RBI Act”), Foreign Exchange Management Act, 1999
(“FEMA”) etc. along with regulations and notifications prescribed
thereunder.
The nature of debentures issued, type of issuing company, residential status
of debenture subscribing persons etc. are the factors to determine which
regulations are applicable on such debentures.
The Company investing in the debentures have to comply with Section
372A of the Companies Act.
Any amount raised by the issue of debentures secured by the mortgage of
any immovable property of the company or with an option to convert them
into shares in the company provided that in case of such debentures secured
by the mortgage of any immovable property the amount of such debentures
shall not exceed the market value of such immovable property.
The exemption is not given if any debenture is not adequately secured by the
mortgage of any immovable property.
It has been clarified that in case of debenture which are partly convertible
into shares, only the convertible portion of the debentures is exempted in
terms of the above exemption. Even in regard to the convertible portion of
debentures, once the period of conversion is over, the unconverted portion of
debentures would acquire the character of loan and would fall within the
definition of “Deposit”, provided they are not adequately secured by
mortgage or immovable property of the company.
Unsecured debenture with an option to convert a part of them into shares of
the company concerned are not covered in rule 2(b)(x) of the Acceptance of
Deposit Rules. Further only so long as option to convert unsecured
debentures into shares remains in force such unsecured debentures shall not
be subject to discipline of Section 58-A of the Companies Act and rules
made thereunder.
(iv) Any amount received from a person who, at the time of the receipt of the
amount, was a director of the company or any amount received from a
relative of a director or its member by a private company:
Provided that the director, relative of a director or member, as the case may
be, from whom money is received, furnishes to the company at the time of
giving the money, a declaration in writing to the effect that the amount is not
being given out of funds acquired by him by borrowing or accepting from
others
This rule exempt any amount received by all companies (private as well as
public) from the definition of “Deposit”, if such amount is received from its
directors (i.e. not joint deposit with non-directors). However as regards to
amount received from a shareholder (i.e. not joint deposit with non-
shareholder) or relative of directors, this rule exempt only private companies
from the definition of “Deposit”. For any invitation and acceptance of
unsecured loans/deposits from relatives of directors and members, the public
company will have to comply with the Acceptance of Deposit Rules.
Private company is prohibited from inviting or accepting any debentures
from public. However a private company can accept debentures through
private arrangement from its members, directors and directors’ relatives.
The money received from a director continues to be treated as exempted
deposit when the person from whom money has been received ceases to be a
director of the company. But, the case is not same in case of a shareholder. If
a shareholder from whom company has received any money ceases to be a
member of the company, the exemption ceases and, thus, the amount
received from him will be considered as “Deposit” within the meaning of
section 58A.
If a private limited company accept an amount, which may be classified as
deposit under section 58A read with the Companies (Acceptance of
Deposits) Rules, 1975, it will cease its status of a private limited company
and has to make all the compliances for such deposits as per requirement of
the said rules, as well as to comply with all the provisions as may be
applicable on public limited company such as sections 58A, 58AA, 58AAA,
81, 256, 257, 198, 268, 269, Schedule XIII, 274(i)(g) 295, 297, 300, 301,
372A, etc.
Procedure for issue of Debentures
(i) Filing of Prospectus
The term ‘prospectus’ means any document described or issued as a
prospectus and includes any notice, circular, advertisement or other
document inviting offers from the public or inviting offers from the public
for the subscription or purchase of any shares in, or debentures securities of
a body corporate.
Any offer of shares or securities / debentures to the general public must be
made by issuance of the prospectus. SEBI (Issue of Capital and Disclosure
Requirements) Regulations, 2009 (“ICDR Regulations”) for issue of fresh
share capital issued by SEBI have to be followed.
Even if shares or securities / debentures are offered by the public unlisted
companies to certain selected persons, the statement in lieu of prospectus has
to be issued.
Section 58-B of the Companies Act provides that the provision of the
Companies Act relating to the prospectus shall, so far as may be, apply to an
advertisement referred to in Section 58-A.
Only a public company has power and privilege to issue prospectus to public
for subscription of shares in or debentures of the company. The prospectus
of a public company shall contain matters specified in Part I of Schedule II
of the Companies Act and shall set out the reports specified in Part II of
Schedule II to the Companies Act of a public company does not issue a
prospectus with reference to its formation then it has to file a statement in
lieu of prospectus with the concerned Registrar of Companies. A private
company cannot invite public to subscribe for its shares in or debentures,
therefore, it cannot issue prospectus.
Transfer of Debentures
The debentures in a company are movable property, transferable in the
manner provided by the articles of the Company. The definition of “goods”
in the Sale of Goods Act, 1930, specifically includes stocks and shares,
Hence it is necessary to provide by the articles the manner in which transfers
are to be affected.
In absence of specific provisions for transfer of Debentures, the regulations
in Table A of Schedule I of the Companies Act will apply.
Where the articles do not provide for the transfer of shares or debentures,
and also expressly exclude the application of the regulations in Table A of
Schedule I of the Companies Act to the company, the general law relating to
transfer of movable property will govern. But though for purposes of
transfer, a share or debenture is to be treated as movable property, it is not, in
fact, just so much a chattel as a garment or a piece of furniture. It is bound
inextricably with the company of whose share capital it is a share and carries
certain rights and obligations inseparable from the company
A company cannot refuse to accept transfer of shares or debentures except as
provided by its articles. It is well settled that unless the articles otherwise
provide, a shareholder or debenture holder has a free right to transfer his
shares to whom he chooses. It is not necessary to look to the articles of
association of the Company for power to transfer, since that power is given
by the Companies Act. It is only necessary to look to the articles of
association of the company to ascertain the mode of transfer and the
restriction upon it. Thus, a clause in the articles of association of the
company providing an absolute restriction on transfer is void
4. What are Inventories? Explain.

Inventory is the raw materials, work-in-process products and finished

goods that are considered to be the portion of a business's assets that are
ready or will be ready for sale. Inventory represents one of the most
important assets of a business because the turnover of inventory represents
one of the primary sources of revenue generation and
subsequent earnings for the company's shareholders.

Merchandise Inventory: It is the inventory of trading goods held by the

trader.

Manufacturing Inventory: It is the inventory held for manufacturing and

selling of goods. Based on the value addition or stage of completion, the
manufacturing inventories are further classified into 3 types of inventory –
Raw Material, Work-In-Progress and Finished Goods. Another type is MRO
 inventories which are to support the whole manufacturing and administrating
operation.

o Raw Materials: These are the materials or goods purchased by the

manufacturer. Manufacturing process is applied on the raw material to
produce desired finished goods. For example, aluminum scrap is used to
produce aluminum ingots. Flour is used to produce bread. Finished
goods for someone can be raw material for someone. For example, the
aluminum ingot can be used as raw material by utensils manufacturer.

The business importance of raw material as an inventory is mainly to

protect any interruption in production planning. Other reasons can be
availing price discount on bulk purchases, guard against market shortage
situation.

o Work-In-Progress (WIP): These are the partly processed raw

materials lying on the production floor. They may or may not be
saleable. These are also called semi-finished goods. It is unavoidable
inventory which will be created in almost any manufacturing business.
This level of this inventory should be kept as low as possible. Since a lot
of money is blocked over here which otherwise can be used to achieve
better returns. Speeding up the manufacturing process, proper
production planning, customer and supplier system integration etc can
diminish the levels of work in progress. Lean management considers it
as waste.

o Finished Goods: These are the final products after manufacturing

process on raw materials. They are sold in the market.
There are two kinds of manufacturing industries. One, where the
product is first manufactured and then sold. Second, where the order is
received first and then it is manufactured as per specifications. In the
first one, it is inevitable to keep finished goods inventory whereas it can
be avoided in the second one.
o Packing Material: Packing material is the inventory used for
packing of goods. It can be primary packing and secondary packing.
Primary packing is the packing without which the goods are not usable.
Secondary packing is the packing done for convenient transportation of
goods.

o MRO Goods: MRO stands for maintenance, repairs and operating

supplies. They are also called as consumables in various parts of the
world. They are like a support function. Maintenance and repairs goods
like bearings, lubricating oil, bolt, nuts etc are used in the machinery
used for production. Operating supplies mean the stationery etc used for
operating the business.

Other Types of Inventories are classified on various basis are as follows:

Materially, there are 4 types of inventories only as explained above.
Following types of inventories are either the reasons to hold those 4 basic
inventory or business requirement for the same. Some of them are suitable
strategies for certain businesses.
Goods in Transit: Under normal conditions, a business transports raw
materials, WIP, finished goods etc from one site to other for various purpose
like sales, purchase, further processing etc. Due to long distances, the
inventory stays on the way for days, weeks and even months depending on
distances. These are called Inventory / Goods in Transit. Goods in transit
may consist of any type of basic inventories.

Buffer Inventory: Buffer inventory is the inventory kept or purchased for

the purpose of meeting future uncertainties. Also known as safety stock, it is
the amount of inventory besides the current inventory requirement. The
benefit is smooth business flow and customer satisfaction and disadvantage
is the carrying cost of inventory. Raw material as buffer stock is kept for
achieving nonstop production and finished goods for delivering any size, any
type of order by the customer.
Anticipatory Stock: Based on the past experiences, a businessman is able to
foresee the future trends of the market and takes certain decisions based on
that. Expecting a price rise, a spurt in demand etc some businessman invests
money in stocking those goods. Such kind of inventory is known as
anticipatory stock. It is normally the raw materials or finished goods and this
strategy is executed by traders.

Decoupling Inventory: In manufacturing concern, plant and machinery

should always keep running. The act of stopping machinery, costs to the
entrepreneur in terms of additional set up costs, repairs, idle
time depreciation, damages, trial runs etc. The reason for halt is not always
demand of the product. It may be because of availability of input. In a
production line, one machine / process uses the output of other machine /
process. The speed of different machines may not always integrate with each
other. For that reason, the stock of input for all the machines should be
sufficient to keep the factory running. Such WIP inventory is called
decoupling inventory.

Cycle Inventory: It is a type of inventory accumulated due to ordering in

lots or sizes to avoid carrying the cost of inventory. In other words, it is the
inventory to balance the carrying cost and holding cost for optimizing the
inventory ordering cost as suggested by Economic Order Quantity (EOQ).
5. Explain the different sources of cash.

Cash is a resource readily available for use. It includes currency (one-

dollar bills, five-dollar bills, etc.), coins, and deposits in bank checking and
savings accounts. Cash may be in the form of many different currencies,
such as dollars, marks, and yen. Although companies use many different
currencies, cash is reported in the financial statements in terms of one
currency. For example, Exxon Mobil Corporation uses many forms of
currency in its world-wide operations, but reports cash on its balance sheet
in terms of United States dollars. DaimlerChrysler AG, on the other hand,
reports cash and cash equivalents in Euros.

Sources of Cash:

Companies obtain cash through borrowing, owners' investments,

management operations, and by converting other resources. Each of these
sources of cash is examined below.

Borrowing cash: Companies borrow cash primarily through short-

term bank loans and by issuing long-term notes and bonds. For
example, assume that on June 16, a company borrows $12,000 for 90
days. Show the effects of borrowing on the company's resources and
sources of resources.
Sources of
Sources of Sources of Management
Total Borrowed Owner Invested Generated
Resources = Resources + Resources + Resources
Assets = Liabilities + Stockholders' Equity
+ $12,000 = + $12,000
cash notes payable

When the company receives $12,000 cash, its resources (assets)

increase. Since the cash was borrowed, the company's sources of
borrowed resources, liabilities, also increase by $12,000.

Remembering that assets increase with debits and that debits equal
credits, prepare the journal entry to record the $12,000 borrowing.
 Post.
Date Description Ref. Debits Credits
June 16 Cash 12,000
Notes Payable 12,000
Bank loan, 90 days

Cash was debited in the above journal entry because cash increased,
cash is an asset, and assets increase with debits. The credit required
because debits must equal credits was to the liability account notes
payable, short-term. If you remember that liabilities increase with
credits, you support this credit to notes payable, short-term because
this liability did increase when the cash was borrowed.

The cost of borrowing cash: When borrowed cash is used, there is a

cost associated with it, called interest expense. For example, assume
on June 16 the $12,000 was borrowed for 90 days at an annual interest
rate of 10%. The total cost of borrowing the $12,000 would be
calculated as follows.

Interest = principal x interest rate x time.

Interest = $12,000 x .10 x 90/365.

Interest = $295.89.

The 90/365 represents the number of days (90) in the year (365) for
which the money was borrowed. If the interest is to be paid to the
bank at the end of 90 days, the company would pay the bank
$12,295.89 ($12,000 + $295.89).

At the end of June, however, the company would recognize that it had
used the bank's money for only 15 days (June 16 through June 30).
Thus, the company would recognize a $49.32 ($12,000 x .10 x
 15/365) increase in its sources of resources for its liability to the bank
(interest payable). The company would also recognize a decrease in its
sources of resources because it used up the bank's services provided in
June (interest expense). These effects could be seen as follows.

Sources of
Sources of Sources of Management
Total Borrowed Owner Invested Generated
Resources = Resources + Resources + Resources
Assets = Liabilities + Stockholders' Equity
+ $49.32 + - $49.32
interest payable interests expense

Remembering that assets increase with debits and that debits equal
credits, prepare the journal entry to record June's cost of borrowing
the $12,000.

Post.
Date Description Ref. Debits Credits
June 30 Interest Expense 49.32
Interest Payable 49.32
June Interest

Expenses reduce stockholders' equity. Stockholders' equity increases

with credits and decreases with debits. Thus, interest expense was
debited for $49.32 in order to reduce stockholders' equity. The credit
required because debits must equal credits was to the liability interest
payable. The interest will be paid after the $12,000 has been used for
the full 90 days. If you remember that liabilities increase with credits,
you support the credit to interest payable because this liability did
increase when the company kept the bank's $12,000 cash and used it
for 15 days in June.

Obtaining cash from owners: As evidence of their investments in

corporations, owners most often receive shares of common stock. For
 example, if owners invest $50,000 in a corporation on June 10, show
the effects on the company's resources and sources of resources.

Sources of
Sources of Sources of Management
Total Borrowed Owner Invested Generated
Resources = Resources + Resources + Resources
Assets = Liabilities + Stockholders' Equity
+ $50,000 = + $50,000
cash common stock

When the company receives the $50,000 cash, its resources (assets)
increase. Since the cash was invested by owners, the company's
sources of resources from owners, stockholders' equity, also increase
by $50,000.

Remembering that assets increase with debits and that debits equal
credits, prepare the journal entry to record the $50,000 owners'
investment.

Post.
Date Description Ref. Debits Credits
June 10 Cash 50,000
Common Stock 50,000
Owners' investment

Cash was debited in the above journal entry because cash increased,
cash is an asset, and assets increase with debits. The credit required
because debits must equal credits was to the stockholders' equity
account common stock. If you remember that stockholders' equity
increases with credits, you support this credit to common stock.

Cash generated by management: Management generates cash

mainly by servicing customers. For example, if managers provide
services to customers on June 11, and receive $1,500 cash, show the
effects on the company's resources and sources of resources.
 Sources of
Sources of Sources of Management
Total Borrowed Owner Invested Generated
Resources = Resources + Resources + Resources
Assets = Liabilities + Stockholders' Equity
+ $1,500 = + $1,500
cash fees revenue

When the company receives the $1,500 cash, its resources (assets)
increase. Since the cash asset was generated by management
providing services to customers, the company's sources of resources,
stockholders' equity, also increase by $1,500. Stockholders' equity
increases because owners have a right to resources generated through
management operations. The specific stockholders' equity account
affected is fees revenue.

Remembering that assets increase with debits and that debits equal
credits, prepare the journal entry to record the $1,500 cash received
for services.

Post.
Date Description Ref. Debits Credits
June 11 Cash 1,500
Fees Revenue 1,500
June fees

Cash was debited in the above journal entry because cash increased,
cash is an asset, and assets increase with debits. The credit required
because debits must equal credits was to the stockholders' equity
account fees revenue. If you remember that stockholders' equity
increases with credits, you support this credit to fees revenue.

Obtaining cash by converting other resources into

cash: Companies often receive cash by converting other resources,
usually accounts receivable, into cash. For example, if managers
collect $800 on June 18, from customers for services provided to them
 in May, show the effects on the company's resources and sources of
resources.

Sources of
Sources of Sources of Management
Total Borrowed Owner Invested Generated
Resources = Resources + Resources + Resources
Assets = Liabilities + Stockholders' Equity
+ $800
cash
- $800
accounts receivable

When the company receives the $800 cash, its resources (assets)
increase. Since the cash was received by converting accounts
receivable into cash, the company's resources (accounts receivable)
also decrease by $800. Thus, the company's total resources and
sources of resources remain unchanged by the conversion of one
resource into another.

Remembering that assets increase with debits and that debits equal
credits, prepare the journal entry to record the $800 cash received
from customers.

Post.
Date Description Ref. Debits Credits
June 18 Cash 800
Accounts Receivable 800
Accounts receivable collection

Cash was debited in the above journal entry because cash increased,
cash is an asset, and assets increase with debits. The credit required
because debits must equal credits was to the asset accounts receivable.
If you remember that assets decrease with credits, you support this
credit to accounts receivable.
 6.What is cash budget and proforma balance sheet? Explain.

INTRODUCTION

Financial forecasting is a planning process through which the management

of the company positions the firm’s future activities keeping in view the
various influencing factors such as the economic, technical, social and
competitive environment. Financial forecasting is essential to the strategic
growth of the firm. Business plans evidence strategies and actions for
achieving the desired short-term, medium-term and long-term results.

The process of financial forecasting allows the financial manager to

anticipate events before they occur, particularly the need for raising funds
externally.

The most comprehensive means of financial forecasting is to go through the

process of developing a series of pro forma or projected financial statements.
There are three main techniques of financial projections as follows:

† Pro forma financial statements

† Cash Budgets and

† Operating Budgets.

Based on the projected statements, the firm is able to judge its future level of
receivables ,inventory, payables and other corporate accounts as well as its
anticipated profits and borrowing requirements. The finance officer can then
carefully track actual events against the plan and make necessary
adjustments. Also, the statements are often required by bankers and other
lenders as a guide for the future.

Pro forma statements are projected financial statements embodying a set of

assumptions about the future performance of a company and the funding
requirements. A systematic approach is necessary for the development of pro
forma statements. The various steps involved in the construction of a pro
forma statement are as follows:

i) Preparation of a pro forma income statement, based on sales projections

and production

plan.

ii) Translation of these into a cash budget, and then finally.

iii) Assimilation of all previously developed material into a pro forma

balance sheet.

This process can be depicted as under:

Development of Pro forma Statements

Pro forma Income Statement

Proforma Income Statement is developed by the following four important

steps:

1) Establishment of a sales projection.

2) Preparation of production schedule and the associated use of new

material, direct labour

and overhead, to arrive at gross profit.

3) Computation of other expenses.

4) Determination of profit by completing the actual pro forma statement.

Sales Projection

Sales Projection or Sales Forecast is the starting point of the financial

forecasting exercise.
Projection of other financial variables are based on sales projection, and
therefore, the necessity for accuracy of sales projection need not be
overemphasized.

Cash Budget

The generation of sales and profits does not necessarily indicate that there
will be adequate cash on hand to meet financial obligations as they come
due. A profitable sale may generate accounts receivables in the short run, but
no immediate cash to meet maturing obligations.

Therefore, we must translate the pro forma income statement into cash
flows. The longer-term pro forma income statement is divided into smaller
and more precise time frames in order to appreciate the seasonal and
monthly patterns of cash inflows and outflows. Cash budgets or cash flow
estimates are very specific planning tools that are prepared every month or
even every week.

Cash budgets show the cash needs or excesses. We have already discussed
about preparation of cash budgets in the previous chapter.

Pro forma Balance Sheet

Preparation of Pro forma Balance Sheet involves integration of pro forma

income statement and cash budget. This is relatively a simple job. As the
balance sheet represents cumulative changes in the business over time, the
prior period’s balance sheet is first examined and then these items are
translated through time to represent the latest balance sheet.