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Leverage: Meaning:

Capital structure decisions aims at determining the types of funds a company should seek to finance its investment opportunity and the preparation in which these funds should be raised. The term capital structure is used to represent the proportionate relationship between the various long-term forms of financing such as debentures, long term debts, preference share capital and equity share capital. Capital Structure and Leverage: Leverage is the action of a lever or the mechanical advantage gained by it; it also means effectiveness or power. The common interpretation of leverage is derived from the use or manipulation of a tool or device termed as lever, which provides a substantive clue to the meaning and nature of financial leverage. When an organization is planning to raise its capital requirements (funds), these may be raised either by issuing debentures and securing long term loan 0r by issuing share-capital. Normally, a company is raising fund from both sources. When funds are raised from debts, the Co. investors will pay interest, which is a definite liability of the company. Whether the company is earning profits or not, it has to pay interest on debts. But one benefit of raising funds from debt is that interest paid on debts is allowed as deduction for income tax. When funds are raised by issue of shares (equity) , the investor are paid dividend on their investment. Dividends are paid only when the Company is having sufficient amount of profit. In case of loss, dividends are not paid. But dividend is not allowed as deduction while computing tax on the income of the Company. In this way both way of raising funds are having some advantages and disadvantages. A Company has to decide that what will be its mix of Debt and Equity, considering the liability, cost of funds and expected rate of return on investment of fund. A Company should take a proper decision about such mix, otherwise it will face many financial problems. For the purpose of determination of mix of debt and equity, leverages are calculated and analyzed. Capital Structure and Financial Structure Distinguished In finance literature one often finds the terms capital structure and financial structure used interchangeably. Capital structure of firm represents the proportionate relationship between the various long-term forms of financial while financial structure refers to the way the companys assets are financed. It is the entire left hand side of the balance sheet, i.e., long term and short term sources of funds. Thus, a firm capital structure refers to the permanent financing pattern and is only a part of its financial structure. An analysis of capital structure involves the use of financial leverage factor.

Concept of Financial Leverage Leverage may be defined as the employment of an asset or funds for which the firm pays a fixed cost or fixed return. The fixed cost or return may, therefore be thought of as the full annum of a

lever. Financial leverage implies the use of funds carrying fixed commitment charge with the objective of increasing returns to equity shareholders. Financial leverage or leverage factor is defined, as the ratio of total value of debt to total assets or the total value of the firm. For example, a firm having a total value of Rs. 2,00,000 and a total debt of Rs. 1,00,000 would have a leverage factor of 50 percent. There are difficult measures of leverage such as. i. ii. iii. The ratio of debt to total capital The ratio of debt to equity The ratio of net operating income (earning before interest and taxes) to fixed charges) The first two measures of leverage can be expressed either in book v8lue or market value the debt of equity ratio as a measure of financial leverage is more popular in practice.

Risk & Financial Leverage:


Q. Risk increases proportionally with financial leverage. Refute this statement with suitable reasons. (Jan. 01) Effects of financial Leverage: The use of leverage results in two obvious effects: i. ii. Increasing the shareholders earning under favorable economic conditions, and Increasing the financial risk of the firm. Suppose there are two companies each having a Rs. 1,00,000 capital structure. One company has borrowed half of its investment while the other company has only equity capital: Both earn Rs. 2,00,000 profit. The ratio of interest on the borrowed capital is 10%and the rate of corporate tax 50%. Let us calculate the effect of financial leverage, both in the shareholders earnings and the Companys financial risk in these two companies.

(a) Effect of Leverage on Shareholders Earnings: Company A Rs. Profit/ Earnings before Interest 2,00,000 and Taxes Equity 10,00,000 Debt Interest (10%) Profit after interest but before 2,00,000 Tax Taxes @ 50% 1,00,000 Company B Rs. 2,00,000 5,00,000 5,00,000 50,000 1,50,000 75,000

Rate of return on Equity of Company A Rs. 1,00,000/Rs. 10,00,000 = 10% Rate of return on Equity of Company B Rs. 75,000/Rs. 5,00,000 = 15%

The above illustration points to the favorable effect of the leverage factor on earnings of shareholders. The concept of leverage is 5 if one can earn more on the borrowed money that it costs but detrimental to the man who fails to do so far there is such a thing as a negative leverage i.e. borrowing money at 10% to find that, it can earn 5%. The difference comes out of the shareholders equity so leverage can be a double-edged sword. (b) Effect of Leverage on the financial risk of the company: Financial risk broadly defined includes both the risk of possible insolvency and the changes in the earnings available to equity shareholders. How does the leverage factor leads to the risk possible insolvency is selfexplanatory. As defined earlier the inclusion of more and more debt in capital structure leads to increased fixed commitment charges on the part of the firm as the firm continues to lever itself, the changes of cash insolvency leading to legal bankruptcy increase because the financial charges incurred, by the firm exceed the expected earnings. Obviously this leads to fluctuations in earnings available to the equity shareholders.

Relationship: Financial and Operating leverage:


Relationship between financial and operating leverage: In business terminology, leverage is used in two senses: Financial leverage & Operating Leverage Financial leverage: The effect which the use of debt funds produces on returns is called financial leverage. Operating leverage: Operating leverage refers to the use of fixed costs in the operation of the firm. A firm has a high degree of operating leverage if it employs a greater amount of fixed costs. The degree of operating leverage may be defined as the percentage change in profit resulting from a percentage change in sales. This can be expressed as: = Percent Change in Profit/Percent Change in Sales The degree of financial leverage is defined as the percent change in earnings available to common shareholders that is associated with a given percentage change in EBIT. Thus, operating leverage affects EBIT while financial leverage affects earnings after interest and taxes the earnings available to equity shareholders. For this reason operating leverage is sometimes referred to as first stage leverage and financial leverage as second stage leverage. Therefore, if a firm uses a considerable amount of both operating leverage and financial leverage even small changes in the level of sales will produce wide fluctuations in earnings per share (EPS). The combined effect of both these types of leverages is after called total leverage which, is closely tied to the firms total risk.

RATIO ANALYSIS

Ratio Analysis is a form of Financial Statement Analysis that is used to obtain a quick indication of a firm's financial performance in several key areas. The ratios are categorized as Short-term Solvency Ratios, Debt Management Ratios, Asset Management Ratios, Profitability Ratios, and Market Value Ratios. Ratio Analysis as a tool possesses several important features. The data, which are provided by financial statements, are readily available. The computation of ratios facilitates the comparison of firms which differ in size. Ratios can be used to compare a firm's financial performance with industry averages. In addition, ratios can be used in a form of trend analysis to identify areas where performance has improved or deteriorated over time. Because Ratio Analysis is based upon Accounting information, its effectiveness is limited by the distortions which arise in financial statements due to such things as Historical Cost Accounting and inflation. Therefore, Ratio Analysis should only be used as a first step in financial analysis, to obtain a quick indication of a firm's performance and to identify areas which need to be investigated further.

What is fund flow statement? Why, how and when it prepared? Financial statements do not give the complete financial information. These statements give the information of funds on a particular date. The purpose of preparation of fund flow statements is to know about from where funds are coming and where being invested. The funds flow statements is generally prepared from the data identifiable and profit and loss account and balance sheets. Fund flow statement is also called as sources and application of funds. It shows the detail of funds business received from sources and the amount of funds the business used for different purposes in the year. Acc. To FOURLKE, A statement of sources and application of funds, is a technical advice designed to highlight the changes in financial position of business enterprise between two dates.

Why fund flow statement is prepared?

Financial statements do not give the complete financial information. The purpose of preparation of fund flow statements is to know about from where funds are coming and where being invested. It discloses the funds at the end of one period of time to the end of another period of time. It provides the useful additional information, not covered by financial statements. The funds flow statement is prepared from data generally identifiable and profit and loss account, balance sheet and related notes. Te another important need of fund flow statement is that income statement and balance sheet does not provide full and needed information. Income statement is restricted to the limited transactions regarding goods and services to customers. The balance sheet also gives the detail of assets and liabilities of the business. There are few other reasons to prepare fund flow statement: 1. It explains the financial consequences of business operations: Fund flow statement gives answer to following conflicting situations. a) How the business could have good liquid position in spite of business making loses or acquisition of fixed assets? b) Where have the profits gone? c) How a business can earn more and more profits. 2. It answers intricate queries: a) How much fund is generated from normal business operations? b) What are the sources of repayment of loans? c) How to utilize the funds up to optimum level? 3. It acts as an instrument for allocation of resources. 4. It is a test of effectiveness in use of working capital.

How and when to prepare fund flow statements? There are different transactions, which can make change in flow of funds and vice versa.

Firstly those transactions which can make a change in flow of funds. 1. Transactions that effect current and fixed assets. A transaction, which changes the balance of current assets and fixed asset, will make a flow of funds. 2. Transactions effecting current assets and non-current liabilities. When a transaction effects a change in current asset and non-current liability, it will result in flow of funds. 3. Transactions effecting current liability and non-current assets. All those transactions, which involve current liabilities and non-current assets, will result in flow of funds. 4. Transactions effecting current liability and non-current liability: when there will be change in current liability and non-current liability will result in flow of funds.

Transaction not effecting funds.

1. If transaction effect accounts of current category only: All those transaction which effect the current assets or current liabilities only will never result into flow of funds. 2. If transaction effect non current accounts only. There will be no change in flow of funds, if a transaction affects accounts of non-current category only.

Schedule of changes in working capital:


When there will be a change in current assets and current liabilities of the firm then that change is covered under schedule of changes in working capital. This is the first step of fund flow statement. So this particulars statement records only change in current assets and current liabilities of the business. By current assets we mean cash and other assets, which are easily converted into cash by normal course of business. By current liabilities we mean which are paid out in short span of time for e.g. creditors, bills payable, bank overdraft etc. the schedule of changes in working capital is prepared by recording current assets and liabilities at the beginning and at the end of the period. If a current asset is more in current year in comparison to previous year then difference is recorded in the increase column and vice versa. If a current liability is more in current year than the previous year the difference is recorded in decrease side.

Performa of Schedule of changes in working capital: Particulars 2005 2006 Increase Decrease

Current assets
Stock Debtors Cash and bank

Current liabilities
Bills payable Creditors Bank overdraft Total liabilities Working capital Increase/Decrease working capital in

Preparation of funds flow statement: In order to prepare fund flow statement, it is necessary to find out the sources and application of funds.

Sources of funds: a) Internal sources: funds flow from operations is the only internal source of funds. The following adjustments will be required in net profit for calculating true funds from operations. Add. Depreciation on fixed assets Preliminary expenses or goodwill written off. Transfer to general reserve Provision for taxation and proposed dividend. Loss on sale of fixed assets.

Less. Profit on sale of fixed assets Profit on revaluation of fixed assets. Dividend received or accrued dividend.

b) External sources Funds from long term loan Sale of fixed assets Funds from increase in share capital.

Applications of funds.

Purchase of fixed assets Payment of dividend Payment of fixed liabilities Payment of tax liability.

Performa of funds flow statement


Sources o funds Issue of shares Issue of debentures Long-term borrowings Sale of fixed assets Operating profit* Decrease in working capital* Amount Application of funds Redemption of redeemable preference shares Redemption of debentures Payment of long-term loans Purchase of fixed assets Operating loss* Increase in working capital* Amount

Cash flow statement


In financial accounting, a cash flow statement, also known as statement of cash flows or funds flow statement,[1] is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities. Essentially, the cash flow statement is concerned with the flow of cash in and cash out of the business. The statement captures both the current operating results and the accompanying changes in the balance sheet.[1] As an analytical tool, the statement of cash flows is useful in determining the short-term viability of a company, particularly its ability to pay bills. International Accounting Standard 7 (IAS 7), is the International Accounting Standard that deals with cash flow statements. People and groups interested in cash flow statements include:

Accounting personnel, who need to know whether the organization will be able to cover payroll and other immediate expenses Potential lenders or creditors, who want a clear picture of a company's ability to repay Potential investors, who need to judge whether the company is financially sound Potential employees or contractors, who need to know whether the company will be able to afford compensation Shareholders of the business.

Purpose
Statement of Cash Flow - Simple Example for the period 01/01/2006 to 12/31/2006 Cash flow from operations Cash flow from investing Cash flow from financing Net cash flow $4,000 ($1,000) ($2,000) $1,000

Parentheses indicate negative values

The cash flow statement was previously known as the flow of Cash statement.[2] The cash flow statement reflects a firm's liquidity. The balance sheet is a snapshot of a firm's financial resources and obligations at a single point in time, and the income statement summarizes a firm's financial transactions over an interval of time. These two financial statements reflect the accrual basis accounting used by firms to match revenues with the expenses associated with generating those revenues. The cash flow statement includes only inflows and outflows of cash and cash equivalents; it excludes transactions that do not directly affect cash receipts and payments. These non-cash transactions include depreciation

or write-offs on bad debts or credit losses to name a few.[3] The cash flow statement is a cash basis report on three types of financial activities: operating activities, investing activities, and financing activities. Non-cash activities are usually reported in footnotes. The cash flow statement is intended to[4]
1. provide information on a firm's liquidity and solvency and its ability to change cash flows in future circumstances 2. provide additional information for evaluating changes in assets, liabilities and equity 3. improve the comparability of different firms' operating performance by eliminating the effects of different accounting methods 4. indicate the amount, timing and probability of future cash flows

The cash flow statement has been adopted as a standard financial statement because it eliminates allocations, which might be derived from different accounting methods, such as various timeframes for depreciating fixed assets.[5]

Cash flow activities


The cash flow statement is partitioned into three segments, namely: 1) cash flow resulting from operating activities; 2) cash flow resulting from investing activities;and 3) cash flow resulting from financing activities. The money coming into the business is called cash inflow, and money going out from the business is called cash outflow.

Operating activities
Operating activities include the production, sales and delivery of the company's product as well as collecting payment from its customers. This could include purchasing raw materials, building inventory, advertising, and shipping the product. Under IAS 7, operating cash flows include:[11]

Receipts from the sale of goods or services Receipts for the sale of loans, debt or equity instruments in a trading portfolio Interest received on loans Dividends received on equity securities Payments to suppliers for goods and services Payments to employees or on behalf of employees Interest payments (alternatively, this can be reported under financing activities in IAS 7, and US GAAP)

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

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

Investing activitiesExamples of Investing activities are


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

Financing activities
Financing activities include the inflow of cash from investors such as banks and shareholders, as well as the outflow of cash to shareholders as dividends as the company generates income. Other activities which impact the long-term liabilities and equity of the company are also listed in the financing activities section of the cash flow statement. Under IAS 7,

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

Items under the financing activities section include:Dividends paid


Sale or repurchase of the company's stock Net borrowings Payment of dividend tax

Disclosure of non-cash activitiesUnder IAS 7, non-cash investing and


financing activities are disclosed in footnotes to the financial statements. Under US General Accepted Accounting Principles (GAAP), non-cash activities may be disclosed in a footnote or within the cash flow statement itself. Non-cash financing activities may include[11]

Leasing to purchase an asset Converting debt to equity Exchanging non-cash assets or liabilities for other non-cash assets or liabilities Issuing shares in exchange for assets