Finance Project

Working Capital Management
GENERAL INTRODUCTION
All business organizations prepare financial statements after every financial year. The financial statements clearly indicate the financial position of the business concern. Published financial statements may be of considerable interest to shareholders, trade organizations, business analyst and many others. Each of these groups may be interest in different aspects of the business concern according to their own purposes. The basis for financial planning, analysis and decision making is the financial information. Financial information is needed to predict, compare and evaluate the firms earning ability. It is also required to aid in economic decision making investment and financing decision making. The financial information of an enterprise is contained in the financial statements or accounting reports. The financial analysis is the process of analyzing the financial strengths and weaknesses of the firm by properly establishing the relationships between the items of the balance sheet and profit and loss account. It is the study of the performance of the unit and therefore is aimed at financial performance of an individual unit. This report deals with the financial performance of MEDREICH STERILABS LIMITED for the financial year 2007 to 2009. This report briefly explains the subject matter (financial statements analysis) of the study conducted. The basis for the financial planning, analysis and decisionmaking is the financial information. Financial information is needed to predict, compare and evaluate the firms earning ability. It is also required to aid in economic decision making investment and financing decision making. The financial information of an enterprise is contained in the financial statements or accounting reports. The financial analysis is the process of identifying the financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and profit and loss account. It is the study of the performance of the unit 1
SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE
and therefore is aimed at the financial performance in an individual unit. This is therefore aimed at analyzing the performance, trend and the areas of strengths and weaknesses of the firm The objective of the study was to thoroughly analyze the companys performance and the financial position over the years i.e., the direction and the trend in which the company is performing and the various and their uses. The balance sheet and the income statement of the company provide some extremely useful information to the extent that the balance sheet mirrors the financial position on a given date in terms of the structure of assets, liabilities and owners equity etc. The comparison of the above statements is therefore an important aid in determining the companys position and performance over a period of time. The first task in the analysis is the selection of the information relevant to the decision under consideration from the total information contained in the financial statements. The second task is to arrange the information in a way to highlight comparison among different variables from balance sheet and income statement of different years. The final step is that of drawing inferences and conclusions. The best tool used for the purpose of finding out trends of an organizations growth over a period of time is Ratio Analysis. The variables in the balance sheet provides considerable information which is eventually helpful for the organization as the trends can be studied and it forms the basis of drawing important inferences. Working Capital is the capital required for the day-to-day operations of the business It maybe regarded as the life blood of business. Its effective position can do much to ensure the success of a business, while its inefficient management can lead not only to loss of profit but also the ultimate downfall the study o f working capital management is important because of its close relation with the day to day operations of the business Therefore to keep healthy management of working capital business needs professionalism and good skill thus the management of working capital varies from industry to industry.
M\S MEDREICH STERILAB LIMITED has been taken for the case study to analyze the financial aspects to working capital for the better understanding of the financial standing of the Company
RESEARCH DESIGN
1) STATEMENT THE OF THE PROBLEM To study the working capital management and to analyze and evaluate the financial position M\S MEDREICH STERILAB LIMITED with special reference to Working Capital Management, Ratio Analysis, and Fund Flow Analysis 2) OBJECTIVES OF THE STUDY Primary objective is to analyze the financial position of Medreich Sterilab Ltd, for the year, 2006-2007, 2007-2008 and 2008-2009 To use working capital management, fund flow analysis, ratio analysis as a tool to identify the liquidity, solvency, profitability and management efficiency of the company To compare the financial position for three years and help in financial control and planning resources To make suggestions out of the findings of the study
3) DATA COLLECTION
The requisite data for the study is collected from the secondary sources of information The Secondary data has been obtained from the financial statements of the company in the form of the Balance Sheet and Profit & Loss accounts. The analysis and interpretation has been thus derived with the help of secondary data available there was use of primary data in the case of financing of working capital through paper work and discussions held with the senior financial manger.
4) PLAN OF ANALYSIS: 4
The data has been compiled, analyzed and tabulated in various forms. The tabulated financial data has been further interpreted. These interpretations have been used to form conclusions and suggest recommendation. Using various financial tools like fund flow statement, ratios and percentages the analysis was done. 5) RESEARCH METHODOLOGY: Three Year Balance sheet &Profit & Loss account stated in annual reports were used for analysis Working Capital &concerned ratios that were used as tools of analysis based upon the companies financial position, performance was evaluated suggestions were made. Regarding financing of working capital both the methods were evaluated by extracting information from balance sheet for three years, then the best alternative was chosen based on which the companies position regarding the financing of working capital was known 6) LIMITATIONS OF THE STUDY: Study makes an extensive use of information provided by financial statements and if there is window dressing, the findings could be misleading. As there is no standard formula for ratios, different people may express different opinions. No other company in the same sector has been considered to evaluate the ratio standards. This being an academic study suffers from time and cost consideration.
CHAPTER SCHEME
The project has been completed in the following chapters:
CHAPTER 1 CHAPTER 2 CHAPTER 3 CHAPTER 4 CHAPTER 5 CHAPTER 6 CHAPTER 7
GENERAL INTRODUCTION RESEARCH DESIGN COMPANY PROFILE WORKING CAPITAL MANAGEMENT ANALYSIS & INTERPRETATION FUND FLOW STATEMENT FINDINGS AND SUGGESTIONS BIBLIOGRAPHY
PHARMACEUTICAL INDUSTRY
There is general feeling in the country that the Indian pharma industry is doing extremely well. This is certainly true, particularly in the Indian context. It is also a fact that several large multi national pharma companies in the world have taken note of the progress of a few Indian pharma units and are recognizing their capabilities and track records. Even under such circumstances, there is some sort of apprehension amongst the Indian pharma industry as to whether it would be able to sustain the past growth level in the coming years, in the light of the impending patent regulations and the liberalized global trade. A clear analysis of the performance of the Indian pharma industry would readily indicate the fact that while a few number of organizations such as Ranbaxy, Dr.Reddys, Orchid, Lupin and others have done extremely well, there have also been a large number of pharma organizations in the medium and small scale sectors, who have failed in the past If one would look into total number of pharmaceutical units (both bulk drug and formulations) that have been set up in India since independence, it would become clear that at least 40% of the units have closed and withered away. Obviously, this implies that everything about Indian pharma industry is not so rosy and promising as projected. While we recognize the success, we should also investigate the cause for such failures.
It is generally said that the success of the Indian pharma industries are only due to its capability in reverse engineering. Such views are uncharitable, as the success of Indian pharma sector has not been due to reasons as simple as that only. Indian pharma industry deserves far more credit and praise for its achievements. It has been able to introduce and practice appropriate marketing strategies both in the Indian and global market, even in the face of severe competition from well established multi national companies. By and large, it enjoys excellent credibility and faith among consumers, particularly in India. Over and above that, it has also practiced reasonable level of fairness in price fixing and has exhibited responsible corporate behavior. It is well-recognized fact in future; the fate and progress of the pharma industries in any part of the world would be largely guided by the R&D capabilities and introduction of new molecules appropriate to the requirements of different regions. This calls for extensive and high level of Research and Development capabilities amongst the pharma industries. The question is as to what extent the Indian units have developed such capabilities. In the past, most have the turn over and profits for Indian pharma units have come from the formulation sector and not from the bulk drug sector. Even the export break through of the Indian units has been largely in the formulation sector. We all know that the formulation sector is not that R&D intensive to the level of bulk drug sector. A number of Indian formulation units themselves have been importing bulk drug for formulation and finished products. This formulation capability by itself would not be adequate to forge ahead in the future. The development and introduction of new bulk drug takes any where between 6 to 10 years and cost millions of dollars. The success rate in development of new molecules has been low and it is said that hardly one or two research exercises are successful out of around 100 attempts.
Further, there are number of cases in the recent years, where the drugs which have already been well introduced in the market have to be withdrawn due to pressures from alert public and environmentalists. Obviously, all such aspects indicate that Research and Development work in pharma sector is not only multi million dollar exercise but it is also a calculated risk. One would wonder as to whether Indian pharma units have necessary turn over and financial muscle to face such risks in the pharma sector in the coming years. It appears that in the coming years, the Indian pharma industry would find it difficult to maintain its market share as bulk drug manufacturer in the global context. They could find it difficult even to maintain market share in the Indian bulk drug market in the face of competition from multi national companies operating all over the world. In this scenario, it would be appropriate for the Indian pharma sector to introspect as to whether it should focus more in functions relating to service sector in the pharma industry instead of manufacturing activity. The service sector such as data base management, bio-informatics, clinical trials, testing and analysis, custom synthesis, contract research etc. are of tremendous importance and have promising future. With army of technologists and scientists around the country and reasonable capability level, Indian pharma sector would emerge even stronger in the global sphere, if it could concentrate in service functions, of which contract research and custom synthesis could play a major part. Obviously, there are both adequacies and inadequacies in the Indian pharma sector. Perhaps, we should look into inadequacies with greater attention and try to over come the constraints.
MEDREICH STERILABS LIMITED
As the world is shrinking and trade barriers are beginning to come down, the pharmaceutical industry is constantly in search of ways to reduce cost without compromising on quality or service; so as to retain a competitive edge in the global market place. Medreich Sterilabs Ltd. (Medreich) is an Indian Company and forms part of the UK Group of companies comprising of Medreich plc. They have an international focus, and world-class accredited plants that are capable of offering low cost, high quality out-sourcing solutions for its customers. They specialize in developing and delivering bespoke solutions for their major international customers. They have the capability to handle significant complexity and to produce a wide range of products and dosage forms, in varied packing presentations. Medreich strictly adheres to all cGMP requirements and through regular Audit interactions with International agencies, they are constantly upgrading their plants to meet the needs of the changing Regulatory scenario, Quality requirements, while keeping an eye on Environment, Health and Safety. Medreich plants are certified by the UK MHRA, TGA Australia, and South Africa MCC as they all are leading multinational and Indian pharmaceutical companies. They are committed to setting the best standards in the industry; to build longterm relationships with their customers, deliver complete satisfaction, while improving business performance. They actively seek strategic alliances with growing, dynamic and leading companies that share their Vision of offering very competitively priced formulations without compromise on Quality and Service.
COMPANY & ITS AFFILIATES: Registered office: MEDREICH STERILAB LIMITED

10
BANASWADI ROAD, BANGALORE. WEBSITE: DIRECTOR: MANAGING DIRECTOR: COMPANY SECRETARY: BANKERS: WWW.MEDREICH .COM C.P.BOTHRA J.R.VENU DASARI RAMESH STATE BANK OF MYSORE CANARA BANK KARNATAKA CORPORATION KARNATAKA STATE INDUSTRIAL INVESTMENT & DEVELOPMENT CORPORATION CHARTED ACCOUNTANTS: A. RAM MOHAN & CO STATE FINANCIAL
FACILITIES OF THE COMPANY

There are four labs and a research and development center situated in Bangalore where each lab is dedicated for the manufacturing of certain specific related medicines. 11
The company has an in house research and development center for constant development of new medicines to keep pace with tough competition in the global market place. It also has a research team working on the packaging of the their company products for cost reduction and to provide better quality products to their international clients The facilities of the company are as follows which are situated in Bangalore 1. Unit one dedicated manufacturing facility for B-LACTAM capsules, tablets, by powder suspension 2. Unit two-dedicated manufacturing facility for non-penicillin capsules 3. Unit three-manufacturing facility for tablets, capsules,& pellets 4. Unit four- manufacturing facility for non-penicillin tablets, liquids &dry powder suspension 5. Unit five-the in house research and development centre
UNIT ONE
FACILITIES AVAILABLE Capsules Two automatic capsule filling line equipped with Check Weighing Metal Detection System
12
Dry Powder Multi-Head Automatic Powder Filling Machine Tablet Tablet manufacturing area with facility for Dry Granulation Compression Auto-coater with PLC controlled Three Blister Packing One Strip Packing One Tropical Blister Packing Bulk Packing Lines with facility to pack from 10's to 1000's Auto Cartoner with Camera Sensor, Barcode and Edge code readers. Adequate Warehousing Space. The production and packaging areas maintained at required pressures, temperatures and humidity levels with the help of 14 Independent HVAC Systems. The facility has independent Site Quality Assurance team, responsible for the final release of the Product. The facility has a well-equipped Quality Control Laboratory capable of carrying out all tests. On-Line Automatic Labeling Inkjet Printing
Packaging Lines:
UNIT TWO
Facilities available Capsules Automatic capsule filling line equipped with Check Weighing Metal Detection System 13
Packaging Lines Blister Packing Strip Packing with non-fill detection, collation of strips
Bulk Packing Lines with facility to pack from 10s to 1000s Adequate Warehousing Space The production and packaging areas maintained at required pressures, temperatures and humidity levels with the help of 14 Independent HVAC Systems. The facility has independent Site Quality Assurance team, responsible for the final release of the Product. The facility has a well-equipped Quality Control Laboratory capable of carrying out all tests.
14
UNIT THREE
Facilities available Three independent and self contained granulation suites. Two suites are equipped with Glatt Fluid Bed Processor of 800 ltrs. And 250 ltrs. 360 Kgs. Automatic Coating Systems with Microprocessor Controller and Printer. Liquid Automatic Tunnel type bottle washing and monoblock filling and capping under LAF. Automatic self-adhesive labeling machine with on-line Inkjet printing. Multimixer with built in homogenizer to manufacture high viscosity suspensions besides other manufacturing and holding tanks to ensure continuous production. Dry Powder Dry Syrup Line is equipped with air jet cleaning system for bottles, blending equipment, filling equipment and packing equipment. Packaging Lines Five blister packing lines. One strip packing line. One container packing line. Auto cartoner with camera sensor, barcode and edge code readers. Hologram, BOPP wrapping, security seal, collating, shrink-wrapping, Pelletisation facility
15
UNIT FOUR
Facilities available TABLETS Automatic coating pan with PLC control, capabilities to Sugar/Film/Enteric Coating. Four tableting machines with large capacity to produce two independent granulation suites with facility to handle all types of process. Tablets of any shape and size. The machine is also equipped to produce Bilayered tablets. CAPSULES: Two fully Automatic capsule filling lines with metal detection system One 150-T multi station Automatic capsule filling machine to encapsulate Powder, Pellets and Tablet or combination thereof One 80-T multi station automatic capsule filling machine to encapsulate Powder and Pellets or combination thereof PELLETS: The facility has the capability to produce immediate release and sustain release pellets with aqueous and non-aqueous polymeric solution or suspensions. Pellets ready to be filled in capsules or compressed into pellets.
PACKAGING LINES: Ten independent packaging lines with auto conveyors to transfer Packing materials and finished products Five 240 EX blister packing machines One flat bed blister packing machine with capability to handle Alu/Alu (COLD Forming) blisters Three container packing lines with facility to pack from 10's to 1000's One strip packing line
A new Research and Development Center has been commissioned to design and develop new and innovative oral dosage forms - using robust and reliable technologies. The Center focuses on the development of products just reaching patent expiry in the International markets. The target is to deliver Standard Technical Files to
16
the European and International market place to allow first to market applications to be made after patent expiry. The Center is run as a strategic business unit, capable of delivering novel cutting edge technology and supporting applications for Intellectual Property Rights (IPR). It is fully equipped with a self-sufficient laboratory and manufacturing area conforming to cGMP The development process covers: Conceptualizing and identifying the product profile Pre-formulations Formulation and manufacturing method development Lab scale development Lab scale development Analytical method development Packaging material development including novel packaging Stability testing protocols Data management (documentation and IPR)
Installed capability at the Research Center includes: Conventional or modified release tablets using coated, uncoated, sublingual, effervescent, bilayered or dispersible technologies. Conventional or modified release capsules containing powder, pellets, microgranules or a combination of either of above. Conventional or modified release granules or pellets ready to be filled into capsules or compressed into tablets or for sprinkling over food or mixing with juice. Syrups and suspensions, as well as dry powder formulations for reconstitution, designed to be robust, even when using unstable API's. New drug delivery systems including the conversion of existing molecules into bio-equivalent novel dosage forms offering more competitive product profiles.
QUALITY POLICY OF THE COMPANY
17
Every Unit produced by the Company, will totally conform to the quality systems & procedures laid down by the company.
Every Unit produced by the Company, will be in accordance with the process, procedures & controls as laid down by the company.
Every input and component that goes into the product produced, will conform to all standards laid down by the Co Every manual, document, certificates, approvals, will be made to conform to the highest quality standards.
Every human resource available in the Company, while they are directly or indirectly connected with the production of every Unit will adhere to all quality systems, controls, & procedure.
Every Unit produced by the Company, will carry the Companys commitment to quality & customer satisfaction.
The Company will make constant & continuous endeavors to upgrade & enhance its procedures, systems & controls to keep up to the latest Quality Standards in vogue at any given point in time.
WORKING CAPITAL MANAGEMENT

Introduction: 18
Working capital is the lifeblood of every business. Its effective provision ensures success and inefficient provision reduces the profit and results in downfall of the company. Mismanagement of business failure. A study of working capital is of major importance to internal and external analysis because of its close relationship with day-do-day operations of a business. Definition: In accounting concept working capital is nothing but, The difference between inflow and outflow of cash. It is also known as the difference between current assets and current liabilities. Current assets consists of cash/bank balance, short from investments, receivables, stocks advance payments etc., current liabilities include creditors, bills payables, bank overdraft, short term loans etc.,
19
TEMPORARY PERMANENT WORKING RESERVE WORKING CAPITAL NEGATIVE WORKING CAPITAL NET WORKING CAPITALCAPITAL GROSS WORKING CAPITAL W O R K I N G C A P I T A L
20
21
1. Gross working capital: It is the amount of funds invested in the various components of current assets. 2. Net working capital: It is the difference between current assets and the current liabilities. The concept of net working capital enables a firm to determine the exact amount available at its disposal for operational requirements. position. 3. Negative working capital: When current liabilities exceed current assets negative working capital emerges. Such a situation occurs when a firm is nearing a crisis of some magnitude. 4. Reserve working capital: It refers to the short term financial arrangement made by the business units to meet uncertainties. Business firms are always exposed to risks, which may be controllable or uncontrollable. In the event of happenings of such events, reserve working capital strengthens the capacity of the company to face the challengers. 5. Permanent working capital: It means the minimum amount of investment in all current assets which is regarded at all times to carry on minimum level of business activities. The operating cycle is a continuous process and therefore, the need for current assets. But, the magnitude of current assets increases and decreases over time. There is always a minimum level of current assets required at all times by the firm to carry on its business operations. The minimum level of current assets is known as permanent working capital or fixed working capital. It reflects the companys liquidity
22
6. Temporary working capital: This is also called the fluctuating or variable working capital. The amount of temporary working capital keeps on changing depending upon the changes in production and sales. For example extra inventory of finished goods will have to be maintained to support the peak periods of sale and investment in receivable may also increase during such period. On the other hand investment in raw materials, work-inprogress and finished goods will decrease. If the market is black. The extra working capital required to support the changing production and sales activities is known as temporary working capital. The figure above shows that the permanent level is fairly constant while temporary working capital is fluctuating sometimes increasing and sometimes decreasing in accordance with seasonable demands. In the case of an expanding firm the permanent working capital line may not be horizontal this is because the demand for permanent current assets might be increasing or decreasing to support a rising level of activity. Both finds working capital are necessary to facilitate the sales process through the operation cycle. Temporary working capital is created to meet liquidity requirements that are purely transient nature. Need for working capital: The basic objective of financial management is maximizing wealth of shareholders. This can be achieved when a firm earns sufficient returns from its operations. The amount of such earnings largely depends upon the magnitude of sales. There is always a time gap between sales of goods and the final realization of cash. Current assets are required during time gap in order to sustain the sales activity. Adequate working capital is required during this period for the purchase of raw material, payment of images or other expenses required for the manufacturing of goods to be sold. Working capital is also required to run the business smoothly.
23
Operating cycle: The duration of the time required to complete the following cycle of events in a case of manufacturing firm is called as operating cycle. consists of the following events. 1. 2. 3. 4. 5. Conversion of cash into raw material Conversion of raw material into work-in-progress Conversion of work-in-progress into finished goods Conversion of finished goods into debtors and bills receivable through sales Conversion of debtors and bills receivable into cash This cycle will be repeated again and again. following chart. This can be shown in the The operating cycle
RAW MATERIAL
CASH
WORK-IN-PROGRESS
ACCOUNT RECIEVABLES
FINISHED GOODS
OPERATING CYCLE Determinants of working capital: A large number of number of factors influence working capital needs of a firm. The basic objectives of working capital management are to manage the firms current assets and current assets and current liabilities in such a way that a satisfactory level of working capital is maintained. The following factors determine the amount of working capital.
24
1. Nature of business: The composition of current assets is a function of the size of a business and industry to which it belongs. Small companies have smaller proportion of cash, receivables and inventory than large corporations. This difference becomes more marked i.e., large corporations. A public utility concern, for example, mostly employees fixed assets in its operations, while a merchandising department depends generally on inventory and receivables. Need for working capital is thus determined by the nature of an enterprise. 2. Size of business: The size of business is also an important impact on its working capital needs. Size may be, measured in terms of scale of operations. A firm with large scale of operation will need more working capital than a small firm. 3. Length Of The Manufacturing Process: Larger the manufacturing process, the higher will be the requirement of working capital and vise versa. This is because of the fact that highly capitalintensive industries require a large amount of working capital to run their sophisticated and long production process. On the same principle of trading concern requires a much lower working capital than a manufacturing concern. 4. Production policy: The production policies by the management have a significant effect on the requirement on working capital of the business. The production schedule has a great influence on the level of inventories. The decision automation etc., will also have an effect on the working capital requirements.
25
5. Volume of sales: This is the most important factor effecting the size and components of working capital. A firm maintains current assets because they are needed to support the operational activities which resulting sales. The volume of sales and size of the working capital are directly related to each other. As the volume of sales increases there is an increase in the investment of working capital. 6. Terms of purchases and sales: A Firm, which allows liberal credit to its customers, may enjoy higher sales but will need more working capital as compared as compared to a firm enforcing strict credit terms. The working capital requirements are also effected by the credit facilities enjoyed by the firm. 7. Business cycle: Business expands during the period of prosperity and declines during the period of depression; consequently, more working capital is required during the period of prosperity and less during the period of depression. 8. Growth and expansion: If a business firm has ambitious plan for expansion, it requires more working capital, to fulfill such requirements. Growth and expansion in business is more essential to exploit the available business opportunity and to increase the existing market share. 9. Fluctuations in the supply of raw materials: Certain companies have to obtain and maintain large reserve of raw materials due to their irregular sales and intermittent supply. This is particularly true in case of companies requiring special kind of raw materials available only from one or two sources. In such a case a large quantity of raw materials is to be kept in store to avoid
26
an possibility of the production process coming to a dead halt. Thus, the working capital requirements in case of such industries would be large. 10. Price level changes: The increasing shifts in price levels make the functions of financial managers difficult. He should anticipate the effect of price level changes on working capital requirements of the firm. Generally, rising price levels will require a firm to maintain higher amounts of working capital. The same levels of current assets will need increased investment when prices are increasing. 11. Operating efficiency: The operating efficiency of the firm relates to the optimum utilization of resources at a minimum cost. The firm will be effectively contributing to its working capital if its efficient in controlling the operating costs. The use of working capital is improved and pace of cash cycle is accelerated with operating efficiency. 12. Profit margin: Firms differ in their capacity to generate profit from business operations. Some firms enjoy a dominant position, due to quality product or good marketing management or monopoly power in the market and earn a high profit margin. Some other firms may have to operate in an environment of intense competition and may earn low margin of profits. 13. Profit appropriations: Even if the net profits are earned in cash at the end of the period, whole of it is not available for working capital purposes. The contribution towards working capital would be effected by the way in which profits are appropriated. The availability of cash generated from operations thus depends upon taxation, dividend and retention policy and depreciation policy.
27
14. Credit Policy: A, company which follows a liberal credit policy to its customers, may have higher sales but will need higher working capital as compared to a company which has an efficient debt collection machinery and observing strict terms. A company enjoying liberal credit facilities from its suppliers will need lower amount of working capital as compared to a company, which does not enjoy such credit facilities.
PRINCIPLES OF WORKING CAPITAL MANAGEMENT:

Principle of risk variation:
28
Risk here refers to the inability of a firm to maintain sufficient current assets to pay for its obligations, if working capital is varied relative to ales; the amount of risk that a firm assumes is also varied and the opportunity for gain or loss is increased. As the level of working capital relative to sales decreases the degree of risk increases. When the degree of risk increases the opportunity for gain or loss also increases. Thus if the level of working capital goes up the amount of risk goes down and the opportunity for gain or loss is likewise adversely affected. Depending upon this attitude, the management changes the size of working capital. Principle of cost of capital: This principle emphasizes the different sources of finance, for each source has a different cost of capital. It should be remembered that the cost of capital moves inversely with risk. Thus additional capital results in the decline in the cost of capital. Principle of equity position: Accounting to this principle the amount of working capital invested in each corporate should be adequately justified by a firms equity position. Every rupee invested in the working capital should be contributed to the net worth of the firm.
Principle of maturity of payments: A company should make every effort to relate maturity of payments be it flow of internally generated funds. There should be the least disparity between the maturities of a firms short-term debt instruments and its flow of internally generated funds because a greater risk is generated with greater disparity. A margin of safety however should be provided for short-term debt payments. Sources of working capital: There are two approaches for sources of finance: a. Hedging approach 29
b.
Conservative approach
a. Hedging approach: The term hedging approach is often used in the sense of risk reducing investment strategy involving transactions of simultaneous but opposite nature so that the effect of one is likely to counter balance the effects of the other. With reference to an appropriate financing mix, the term hedging can be said to refer to a process of matching maturity of financial needs. This approach to financing decision to determine an appropriate financing mix is, therefore also called as maturity approach. According to this approach the maturity of the source of funds should match the nature of the assets to be financed for the purpose of analysis, the assets can be broadly classified into two classes. 1. Those that are required in a certain amount for a given level of operation and hence do not vary over time. 2. Those that fluctuates over time. When the firm follows marching approach, long term financing will be used to finance permanent working capital. Temporary working capital should be financed out of short-term funds. The rationale underlying marching approach is treat the maturity of sources of funds should match the nature of assets to be financed. Estimated total funds for company X for the year Y
Total Funds Months 1 required (Rs in Thousand) 2
Permanent Requirements (Rs in Thousand) 3
Seasonal Requirements(Rs in Thaousand) 4 30
January February March April May June July August September October November December
9500 9000 8500 8000 7900 8150 9000 9350 9500 10000 9000 8500
7900 7900 7900 7900 7900 7900 7900 7900 7900 7900 7900 7900
1600 11000 600 100 0 250 1100 1450 1600 2100 1100 600
According to the hedging approach the permanent portion of funds should be financed with long-term funds and the seasonal portion with short-term funds. With the approach, the short term financing requirements (current assets) would be just equal to the short term financing (current liabilities). There would therefore be on net working capital. b. Conservative approach: This approach suggests that the estimated requirements of funds should be met from long term sources, the use of short term funds should be restricted to only emergency situations or when there is an unexpected outflow of funds. In the case of Hypothetical company X in the total requirements, including the entire rupees 10,000 needed in October, will be financed by long term services. The short-term funds will be used to meet contingencies. The amount given represent the extent to which short term financial needs are being financed by long term funds, that is the net working capital. The net working capital reaches the highest level (Rs. 2100) in October (Rs. 10,000 7,900). It may be noted that any long term financing in excess of Rs. 7900 in permanent financing needs of the company represents net working capital. Other sources of working capital: 1. 2. 3. 4. Loans from financial institutions Floating of debentures Accepting public deposits Rising of funds by internal financing 31
5.
Issue of shares
1. Loans from financial institutions: The option is ruled out because banks do not finance always for working capital requirement. This facility may not be available to all companies. 2. Floating of debentures: Probability of sources is less because still Indian capital market could not get popularity. The company not associated with reputed groups fails to attract investors. However issue of convertible bonds is gaining momentum. 3. Accepting public deposits: The success is directly related to the image of the company problem of low profitability in many companies is very common. 4. Issue of shares: It can be considered but the companies have to command respect of investors how profit margin and lack of knowledge of the company makes this sources not an attractive one. 5. Raising of funds by internal financing: It is a problem for many companies because the prices of end products are controlled and do not permit the companies to pay reasonable dividend and retain profit for additional working capital requirement. However feasible solution lies in increasing the profitability through cost control, reduction, managing cash operating cycle and rationalizing inventory or stock etc., Modes of security: Hypothecation:
32
Under this mode of security the bank provides credit to borrowers against the security of movable property usually inventory of goods. The goods hypothecated, however continue to have in the possession of the owner of these goods. The right of lending bank (hypothecated) depends upon the terms of the contract between the borrower and the lender although the bank does not have physical possession of the goods it has the legal right to sell the goods to realize the outstanding loan. Pledge: As a mode of security is different from hypothecation in that in the former unlike in the latter, the goods, which are offered as a security, are transferred to the physical possession of the lender an essential prerequisite of pledge. Therefore it means that the goods are in the custody of the bank. The borrower who offers the security is called pawner while the bank is called the Pawnee. The lodging of the goods by the pawner is a kind of bailment. The bank must take reasonable care of goods pledged with it. The term reasonable care means, care which a prudent person would take to protect his property.
Lien: The term lien refers to the right of a party to retain goods belonging to another party until a debt due to him is paid. Lien can be of two types, particular lien and general lien. Particular lien is a right to retain goods until a claim pertaining to these goods is fully paid. On the other hand general lien can be applied till all dues of the claim are paid. Bank enjoys general lien.
Mortgage:
33
It is the transferred of interest in specific immovable property for securing the payment of money advanced. The person who parts with the interest in the property is called mortgager and the person in whose favor the transfer is the made. The mortgaged property of which the mortgage interest in the property is terminated as soon as the debt is paid. Charge: A charge is not that transfer of interest in the property through it is a security of payment. But a mortgage is a transfer of interest in the property. 1. A charge need not be in writing but a mortgage deed must be attested. 2. A charge may be created by the act of parties or by the operation of law, but a mortgage can be created only by the act of parties. 3. Generally a charge cannot be enforced against a transferee or consideration without notice. In a mortgage the transferee of the mortgaged property can acquire the remaining interest in the property if any is left.
MANAGEMENT OF CASH, INVENTORY AND RECEIVABLES

Cash management: What is cash? Cash is the most liquid asset that a business owns. It includes money and such instruments as cheques, money orders and bank drafts. Cash in the business enterprise may be compared to the blood in the human body. In broad sense it includes rear cash items such as time deposits with banks, marketable securities etc., and such securities / deposits can be immediately sold or converted into cash if necessary. The term cash management includes both cash and rear cash assets. Motives of holding cash: 1. Transaction motive:
34
A firm enters into a variety of business transactions in both in flows and outflows of cash. At time the cash outflows may exceed the cash inflows. In order to meet the business obligations in such situations, it is necessary to maintain adequate cash balance. The firms with the motive of meeting routine business payments keep this cash balance. 2. Precautionary motive: A firms cash balance to meet unexpected contingencies such as floods, strikes, presentment of bills for payment earlier than the expected date, unexpected showing down of collection of accounts receivables, sharp increase in price of raw materials etc., The more is the possibility of such contingencies, the more is the amount of cash kept by this firm. 3. Speculative motive: A firm also keeps cash balance to take advantage of unexpected opportunities typically outside the normal cause of the business. Such move is therefore of purely a speculative nature. For example a firm may like to take an payment of immediate cash or delay purchase of materials in the anticipation of declining prices. Similarly, it may like to keep some cash balance to make profit by buying securities in times when prices fall on account of tight money conditioned. Compensation motive: Banks provide certain services to their clients free of charge. They therefore, usually require clients to keep minimum cash balance with them, which helps to earn interest and thus compensate them for free services provided. Business firms normally do not enter into speculative activities and therefore out of four motives of holding cash balance the two most important motives are the cash transactions and compensation motive. How to have effective cash management?
35
Big corporations with sizable funds generally display a highly independent management of cash assets. In these firms a responsible fiscal officer is charged with responsibility of managing working cash balance in relation to the needs for the payment of obligations. To search for the optimum cash probably overstates the companys capabilities. A proper cash management necessitates the development and application of some practical administrative procedures to accelerate the inflow of cash and to improve the utilization of excess funds. includes: 1. 2. 3. Planning of cash requirements Effective control of cash flow Production utilization of exceeds funds This practical administrative procedure
36
Objectives of cash management: A highly liquid, vital asset is cash. It is needed to meet every type of
expenditure. Hence it should be sufficiently made available. If a firm falls to provide funds to meet the obligations, it will be clear indication of technical insolvency of firm. If the cash position of the firm is strong, it can command business operations. Cash discounts can be obtained on purchases. Obligations can be met immediately. Cost of capital will be minimized. However, it cannot also hold cash in an idle way. It should be made productive. Keeping these two views, viz., liquidity and profitability, the following objectives of cash management can be identified. i. To make cash payments ii. To maintain minimum cash reserve To make cash payments: The very objective of holding cash is to meet the various types of expenditure to be incurred in business operations. Several types of expenditures have to be met at different points of time and the firm should be prepared to make such cash payments. The firm should remain liquid to meet the obligations. suffers. It is observed that cash is an oil to lubricate the every turning wheels of business, without it the process of grinds to stop. Thus one of the basic objectives of cash management is to maintain the images of the organization by making a prompt payment to creditors and to avail cash discounts facilities. To maintain minimum cash reserve: Another important objective of cash management is to maintain reserve. This means in the process of meeting obligations on time, the firm should not maintain unnecessarily heavy cash reserves. It cannot keep cash idle. Excess cash balance should be productive. Maintaining minimum cash reserve is made possible by synchronizing cash inflows and outflows through cash budgeting. Cash collection should be expedited and cash outflows should be controlled to conserve cash
Otherwise the business
37
resources. Thus as far as possible the firm should maintain minimum cash reserve to attain the objective of profitability. Importance of cash management: Cash management assumes more important than other current assets because cash is the most significant and the least productive asset that the firm holds. It is significant because it is used to pay firms obligations. However, cash is unproductive and as such, the aim of cash management is to maintain adequate cash position to keep the firm sufficiently liquid to use excess cash in some profitable way. Management of cash is also important because it is difficult to predict cash flows accurately and that there is not perfect coincidence between inflows and outflows of cash. Thus, during some periods, cash outflows exceed cash inflows, because payments for taxes, dividends, excise duty, seasonal inventory build up etc., are met through it. At other times cash inflows will be more than cash payments, because there may be large cash sales and debtors may be realized in large sums promptly. Cash management is also important cash constitutes the smallest portion of the total current assets, even then, considered time management is devoted for it.
Strategies of cash management: 1. Cash planning: Cash inflows and outflows should be planned to project cash surplus or deficit for each period of planning. Cash budget should be prepared for this purpose. 2. Managing cash flows: The inflow and outflow of cash should be property managed. The inflow of cash should be accelerated, while the outflow of cash should be decelerated as far as possible. 3. Optimum cash level:
38
The firm should decide on the appropriate level of cash balances. The cost of excess cash and the danger of cash deficiency should be matched to determine the optimum level of cash balances. 4. Investing idle cash: The idle cash or precautionary cash balances should be properly invested to earn profits. The firm should decide on the division of such balances into bank deposits and marketable securities. Functions of cash management: 1. 2. 3. 4. 5. 6. 7. 8. 9. To forecast cash inflow and outflow. Plant the cash requirement. Determine the safe level of cash. Monitor the safety level of cash. Locate funds needed. Regulate cash inflow. Determine the criteria for investment of excess cash. Regulate cash outflow. Avail banking facilities and maintain good relationship with bankers.
Problems of cash management 1. Impact of inflation on cash flow: Inflation is growth in value terms and therefore it provides of rapid inflation a firm should expect to find itself in a very unfavorable cash flow position, like that of the firm which is growing very fast. In the words of W.C.F. Hautrey in advances terms it comes dangerously close to compounding a felony.
Timing of cash flow:
39
Period to another the figure indicates the variations during the different firms with identical cash balance at the beginning and at the end of the year, but with vastly different patterns of cash flow. Most amounts are to be dimensional, which means an annuity multiplied by a price. Cash flow amounts passes the perverse third dimension of time and indeed, it is the time dimension which is at the root of the various problems created by accounting concepts, therefore it the long term profit are aimed at but in short term the cash flow is much more important. 2. Environment: There are environmental constraints that create cash flow problems for a firm. Such problem may be created by the very nature of its operations, such a location or season ability of the market place. Every firm should, therefore, examine its own position in respect of its environment that will affect its short-term flow. 3. Managerial decisions: A cash flow does not flow of its own accord. It is direct consequence of management decisions. The management procedures employed for maximizing the use of cash through the control of payable and related payments are: Timings payments to vendors so that bills are paid only as they fall due. Establishing procedure that will prevent or minimize the loss of discounts. Centralizing payable and disbursement procedures. Reducing compensating balance a deposit with banks. Improving control over inter-company transfers Utilizing manpower more effectively. Strategic tax planning.
This need not be if management uses strategic tax planning to minimize its tax expenditure. Currently, a management employs the following the techniques to reduce its tax payment. 1. It uses acerbated depreciation method or adopts guidelines and depreciation rate.
40
2. It uses investment credit to fall advantage by strategic acquisition and disposition of property, plant and equipment. 3. It reduces research and developments, costs and similar expenses in the years in which they are incurred instead of capitalizing them and amortizes such costs over a number of years. 4. It adopts changes in accounting procedures particularly those initiated by the internal reserve service or exploits changes in reporting periods. Cash forecasting: Cash forecasts are required to prepare cash budgets. Cash forecasting may be done on short term or long-term basis. Generally, forecast covering period of one year or less are considered short term, those beyond one year considered long term. Types of cash forecast
Short term forecast
Long term forecast
Short term forecast: It covers a period of one year or less. The important uses of short term cash forecast are: It helps in determining cash requirements. It helps in anticipating short term financing. It helps in managing money market investments.
Long-term cash forecasting: Long-term cash forecasts are prepared to give an idea of the companys financial requirements. Once a company has developed a long term cash forecast, it can be used to evaluate the impact of new product developments or plant acquisition on the firms financial position; three, five or more years in future.
41
The Major uses of long-term cash forecasts are: 1. It indicates a companys future financial needs, especially for its working capital requirements. 2. It helps in evaluating proposed capital projects. It pinpoints the cash required to finance these projects as the cash to be generated by the company to support them. 3. It helps in improving corporate planning. Long-term cash forecasts compel each division to plan for future and to formulate projects carefully. Long-term cash forecasts may be two, three or five years. How to manage debts? a. Establish a credit policy: The company should consider whether it is appropriate to offer credit at all and if so how much, to whom and under what circumstances. b. Assess customers credit worthiness: From their banker or other sources before allowing trade credit. c. Establish effective administration of debtors: That not goods are dispatched until it has been vouched that the present order will take the customer above his predetermined credit limit. That invoices for supplied on credit go off the customers as soon as possible after the goods are dispatched and this encourages the customers to initiate payments sooner rather than later. That existing debtors are systematically reviewed and that slow payers are sent reminders. d. Establish a policy on bad debts: The company should decide what is policy on writing off bad debts should be. This policy should be planned except in unusual circumstances. It is important that writing off a bad debt only occurs when all steps mentioned in the policy have been followed. Such writing off should be done at a senior level management.
42
e. Consider offering discount for prompt payment: It is possible to enter into agreement with a factoring company. In such cases, payment is received from factoring company immediately after sale.
43
INVENTORY MANAGEMENT
Inventory: It refers to stock, raw materials, components, and spares or work-in-progress maintains in an organization to have continuous production and sales. Inventory management is the third component of working capital management. It involves the processes of providing continuous flow of raw materials to production department. More than 60% of the working capital will normally be invested in the inventory. Hence, the management of inventory has gained considerable recognition in the subject of financial management. An efficient system of inventory management directly contributes to the growth of profitability of the business concern. Due to inflation and the concept of time value of money, inventory management has gained important recognition in the day-to-day management of business units. The scientific process of implementing inventory management provides inventory at right time, from right source and at right prices. It also involves the step that is to be taken with regard to storage and supervision of these materials. The main objective of inventory management is to reduce the order placing and receiving and inventory carrying cost. This not only ensures continuous flow of raw materials but also the cost of production. The excess and inadequate supply of raw materials directly disturbs the normal functioning of the business units. Excess inventory leads to idle investment, high carrying cost and wattage. Inadequate inventory directly affects the production process. Therefore, scientific principles are to be adopted to manage the inventory. To avoid all these problems, in Japan, JIT concept has been introduced (Just In Time). It refers to the supply of raw materials to the production department directly by the suppliers. The agreement will normally be made with supplier of materials on such terms, so that the supply of raw materials must be made without any interruption to the normal production activities. The success of this arrangement mainly depends on the sound infrastructure facilities. In India, only few industries have introduced JIT concept to procure raw materials directly. Example: Kirloskar and Maruthi Udyog Private Limited. These have introduced this technique in procuring certain components directly from the suppliers.
44
OBJECTIVES OF INVENTORY MANAGEMENT

The important objectives of inventory management are: 1. To provide continuous supply of raw materials to carry uninterrupted production. 2. To reduce the wastage and to avoid loss of pilferage, breakage and deterioration. 3. To exploit the opportunities available to reduce the cost of purchase. 4. To introduce scientific inventory management techniques. 5. To provide right materials at right time, at right sources and at right prices. 6. To meet the demand for goods by the ultimate consumers on time. 7. To avoid excess and inadequate storing of materials. 8. To protect quality of raw materials. 9. To reduce the order placing and receiving costs to the minimum. 10. To ensure effective utilization of the floor space. Costs associated with holding inventory: The continuous flow of inventory is most essential to carry out smooth productive activities. The success and timely supply of finished goods, mainly depends on uninterrupted supply of raw materials to the production department. To ensure this flow of raw materials, the company has to maintain adequate quantity of inventory. Storing of these components involves many types of costs and uncertainties. As the value of the materials, increases than the value of a rupee, it should be maintained judiciously. Some of the costs associated in managing the inventories are discussed below. 1. Financial costs: It is also known as capital cost. The finance required to purchase the inventory and the cost beard for mobilizing, it is known as financial cost. Therefore adequate supply of finance at cheapest cost must be made available to maintain the inventory. 2. Costs of storage:
45
Inventory is to be stored properly by protecting the quality.
The space
required for storing the inventory must be adequately provided. This cost consists of the rent payable for storing the materials and maintenance of inventory cost (Insurance). 3. Price fluctuations: Inventories are exposed to wide fluctuations in the price. Many a times, the prices of materials may be reduced. If the price paid for procuring the materials is higher than the price that is prevailing, it is a loss to the business firm. 4. Risk of obsolesce: Due to the increased research and innovative and creative minds of technologies, new materials and products will enter into the market. Under such circumstances, the product manufactured today becomes obsolete. 5. Deterioration in quality: In a practical situation, the production department for various reasons may not issue most of the materials stored. In the process, such material losses its quality or deteriorates itself from original value. 6. Theft, damages and accident: The materials are stored in the warehouse. If it is not properly taken care, it is exposed to different types of uncertainty viz., theft, damage and fire accident etc., all these are losses or increase the cost production. 7. Order placing cost: Order placing cost is the permanent cost, which is incurred by the business firm to place the order for materials, the salary of clerk, manager and establishment charges will also be considered in managing the inventory. 8. Inventory carrying cost: It maintains the expense of stores, bins to the staff who are in charge of the warehouse or storage. Hence these costs are reduced to increase the profitability of the firm. 9. Cost of shortage of stock:
46
Many a times, business firms may not be able to arrange the adequate supply of regular for various reasons. As a result, production work may be stopped. Therefore, sufficient care should not be taken to have this cost running the business. Tools of inventory management:
T O O L S
Fixation of levels ABC analysis EQQ Perpetual inventory system VED analysis FSN analysis Periodical inventory evaluation
1. Fixation of levels: It is a tool through which the inventories are maintained by fixing different levels namely: maximum level, re-order level, Minimum level and Danger level.
47
Fixations of levels are made by considering different factors viz., nature of raw materials, cost, availability lead-time, storage space and cost etc., Maximum level: It is a level set for materials beyond which it should not be stored. Considering the various factors namely availability of raw materials, lead-time, storage space etc., Materials stored beyond maximum level creates several financial and managerial problems to the firm sets maximum level. The following formula is used to fix maximum level. Maximum stock level = Re-order level = Re-ordering quality (minimum consumption x minimum re-ordering period) Re-order level: Re-order level is that level fixed for the materials to indicate the urgency of procuring them for the market. This level is fixed by considering the rate of consumption of materials, lead-time and the availability of raw material. Once the materials reaches this level, stores controller places his request to purchase the materials. So those, he can maintain storage of such items to maximum level. Re-order level = maximum consumption x maximum re-order period. Minimum level: It is also known as safety stock, below which the storing of materials leads to severe consequences. In other words, it is a level at which stores controller takes immediate action in procuring the materials. Any negligence on the part of the in charge of stores may lead to stoppage of production. Considering lead-time, rate of consumption and the nature of material sets this level. Minimum stock level = re-ordering level (normal consumption x normal re-order period) Danger level: It is the level beyond which storage of materials should not fall. It also indicates the necessity to arrange for quick purchase of materials. Otherwise, a firm has to stop the production of major plants. The stores in charge may procure the materials even at the cost of extra expenses and strain.
48
Danger level = average consumption x maximum re-order period for emergency purchase. 2. ABC analysis: Under this method, the material is managed by giving importance to its value. Classifications are being made by grading the materials as A,B and C. Grade A materials are costly high in value but less in number and are supervised and controlled closely. Grade C materials are cheap in value but more in quantity and least attention are given in monitoring these times. Grade B materials are moderate in value and moderate number of such items are maintained with moderate control. 3. Economic order quantity: Economic order quantity is that quantity of materials to be ordered where it will have least or minimum order placing and carrying cost. It is also called as the size of the materials to be purchased most economically. The ordering cost or order placing costs consists of salary of the staff who are in charge of ordering goods, transportation costs, inspection costs, cost of stationery, typing, postage, telephone charges etc., Carrying costs refers to the cost of capital, cost of storage, insurance cost and cost of spoilage etc., both these costs should be maintained at minimum to order for a specific quantity of materials this can be calculated by using a formula where A = annual consumption in rupees; S = cost of placing an order; I = inventory carrying cost of one unit. 2AS Economic order quality = I 4. Perpetual inventory system: It is also referred as continuous stock checking. Under this system, registers are maintained for materials, entries are made as and when the materials are received and issued. The physical verification of materials is conducted throughout the year. Hence it is identified as a costly technique of inventory Though it is a costly technique, the benefits enjoyed by management are many statements of materials, follow up monitoring etc., can be smoothly carried out. As a result for inventory management. control. the action, of this
benefit, many trading as well as manufacturing concerns are adopting this technique
49
5. VED analysis: It is most suitable method for automobile industries specially to maintain spare parts. All parts are classified into vital, essential and desirable components. Vital parts for the manufacturing of a product will be closely monitored. Inadequate supply of these parts may substantially damage the productive activities. E type of materials is no doubt that they are essential, but their levels of stocks are moderately low. Desirable (D) components may or may not be maintained. Non-availability of D type of spares do not damage the normal functioning of the industry. 6. FSN analysis: Under this method, materials are grouped according to the movements. Fast moving items, slow moving and non-moving items. Fast moving items are stored in large quantity and a close watch on the movement of such items is kept. The production department does not frequently need slow moving items; accordingly moderate quantity with moderate supervision will be maintained. The production departments rarely require non-moving items. Hence a smaller number of materials are kept in stores and less importance is given in inventory management. 7. Periodical inventory valuation: Under this system inventory valuation with checking will be carried out at different intervals, generally twice or thrice in a year. During the period of stock checking, normal functioning of the organization will be closed for one or two days and complete stock verification and valuation will be done accordingly. Most of the trading concerns adopting this technique for their inventory management. Factors influencing inventory requirement: 1. Lead-time: It refers to the time gap between the recognition of a need and its fulfillment. During lead-time, production has to depend on the existing stock of raw materials, as there is no delivery of the same. Both lead-time and consumption rate can be increased abruptly and inventories are generally maintained to tie over this
50
contingency. Therefore, as the lead-time increases, the inventory maintained on hand also increases. 2. Cost of holding inventory: Whenever inventory are held, it involves costs Material cost:
The cost of purchase of raw materials plus transport and handling charges. Order cost: The cost of placing an order with the supplier and generally, in the nature of stationery and administrative costs. Carrying cost:
Consists of the cost of funds locked up in inventory, storage cost etc., Stock out cost:
The cost of shortage of inventory, causing a loss in current profits and decrease in future sales. 3. Reorder point: The represents the level of inventory at which an order should be placed to replenish stocks and is determined by the rate of consumption of inventory and leadtime. If the reorder point is at a higher level, inventory will be high and if is set a lower level, stock of raw materials will tend to be low. 4. Reduction in variety: Generally, a production firm will have in stock a large variety of items used in different stages of production process. As the operations of the firm expand, the stocks of these items too increase, making control difficult. Therefore, firms try to reduce the variety of stock items, which they hold, thus reducing the inventory on hand. 5. Service level:
51
The service level of a firm is the ratio of the number of orders it can fulfill to the number of orders received i.e., how many of the orders a firm has received can be fulfilled by it. To have a higher service level, a firm most obviously has a high level of raw materials and finished goods. 6. Scrap and obsolete inventory: Sometimes, a firms inventory can become obsolete due to technological development or change in consumer tastes and preferences. In such a situation, a firm must quickly dispose off its obsolete inventory to avoid incurring further losses. This decreases the level of inventory on hand. 7. Nature of business: Production and trading concerns have to carry large inventory. Trading
concerns have to carry large inventory to ensure smooth trading activity. While retailers have to stock a variety of products, since they sell to ultimate consumers, wholesalers need to carry stock of only a single / few items, since they sell to intermediaries. Retailers may thus need more funds. Similarly, service firms do not carry an inventory since they provide services. 8. Inventory turnover: Firms belonging to the same industry may have different inventory levels due to difference in turnover. Inventory turnover reveals how many times the inventory turns over during a period i.e., the ratio of sales to inventory. Greater the turnover, lesser the investment in inventory. A firm having a high turnover can manage a relatively large volume of trade with the same amount of inventory. Inventory carrying costs also tend to be less, as also risks associated with price declines. 9. Method of inventory valuation: The level of inventory also depends on the method of valuing inventory. Under FIFO, material acquired is consumed first and the closing stock represent
52
material acquired last. Under LIFO, goods acquired recently are disposed off first and the closing stock represents material purchased in the beginning of the period. if LIFO were followed in times of rising prices, investment in inventory would be less than if FIFO had been used. The opposite is true to declining prices. 10. Ability of management to predict disruption: If the management of a firm can predict disruptions in production with reasonable accuracy, it can maintain a lower inventory than when it cannot predict disruptions, as higher levels will have to be maintained to meet contingencies. 11. Credit terms availed: If the supplier provides material on demand but agrees to accept payment only at the time of sale of finished goods, a firm need not maintain high inventory levels. Factors influencing inventory of raw material: 1. Quantity of estimated production: The quantity of raw material to be stocked depends on the quantity and pattern of goods to be produced. The production and sales manager must thus be consulted before fixing the raw materials to be held. If the firm anticipates a decrease in demand, production naturally decreases and therefore fewer raw materials would need to be stocked. The opposite is true, if demand is expected to rise. Moreover, if a firm produces a variety of finished goods, its investment in inventory will be substantial because different kinds of raw materials will have to be stored. 2. Nature of business: The nature of business of a firm influences the level of raw material it has to stock. Production firms, for e.g., tend to have a higher stock of raw materials while trading firms will not have any stock of raw materials they store only finished goods. 3. Need to increase inventory: Sometimes, it is more profitable for a firm to have higher levels of raw materials. Increased inventory is advantageous in the following situations.
53
When quantity discounts are being offered, which prove economical to the firm, i.e., when the benefits of the discount far exceed the cost of carrying increased inventory. When the supply of raw materials is not reliable or is seasonal. In cases where the firm produces a seasonal product and so needs to increase stocks of raw materials during the peak season. When the lead-time is high, the firm will have to carry out more safety stocks to meet the delay in delivery of material. 4. Business cycles: During the boom period, stocks of raw materials have to be high to meet the expected rise in demand. Moreover, prices of raw materials are usually cheaper in the initial stages of a boom period and companies therefore take advantage of this and buy in bulk increasing their stock levels in the process. 5. Management policy: The policy of the management towards inventory and its control determines the level of raw material. For e.g., if the firm follows the JIT method of stocking inventory, there will be lower levels of raw materials, lesser investment in inventory, lesser cost and lower risk. However the JIT approach has its disadvantages the unit price of raw material in small purchases is higher than in big lots. Ordering costs also increase, because of frequent orders and there exists a risk in the case of rising prices of raw materials. To overcome these drawbacks, a firm may store a higher level of raw material, which increases the investment in inventory. Factors influencing inventory of finished goods: Since a firm has no control over the rate at which its products are sold, it has to hold an adequate stock of finished goods to meet changes in demand. But holding a large stock of finished goods increases the carrying cost and also the risk of loss in case of a price decline or changes in consumer tastes and preferences. The following factors influence the level of finished goods stocked by a firm. 1. Inventory turnover: The level of finished goods inventory, depends on how well production and sales are co-ordinate. A liberal credit polity can dispose off finished goods faster, thus reducing the level of finished goods, but it also increase the funds tied up in inventory, because cash is not immediately realized when finished goods are sold. The possibility of bad debts also increases.
54
2. Need to store finished goods: The need to store finished goods varies from business to business. Firms producing seasonal goods, for e.g., have to store higher level of finished goods to meet continuous demand throughout the year. Some firms supply raw materials to other firms on the conditions that the latter source their finished goods to them. The firm sending the finished goods to its suppliers need not hold a very high level of finished goods, as also firms which manufacture against advance orders. 3. Business cycle: A firm ends up carrying out a higher inventory of finished goods during recession, because of decreased demand and a lower inventory during boom due to peak demand. 4. Durability of product: The durability of product determines its stock level. Perishable products such as processed foods cannot be stored in large numbers. Producers of FMCGs cannot afford too large or too small an inventory due to rapid changes in consumer tastes and preferences rendering the goods obsolete; durable goods however can be stocked in large numbers. 5. Management attitude: Dynamic, proactive managers try to anticipate future changes in demand by using advanced techniques to increase the accuracy of such estimates. Therefore, adjustments in production and inventory can be made and the risk / loss due to faulty estimates can be reduced. Conservative managers on the other hand do not bother about estimating changes in demand they prefer to carry large stocks and err on the side of caution.
55
Factors influencing inventory of work-in-progress: Until work in progress are converted to finished goods and sold, funds are tied up in them. The following factors determine the inventory of work-in-progress. 1. Length of production cycle: Longer the time taken for inventory to travel through various production processes, greater are the funds invested in work inprogress and vice versa. A complicated production process would mean a longer production cycle and large funds locked up in work in progress. The production process can however be speeded up and the production cycle shortened, by implementing advanced techniques of production. 2. Operating efficiency: Greater the operating efficiency, shorter the production cycle and lower the funds invested in work in progress. 3. Sub contract: Some firms sub-contract various jobs of the production process to outside contractors and merely assemble the various parts received from these contractors. Such firms will have a very low investment in work in progress.
56
RECEIVABLE MANAGEMENT
Introduction: What are accounts receivable? John.J Hampton defines accounts receivable as Asset accounts representing amounts owed to a firm, as a result of the sale of goods / services in the ordinary course of business. Therefore, they represent the claims of a firm against its customers and are shown in the assets side of a balance sheet under the heading accounts receivable / trade receivable / customer book / book debts. Firms to allow customers a reasonable period of time to pay for goods purchased and thus represents an extension of credit to them provide the facility. The problem of managing receivables arises only when goods are sold on credit, which has become the sine qua non of todays competitive economy. If competitors are offering credit, a firm will be forced to do the same to retain, if not increase in its market share. As a marketing tool, credit is generally used to promote sales and profits. However, it is also lengthens the cash cycle since goods sold are not converted to cash but a book. If funds are not tied up in receivables, the company can invest the same in profitable avenue and earn a good return. Therefore, the opportunity cost of lost profits is one of the major costs of carrying receivables. The others are cost in involved in investigating the credit worthiness, collection costs and risk of bad debts. A firm selling goods for cash can reduce these costs, but only at the cost of sales / customers. A firm, selling on cash, cannot survive when its reducing the volume of receivables without harming sales. He should manage receivables in such a way that it optimizes profits. The objective of the credit policy should be to promote sale and profits till the point where the ROI in funding additional receivables is less than the cost of funds used to do the same. Meaning of receivables management: Accounts receivables form the second largest constituent of CA after inventory and thus the need for their effective management arises. Since selling goods on credit locks up funds in receivables, the firm will have to borrow money to finance its operating needs. The finance manager has to determine the ideal level of
57
receivables, so that there is smooth flow of working capital.
A higher debtors
turnover ratio will also help us in minimizing borrowings to meet the working capital requirement. Receivables management, therefore consists of maintaining debtors at an optimum level, determining the degree of credit sales to be made, making the turnover of debtors faster, minimizing the cost of borrowing funds for working capital, etc., Purpose of receivables management: Receivables came into existence as result of credit sales. The objective of receivables is thus directly related to the objectives of credit sales. 1. Increasing sales: A firm tends to sell more goods on credit than the cash, because many customers are either not prepared or not in a position to pay cash when they purchase goods. The firm can therefore sell goods to such customers, only if it offers credits. 2. Increasing profits: Profits increase when goods are sold on credit. This happens, because of two reasons Increased sales, Higher profit margin charged on credit than on cash sales.
3. Meeting competition: If a firms competitors have been extending credit facilities, the firm is forced to do the same. Otherwise, its chance to lost customers, who would rather buy goods where credit facilities are offered. Objectives: Accounts receivables represent an extension of credit to customer allowed them a reasonable period of time in which to pay for the goods, which they have
58
received. The creditors are generally made to open an account in the sense that they are no formal acknowledgement of the debt obligation through a financial instrument. As marketing tools they are intended to promote sales and thereby profits. However, extension of credit involves risk and cost. The objective of receivables management is it permits sales and profits until that point is reached where the return on investment is further additional credit (cost of capital). The specific cost of benefits that is relevant to the determination of the objectives of receivables management are examining below. Costs: There are major categories of cost are 1. 2. 3. 4. Collection costs Capital costs Delinquency costs and Default costs
1. Collection cost: The costs are administrative cot incurred in collecting the receivables from the customers to whom credit sales have been made. Additional expenses on the creating and maintenance of credit department with staff accounting records, stationery, postage, and other related items. Expenses involved in acquiring credit information either through outside specialist agencies or by the staff of the firm itself. 2. Capital cost: The increased level of accounts receivables is an investment in assets. They have to be financed thereby involving a cost. There is a time lag between the sale of goods to and payments by the customers. Meanwhile the firm has pay employees and suppliers of raw materials thereby implying that the firm should arrange for additional funds to meet its obligation while waiting for payments for its customers. The cost on the use of additional capital to support credit sales, which alternatively could be profitably, employed else where is therefore a part of the cost of extending credit or receivables. 3. Delinquency cost: Yet another cost is associated with extending credit to customers. This rise out of the failure of the customers to meet obligation when payment on credit sales due after the expiry of the period of credit. Such cots are called delinquency cost. The important components are
59
on.
Blocking up of funds for an extended period Cost associated with steps that have to be intended to collect the over dues,
such reminders and other collection efforts, legal charges whenever necessary and so
4. Default cost: Finally in addition to the above costs the firm may not be able to recover the over dues because of the inability of the customers. Such debts are treated are bad debts and have to be written off as they cannot be realized. Such credit is known as default cost associated with credit sales and accounts receivables. Purpose of receivables: 1. Achieving growth in sales: If it sells goods on credit, it will generally be in a position to sell more goods than if it insisting on immediate cash payment. This is because many customers are either not prepared or not in a position to pay cash when they purchase the goods. The firm can sell goods to such customers in case it resorts to credit sales. 2. Increasing profits: Increase in sales results in higher profits for the firm not only because of increase in the volume of sales but also because of the firm charging a higher margin of profit on credit sales as compared to cash sales. 3. Meeting completion: A firm may have to resort of granting of credit facilities to its customers because of similar facilities to its customers because of similar facilities being granted by the competing firm to avoid the loss from customers who would buy else where if they did not receive the expected credit. Characteristics of maintaining receivables: 1. Expansion of sales: Thought it is a good policy to effect cash sales to minimum possible extent, it may not always be possible to do so customers may not be willing to buy goods on cash down basis. They have therefore to be encouraged with the offer of credit terms.
60
In the absence of such an offer, a firm may not be able to sell goods. Receivables enable it to push its sales effectively in the market. 2. Increased profits: As a result of increase in sales profits rise. This is ordinarily so because the marginal contribution effected by an increase in sales is greater than additional cost associated with such increase as also with administration of credit policy. the firm are thrown open for the use of customers. 3. Financing receivables: The uses of credit invariably involve the tie in of capital. It follows therefore that this capital has to be financed by some source of funds. It is usually customary to finance receivables out of: profit retained in business Contribution from stock holders Debt financing. Whatever the source of financing, it carries its own cost with the help of which receivables must be financed. Receivables may be financed from ting capital or longterm debt or by using additional capital or long-term debt as the case may be. The maintenance of receivables involves a credit sanction, which means that the funds of
4. Administrative expenses: The maintenance of receivables calls for the use of an administrative machinery in different ways. A firm may be constrained to appoint several persons or engage collection agencies to remind and even call on the delinquent customers to make payment. A number of collection letters and reminders usually follow which eventually increase the cost of collection.
61
5. Bad debts: The decision to maintain receivables implies that some amount of bad debts would be incurred because of default on the port of the delinquent customers. A firm can only hope to nullify its bad debts. As best it can only hope and strive hard for reducing them to the minimum. It is therefore advisable for a firm to assess the impact of the changes in collection cost is bad debt losses administrative expenses and such other factors from time to time. Level of sales: The most important factor in determining the volume of receivables is the level of a firms credit sales. With an increase in the size of sales, it may decide to bring about a proportionate increase in the magnitude of receivables. Credit policy: A firm with a liberal credit policy may keep a higher level of receivables that with a conservative or rigid credit policy. Moreover, customers may not pay their receivables promote. It should be remembered that weak customers might be In establishing its credit policies a firm to find a promoted in payment if they are persuaded to pay, failing which they are likely to be converted into defaulters. satisfactory middle ground between incurring collection costs that accompany a highly aggressive policy and suffering excessive default and bad debts that accompany lenient policy. Terms of trade: The size of receivables is closely linked with a firms trade terms which include the period of credit, the rate of discount, etc., The pressure of competition always tend to constrain a firm to offer credit terms that are at least as generous as those offered by competitors. The terms of credit thus become almost customary. Profits:
62
A firm investigates different possibilities and forecast the effect of each possibility on its future profits. As the level of receivables increases cost of financing them goes, up, however with an increase in receivables there is also an increase in sales, the relation between cost and benefit in the maintenance of receivables has to be properly traced. If in the ultimate analysis it were discovered that the benefit is greater than the cost of the decision would certainly be in favors in maintaining receivables. Market: It may be necessary for a firm to explore a new market for its products or services. One of the attractive ways in which a firm enters a new market is by inducing customers to buy from it because of the facilities of receivables extended to them. Such an inducement moreover accelerates the growth rate to the firm and enables it to undertake plans to expansion. Grant of credit: Size of receivable depends upon the policies and practices of the firm in determining which customers are to be granted credit. Payable habits of customers: These too are capable of influencing a firms policy in regard to receivables. Collection policies: The vigor with which a firm collects its dues from customers affects its policies in regard to receivables; for, if the amount when due are not collected, a firm suffers some financial difficulties, if not losses. Credit policy: Risks of loss and the burdens involved in the tying up of funds are considered while determining a credit policy. Operating efficiency: The degree of operating efficiency in billing record keeping and other functions also exercise influence on a firms credit policy. The volume of cash sales:
63
The tendency of credit expansion is usually related to the volume of credit sales. Credit collection: Individual firms set up their own well organization credit collection departments. Advantages of receivables: It is an interesting fact that business enterprises have little or no understanding of this method of borrowing or how simply their accounts receivables may be employed as a source of borrowing cash. The assignment of accounts receivables furnishes additional operating cash and there is no need for diluting the equity and control of owners. Owners moreover, small and medium size corporations find it difficult to rise additional as through security issues. Small medium size and even large corporations find it expensive to raise funds through long-term debt. The accounts receivables financing arrangements provides a business firm with an established source of fund which may be used for long as well as short term purposes and which does not obligate it to pay money when it is not needed. Business firms find it very difficult to secure cash through unsecured loans from commercial banks and other debts, account receivables financing therefore serves as limited loan to a rapid and successful finance undertaking company. Accounts receivable financing is of a revolving nature and provides a continuous source of operating. It is flexible because borrowing under it may be contributed throughout its life or used only temporarily to meet a constant need. If a firm makes use of accounts receivables financing it does not have to wait to get back the money, it has invested in the goods it sells. It simply assigns the credit sales of its financing source. A wise use of debt capacity as in the employment of accounts receivables for a firm will have more cash with which it can take advantage of any profitable opportunities, which may develop. It enables businessmen to protect and improve a firm credit rating for the latter is in position to pay on due dates.
64
Costs of maintaining accounts receivables: Capital costs: Maintaining receivables result in locking up of funds. This is because there is a time lag between the sale of goods and payment by customers. The firm therefore has to arrange for funds to meet. Its obligations-payments to employees, suppliers etc., and while waiting for its customers to pay up. These funds can be owned or borrowed. Both however, involve a cost. While the cost of borrowed funds is represented by the rate of interest the firm has to pay, the cost of owned funds is nothing but the opportunity cost of funds.
Administrative costs: Additional administrative costs have to be incurred in the form of salaries to staff maintained for keeping the accounts of customers, cost of investigation of potential credit customers to determine their credit worthiness, etc.,
Collection costs: Additional costs are incurred to collect payment from credit customers and extra efforts may be needed to recover money from defaulting customers.
Cost of bad debts: Sometimes, defaulting customers cannot pay up, the firm has to write off their dues as bad debt.
Factors affecting size of receivables: Volume of credit sales: The basic factor, which increases or decreases the size of receivables, is the volume of credit sales. If a firm sells goods only for cash, it will no have receivables. Higher the proportions of credit sales to total sales, greater the size of receivables. The level of credit sales depends on the management policy. If a firm need sales to push a product, it will have to adopt a liberal credit policy, which increases the size of receivables. 1. Credit policies: Credit policy refers to those decisions variables, which influence the amount of trade credit i.e., investment in receivables. In other words, it is a policy adopted to increase credit sales, which consists of
65
Time period allowed collecting debts Types of discounts offered Assessment of potential customers credit worthiness Collection policy Any special terms offered depending on the particular circumstances of the
firm and the customer. A firms credit policy determines the amount of risk it is willing to take in its sales activities. A lenient / liberal credit policy will imply a higher level of receivables because even customers who can afford to pay cash immediately delay payments. Financial weak customers will default increasing the size of receivables. The policy varies with changes in the economy. During recession companies will have to adopt a more liberal credit policy to encourage sales, which increases the size of receivables. Customers may also take a longer time to pay. During boom people will want to buy more with the surplus cash and credit will be low, reducing size of receivables. Collection period also gets reduced. The credit policy can be rigid or liberal. If a firm follows a rigid credit policy, the volume of its receivables will be low, as also the risk and debtors management will be better. If liberal credit policy is followed, the size of receivables increases and with it, the risk of bad debts, as even customers who can afford to pay avail of credit. The inflow of cash thus reduces. 2. Competition: If a firm is in a competitive industry, it will be forced to follow a liberal credit policy to retain its market share. This is reflected in the increased size of receivables. 3. Location: The location of a firm influences its credit policy. If the firm is situated in an isolated or far-off place, it may be coerced to offer liberal credit to attract customers. 4. Kind of products: The type and nature of products manufactured by a firm influence the size of receivables. Firms manufacturing exclusive products can afford a conservative policy. While those manufacturing competitive products will have to offer liberal credit. When new products are introduced, liberal credit policies have to be followed till the market accepts the new product.
66
5. Expansion plans: When a firm wants to enter new markets, it may have to offer incentives to customers in the form of liberal credit. correspondingly. 6. Relation of profits: Credit is used to increase sales and thereby the profits but beyond a certain point, the cost of increased sales will be greater than the revenue from the same. Therefore, it is advantages to a firm to increase sales only upto the point where benefits exceed the cost. 7. Credit collection efforts: Effective and efficient collection efforts can reduce the size of receivables without harming sales. If adequate attention is not paid to collection or if collection is not effective the firm will find it saddled with the high debts. Therefore, during the early stages of expansion, more credit becomes essential and the size of receivables increases
8. Customer habits: Some customers delay paying their dues though they are financially sound. The unnecessarily increase the size of receivable and the cost of funding them. Therefore, customer payment habits should be studied before granting credit. Approach to receivables management: It is the credit department in an organization, which performs the job of granting credit to customers, supervising the collection of receivables. The basic objective of receivables management is to maximize the ROI of funds invested in receivables. Managing receivables means making decisions relating to the incitement of funds in receivables, as a part of internal short run operating process. The goal of liquidity entails using cash as economically as possible to expand receivables without adversely affecting sales and the chances of increasing short-term profits. Therefore, finance managers must keep in mind the dual objectives of maintaining sufficient cash for current operations and of expanding credit sale to earn
67
more profits. Policies, which stress on short credit periods, strict. Credit standards and a highly aggressive collection policy may help reduce bad debts and the amount of funds locked up in receivables, but they also discourage sales and therefore depress the profits. Consequently, the rate of return on the total investment of the firm may be lower than that achievable with a higher level of sales, receivables and profits. Liberal credit policies, on the other hand, may increase the receivables and bad debts without increasing sales and profits correspondingly. So, the objective of receivables management is to achieve a balance between these two policies, which result in the combination so those sales and profit rates that maximize the overall rate on total investment. To achieve this, there must be co-ordination between the sales and finance manager. The two basic goals of financial management, liquidity and profitability, concentrate on the following in receivables management. 10. The prospect of collecting receivables when they become due. 11. The prospect of shortening future receivables activities. Liquidity increases as the certainty of collecting receivables on maturity increase and vice-versa.
RATIO ANALYSIS AND CLASSIFICATION OF RATIOS

Ratio Analysis: Ratio analysis is a powerful tool of financial analysis. In such an analysis the ratios are used as yardstick for evaluating the financial condition and performance of the firm. Analysis and interpretation of various accounting ratios give a skilled and experienced analyst a better understanding of the financial condition and performance of the firm than what he could have obtained only through a perusal of financial statements. Meaning of ratios: The relationship between two accounting figures, expressed mathematically is known as a ratio (financial ratio). The term ratio refers to the numerical or quantitative relationship between two figures. A ratio is the relationship between two figures, and obtained by dividing the former by the later. Radios are designed to show how one number is related to another. Ratios are relative form of financial statements to measure the firms liquidity, profitability and solvency.
68
Significance of ratio analysis: Following are the significance of ratio analysis A. Managerial uses of ratio analysis: 1. Helps in decision-making: Financial statements are prepared primarily for decision-making. But the information provided in financial statements is not and in itself and no meaningful conclusion can be drawn from these statements alone. Ratio analysis helps in making decisions from the information provided in these financial statements. 2. Helps in financial forecasting and planning: Ratio analysis is of much help in financial forecasting and planning. Planning is looking ahead and the ratios calculated for a number of years work as a guide for the future. Meaningful conclusions can be drawn for future from these ratios. Thus, ratio analysis helps in forecasting and planning. 3. Helps in communicating: The financial strength and weakness of a firm are communicated in a more easy and understandable manner by the use of ratios. The information contained in the financial statements is conveyed in a meaningful manner to the one for whom it is meant. Thus, ratios help in communication and enhance the value of the financial statements. 4. Helps in co-ordination: Radios even help in co-ordination, which is of utmost importance in effective business management. Better communication of efficiency and weakness of an enterprise results in better coordination in enterprise. 5. Helps in control: Ratio analysis even helps in making effective control of the business. Standard ratio can be based upon preformed financial statements and variances and deviations, if any, can be found by comparing the actual with the standards so as to take a corrective action at the right time. The weakness or otherwise, if any, come to the knowledge of the management which helps in effective control of the business.
69
6. Other uses: These are so many other uses of the ratio analysis. It is an essential part of the budgetary control and standard costing. Ratios are of immense importance in the analysis and interpretation of financial statements as they bring the strength or weakness of a firm. B. Utility to share holders / investors: An investor in the company will like to assess the financial position of the concern where he is going to invest. His first interest will be the security of the investment and then a return in the form of dividend or interest. For the first purpose he will try to assess the value of fixed assets and the loan raised against them. The investor will feel satisfied only if the concern has sufficient amount of assets. Longterm solvency ratios, on the other hand, will be useful to determine profitability position. Ratio analysis will be useful to the investor in making up his mind whether present financial position of the concern warrants further investment or not. C. Utility to creditors: The creditors or suppliers extend short-term credit to concern. They are interested to know whether financial position of the concern warrants their payments at a specified time or not. The concern pays short-term creditors out of its current assets. If the current assets are quite sufficient to meet current liabilities then the creditors will not hesitate in extending credit facilities. Current and acid test ratios will be an idea about the current financial position of the concern. D. Utility to employees: The employees are also interested in the financial position of the concern especially profitability. Their wage increases and amount of fringe benefits are related to the volume of profits earned by the concern. The employees make use of information available in financial statements. Various profitability ratios relating to gross profit, operating profit, net profit, etc enable employees to put forward their viewpoint for the increase of wages of other benefits. E. Utility to government: Government is interested to know the overall strength of the industry. Various financial statements published by industrial units are used to calculate ratios for
70
determining short-term, long term and overall financial position of the concerns. Profitability indexes can also be prepared with the help of ratios. Government may base its future policies on the basis of industrial information available from various units. The ratios may be used as indicators of overall financial strength of public as well as private sector. In the absence of the reliable economic information, governmental plans and policies may not prove successful. F. Tax audit requirements: The finance act, 1984, interested section 44 AB in the Income Tax Act. Under this section every assesse engaged in any business having turnover or gross receipts exceeding Rs. 40 lacks is required to get the accounts audited by a chartered accountant and submits the tax audit report before the due date for filing the return of income under section 139(1). In case of a professional, a similar report is required if the gross receipts exceed Rs. 10 lacks. Clause 32 of the Income Tax Act requires that the following accounting ratios should be given: Gross profit / turnover Net profit / turnover Stock-in-trade / turnover Material consumed / finished goods produced.
Advantages of ratio analysis: Simplifies financial statements Facilitates inter-firm comparison Makes inter-firm comparison possible Helps in planning
Limitations of ratio analysis: The ratio analysis is one of the most powerful tools of financial management. Though ratios are simple to calculate and easy to understand, they suffer from some serious limitations. 1. Limited use of a single ratio: A single ratio, usually, does not convey much of a sense. To make a better interpretation a number of ratios have to be calculated which is likely to continue the analyst than help him in making any meaningful conclusions. 2. No fixed standards:
71
No fixed standards can be laid down for ideal ratios. There are not wellaccepted standards or rules of thumb for all ratios, which can be accepted as norms. It renders interpretation of the ratios difficult. 3. Inherent limitation of accounting: Like financial statements, ratios also suffer from the inherent weakness of accounting records such as their historical nature. necessarily true indicators of the future. 4. Change of accounting procedure: Change in accounting procedure by a firm often makes ratio analysis misleading, example, a change in the valuation of methods of inventories, from FIFO to LIFO increases the cost of sales and reduces considerably the value of closing stocks which makes stock turnover ratio to be lucrative and an unfavorable gross profit ratio. 5. Window dressing: Financial statements can easily be window dressed to present a better picture of its financial and profitability position to outsiders. Hence, one has to be very careful in making a decision from ratios calculated from such financial statements. But it may be very difficult for an outsider to know about the window dressing made by a firm. 6. Personal bias: Ratios are only means of financial analysis and not an end in itself. Ratios have to be interpreted and different people may interpret the same ratio in different ways. 7. Incomparable: Not only industries differ in their nature but also the forms of the similar business viable differ in their size and accounting procedures, etc., It makes comparison of ratios difficult and misleading. analysis. 8. Absolute figure distractive: Ratios devoid of absolute figures may prove distortive, as ratio analysis is primarily a quantitative analysis and not a qualitative analysis.
Ratios of the past are not
Moreover, comparisons are made
difficult due to differences in definitions of various financial terms used in the ratio
72
9. Price level changes: While making ratio analysis, no consideration is made to changes in price levels and this makes the interpretation of ratio invalid. If the price level changes are considered for ratio analysis, then it may lead to misleading results. 10. Ratios are a composite of many figures: Ratios are a composite of many different figures. Some over a time period, others are at an instant of time while still others are only averages.
FUNCTIONAL CLASSIFICATION OF THE RATIOS

1. Liquidity ratios or short-term solvency ratios: Liquidity refers to the ability of a firm to meet its obligations in the short run, certain the financial condition of a firm. Liquidity ratios are calculated by establishing relationships between current assets and current liabilities. To measure the liquidity of a firm, the following ratios can be calculated. a. Current ratio: Current ratio may be defined as the relationship between current assets and current liabilities. This ratio, also know as working capital ratio. This ratio is most widely used to make the analysis of a short-term financial position or liquidity of a firm. It is calculated by dividing the total of current assets by current liabilities. Thus, Current Assets Current ratio = Current liabilities
Components of current ratio: Current assets: 1. Cash in hand
73
2. 3. 4. 5. 6. 7. 8. 9.
Cash at bank Debtors Bill receivable Prepaid expenses Money at calls and short notice Stock Sundry supplies Other amounts receivable with in a year
Current liabilities: 1. 2. 3. 4. 5. 6. 7. 8. Creditors Bill payable Bank overdraft Expenses outstanding Interest due or payable Reserve for unbilled expenses Installment payable on long-term loans Any other amount which is payable in short period (one year)
Significance of current ratio: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Current ratio indicates the firms ability to pay its current liabilities i.e., dayIt shows short-term financial strength and solvency of a firm. It is a test of a credit strength and solvency of a firm. It indicates the strength of the working capital. It indicates the capacity to carry on work effective operations. It discloses the over-trading or under-capitalization. It shows the tendency of over investment in inventory. Higher the ratio i.e., more than 2:1 indicates adequate working capital. Lower ratio i.e., less than 2:1 indicates inadequate working capital. It discloses the quantity of working capital position. to-day financial obligations.
Ideal Ratio:
74
A ratio equal or near to the thumb of 2:1 i.e., current assets double the current liabilities is considered to be satisfactory.
CALCULATION OF THE RATIO FOR THE COMPANY FOR 2008-10 Particulars Current Assets Current Liabilities Ratios 2008 52,99,17,00 0 36,55,53,00 0 1.44 2009 61,67,88,00 0 35,92,18,00 0 1.71 2010 69,15,53,30 0 42,91,07,40 0 1.61
INTERPRETATION: The company is showing an ideal ratio of almost 1.5:1for all the three years .This shows that the company is liquid and that it has the ability to pay its current obligation in time as and when they are due. The current ratio for the company is the best for the year 2009 at 1.71:1 and the lowest at 1.44 in the year 2008 this shows that the company has a favourable growth rate as far as current ratio is concerned. b. Quick ratio: Quick ratio is also known as liquid ratio or acid test ratio or near money ratio. It is the ratio between quick or liquid assets and quick liabilities. The term quick asset refers to current assets, which can be converted into cash immediately or at a short notice without diminution of value. Liquid assets comprise all current assets minus 75
stock and prepaid expenses. Liquid assets liabilities comprise all current liabilities minus bank overdraft. The quick ratio can be calculated by dividing the total of the quick assets by total current liabilities. Thus,
Quick or liquid assets Quick ratio = Liquid or current liabilities Sometimes bank overdraft is not included in current liabilities while calculating quick or acid test ratio, on the argument that bank overdraft is generally a permanent way of financing and is not subject to be called on demand. In such cases, the quick ratio is found by dividing the total quick assets by quick liabilities (i.e., current liabilities bank overdraft). Significance of quick ratio: 1. 2. 3. 4. 5. 6. 7. 8. It is the true test of business solvency. Higher ratio i.e., more than 2:1 indicates financial difficulty. Lower ratio i.e., less than 1:1 indicates financial difficulty. This is an important ratio of financial institutions. It is a stringent test of liquidity. It gives better picture of firms ability to meet its short-term debts out of shortIf the current ratio is more than 2:1 but liquid ratio is less than 1:1 it indicates It is more of qualitative nature of test.
term assets. excessive inventory.
Ideal Ratio: An acid test ratio of 1:1 is considered satisfactory as a firm can easily meet current claims. It is the true test of the firms solvency. It gives a better picture of firms ability to pay its short-term debts out of short-term assets. It is more of a qualitative nature of test. CALCULATION OF THE RATIO FOR THE COMPANY FOR 2003-05 Particulars 2008 2009 2010 76
Liquid Assets Current Liabilities Ratios
31,20,02,000 36,55,53,000 0.85
41,64,54,000 35,92,18,000 1.15
38,29,15,600 42,91,07,000 0.89
ANALYSIS & INTERPRETATION: Usually, a high acid test ratio is an indication that the firm is liquid &has the ability to meet its current or liquid liabilities in time & on the other hand a low quick ratio represents that the firms liquidity position is not good. From the above table, it is depicted that the ratios in 2007-08 is 0.85, 1.15 in 2007-08, & 0.89 in 2009-10.The rise in quick ratio from 2008-2009 shows that the firms went short of its assets to meet its short term obligations &in 2010 the ratio comes down to 0.89 as the firm covered its short term obligations, but it is not up to the ideal ratio of 1:1. C. Absolute liquidity ratio or cash position ratio: It is a variation of quick ratio. When liquidity is highly restricted in terms of cash and cash equivalents, this ratio should be calculated. Liquidity ratio measures the relationship between cash and near cash items on the one hand, and immediately maturing obligations on the other. The inventory and the debtors are excluded from current assets, to calculate this ratio.
Cash + Marketable securities Cash position ratio = Current Liabilities
Generally, 0.75:1 ratio is recommended to ensure liquidity. This test is more rigorous measure of a firms liquidity position. If the ratio is 1:1, then the firm has
77
enough cash on hand to meet all current liabilities. This type of ratio is not widely used in practice
CALCULATION OF THE RATIO FOR THE COMPANY FOR 2007-09 Particulars Absolute Liquid Assets Current Liabilities Ratios 2008 72,64,000 36,55,53,000 0.019 2009 1,18,41,300 35,92,18,000 0.032 2010 1,55,69,000 42,91,07,400 0.036
ANALYSIS & INTERPRETATION: From the above table it is depicted that quick ratios are 0.019 in 2007-08,0.032 in 2008-09 0.036 in 2009-10. The all depict that the company is incapable of meeting its short-term obligations. This shows there has been a continuous fall in absolute liquid assets, which indicates that the firm is accelerating to cover its short term debts, never the less the ratio is not up to the standard one.
78
D. Inventories to working capital ratio: It represents the relationship between inventory or stocks and working capital of the firm. Inventory or stock refers to closing stock of raw materials, work-inprogress (i.e., semi-finished good) and finished goods. Working capital is the excess of current assets over current liabilities. It is usually expressed as a percentage. It is expressed as:
Inventory Inventory to working capital ratio = Working capital x 100
The ratio indicates the portion of working capital tied up in inventories or stocks and thereby throws some light on the liquidity of a concern. It also indicates whether there is overstocking or under stocking. of working capital. Ideal Ratio: As per the standard, in the inventory to working capital ratio, the inventories should not absorb more than 75 percentage of working capital As per the standard or ideal inventory to working capital ratio, the inventories should not absorb more than 75%
CALCULATION OF THE RATIO FOR THE COMPANY FOR 2008-10

79
Particulars Inventory Working Capital Ratios
2008 21,39,14,000 16,03,64,000 1.33%
2009 20,03,34,000 25,75,70,000 0.77%
2010 30,86,38,000 26,24,46,000 1.17%
Analysis and Interpretation: In the above table, the ratio in 2007-08 was 1.33 %, 77% in 2008-09, 117 % in 2009-10, which shows that there was over stocking of inventories which came down in 2008-09 and again increased in 2009-2010, which is not a good sign for the company. Thus, the company should curtail its inventory over stocking in order to get an optimum liquidity.
3. Activity ratios or turnover ratio: It is also refers to as assets management ratios measures the efficiency or effectiveness with which a firm manages its resources or assets. The ratios are called turnover ratios because they indicate the speed with which assets are converted or turned over into sales. These ratios are calculated by establishing relationship between sales and assets. The various turnover ratios are as follows: a. Inventory turnover ratio: This is also known as stock velocity. This ratio is calculated to consider the adequacy of the quantum of capital and its justification for investing in inventory. A firm must have reasonable stock in comparison to sales. It is the ratio of cost of sales and average inventory. This ratio helps the financial manager to evaluate inventory policy. This ratio reveals the number of times finished stock is turned over during a 80
given accounting period. This ratio is used for measuring the profitability. The various ways in which stock turnover ratios may be calculated are as follows: Cost of goods sold Stock turnover ratio = Average stock Cost of goods sold may be calculated as under: Cost of goods sold = Opening stock + purchases + Direct Expenses closing stock This ratio indicates whether investment is inventory is within proper limit or not. The quantum of stock should be sufficient to meet the demands of the business but it should not be too large to indicate unnecessary lock-up of capital in stock and danger of stock-items obsolete and getting it wasted by passing of time. The inventory turnover ratio measures how quickly inventory is sold. It is a test of efficient inventory management. To judge whether the ratio of the firm is satisfactory or not, it should be compared over time on the basis of trend analysis CALCULATION OF THE RATIO FOR THE COMPANY FOR 2008-10 Particulars Cost Of Goods Sold Average Stock Ratios 2008 99,41.59,500 3,37,24,400 29.47 2009 1,02,53,90,000 4,01,43,000 25.54 2010 1,24,87,31,400 6,35,37,300 19.65
Cost Of Goods Sold Includes=Opening stock+Purchases+Manufacturing expensesClosing stock Average Stock =Opening stock + Closing stock/2 ANALYSIS & INTERPRETATION: Usually, a high inventory turn over indicates efficient management of inventory because more frequently the stocks are sold, the lesser amount of money is required to finance the inventory. A low inventory turn over ratio indicates an inefficient management of inventory.
81
From the above table we can observe that there has been a decrease in the inventory turn over ratio from 29.47 in 2008 to 19.65 in 2010, which is an indication of low inventory turnover ratio due to which the company has to finance more amount of money in inventory. b. Debt collection period ratio: It indicates the numbers of time on the average the receivable are turnover in the each year. The higher the value of ratio, the more is the efficient management of debtors. It measures the accounts receivable (trade debtors and bill receivables) in terms of number of days of credit sales during a particular period. It is calculated as follows: Average debtors Debt collection period= Net credit sales The purpose of this ratio is to measure the liquidity of the receivables or to find out the period over which receivable remain uncollected. x 365
Ideal Ratio: The shorter the collection period the better is the quality of debtors as a short collection period implies quick payment by debtors. Similarly a higher collection period implies an inefficient collection performance, which in turn adversely affects the liquidity or short term paying capacity of a firm out of its current liabilities.
82
CALCULATION OF THE RATIO FOR THE COMPANY FOR 2008-10 Particulars Days Debtors Ratio Days Turnover 2008 365 4.17 88 Days 2009 365 3.84 95 Days 2010 365 4.13 89 Days
Analysis and Interpretation: Debtors turnover ratio indicates the number of times the debtors are turn over during a year. Higher debtors velocity shows good management while low debtors velocity shows inefficient management of debtors/sales and less liquid are the debtors. But a precaution is needed while interpreting a very high debtors turnover ratio because a very high ratio may imply a firms inability due to lack of resources to sell on credit. From the above table we observe that the collection period has been 88 days in 2007-2008, 95 days in 2008-2009, 89 days in 2009-2010. Which shows that the firm has been set standards of period of 90 days is poor collection from its debtors. c. Debt payment period ratio: This is also known as accounts payable or creditors velocity. A business firm usually purchases on credit goods, raw materials and services from other firms. The amount of total payables of a business concern depends upon the purchases policy of the concern, the quantity of purchases and suppliers credit policy. Longer the period of outstanding payable is, lesser is the problem of working capital of the firm. But when the firm does not pay off its creditors within time, it may have adverse effect on the business. Creditors turnover indicates the number of times the payable rotate in a year. It signifies the credit period enjoyed by the firm paying creditors. Accounts payable include sundry creditors and bills payable.
83
Payables turnover shows the relationship between net purchases for the whole year and total payable (average or outstanding at the end of the year). Accounts creditors Debt payment ratio = Net credit purchase x 365
Net purchase = all credit purchases purchase returns Ideal Ratio: A higher ratio shows that the creditors are not paid in time. A lower ratio shows that the business is not taking the full advantage of credit period allowed by the creditors.
CALCULATION OF THE RATIO FOR THE COMPANY FOR 2008-10 Particulars CREDITORS AVG ACCOUNTS PAYABLE DAYS 2008 98,83,12,800 32,38,37,600 119 2009 89,60,36,000 31,73,04,87,300 130 2010 1,19,83,64,500 34,22,08,200 105
Analysis & Interpretation: A higher payment period implies that greater credit period is enjoyed by the firm and consequently larger the benefit reaped by the credit suppliers. A higher ratio may also imply lesser discount facilities availed or higher prices paid for the goods purchased on credit. From the above table, one can ascertain that the company is moderately using its used its credit facilities provided to it by its creditors.
84
d. Cash turnover ratio: Its calculated as Net annual sales Cash turnover ratio = Cash
Cash for the purpose means cash in hand, cash at bank, and readily realized marketable securities. Turnover refers to the total annual sales (cash sales credit sales) effected during the year however, sales means net annual sales i.e., total sales sales returns. This ratio indicates the extent to which cash resources are efficiently utilized by the enterprise. It also helps in determining the liquidity of the concern.
85
Particulars NET ANNUAL SALES CASH Ratios
2008 1,13,23,19,000 72,64,000 155.87
2009 1,23,39,34,000 1,18,41,300 104.20
2010 1,42,54,31,000 1,55,69,000 91.55
Analysis & Interpretation: This ratio measures the velocity of sales turnover with a minimum cash balance. From the above information it is clear that the company has achieved favorable sales figure in the year 2006-07 as well as in the preceding years.
86
e. Working capital turnover ratio: This ratio is a measure of the efficiency of the employment of the working capital. It indicates over trading and under trading and is harmful for the smooth conduct of business. This ratio finds out the relation between cost of sales and working capital. It helps in determining the liquidity of a firm in as much as it gives the rate at which inventories are converted to sales and then to cash.
Net sales Working capital turnover ratio = Net working capital (Net working capital = current assets current liabilities) Higher sales in comparison to working capital mean overtrading and lower sales in comparison to working capital means under trading. A higher working capital turnover ratio shows that there is low investment in working capital and there is more profit.

87
Analysis & Interpretation:
Particulars Sales Net Working Capital Ratios
2008 1,13,23,20,000 16,03,63,000 7.06
2009 1,23,39,34,000 25,75,70,000 4.79
2010 1,42,54,31,000 26,24,46,000 5.43
Higher sales in comparison to working capital mean over trading &lower sales in comparison to working capital means under trading. A higher working capital turnover ratio shows that there is low investment in working capital &there is more profit. From the above table it can be ascertained that the amount invested by the company in working capital for the year 2007-08 was 7.06, 4.790 in 2008-09, 5.43in 2009-10 which is favorable to the company as there is less amount of cash outlay in terms of working capital which helps the firm to maintain a favorable liquidity position.
f. Fixed assets turnover ratio: It is also known as sales to fixed asset ratio. This ratio measures the efficiency and profit earning capacity of the firm. Higher the ratio, greater is the intensive utilization of fixed assets. Lower ratio means under-utilization of fixed assets. Net sales Fixed asset turnover ratio = Net fixed assets (net fixed assets = value of assets depreciation) CALCULATION OF THE RATIO FOR THE COMPANY FOR 2008-10
88
Particulars Sales Net Fixed Assets Ratios
2008 1,13,23,19,000 24,91,26,000 4.54
2009 1,23,39,34,000 23,59,31,000 5.23
2010 1,42,54,31,000 27,38,90,000 5.20
Analysis & Interpretation: The assets turnover ratio has increased over a period of time from 4.54 in 2007-08, 5.23 in 2008-09, and 5.20 in 2009-10, which proves the company is making effective utilization of its fixed assets to the fullest extent. h. Total assets turnover ratio: This is the ratio between sales and total assets and it shows whether or not the total assets have been properly utilized and measures the effective use of capital. The higher the ratio, the greater will be the return but too high a ratio means over trading. Net sales Total assets turnover ratio = Total assets The standard ratio is 2:1 CALCULATION OF THE RATIO FOR THE COMPANY FOR 2008-10 Particulars 2008 Net Sales 1,13,23,20,000 Total Assets 77,50,83,000 Ratios 1.46 Analysis& Interpretation: 2009 1,23,39,34,000 88,53,22,000 1.39 2010 1,42,54,31,000 1,09,09,57,000 1.30
It depicts whether or not the total assets have been properly utilized & measures the effective use of capital. The higher the ratio, the greater will be the return but too high a ratio means overtrading. From the above table we can observe that the ratios have been steadily increasing from 2008-09 though there was a slight decrease in the ratio in 2008-09 the company is making full utilization of its of its total assets 4. Profitability ratio:
89
It measures the overall performance of business profit margin ratios and rate of return ratios. Profit margin ratios show the relationship between profit and sale. Rate of return ratios reflect the relationship between profit and investments. The various profitability ratios are as follows. a. Gross profit ratio: The gross profit ratio is also known as gross margin ratio, trading margin ratio etc., it is expressed as a Per Cent Ratio. The difference between net sales and cost of goods sold is known as gross profit. Gross profit is highly significant. The earning capacity of the business can be ascertained by taking the margin between cost of goods sold and sales. It is very useful as a test of profitability and management efficiency. It is generally contented that the margin of gross profit should be sufficient enough to recover all operating expenses and other expenses and also leave adequate amount as net profit in relation to sales and owners equity. Thus, in a trading business, gross profit is net sales minus trading cost of sales. Gross profit Gross profit ratio = Net sales OR Sales cost of goods sold Gross profit ratio = Net sales Gross profit ratio shows the gap between revenue and trading costs. Maintenance of steady gross profit ratio is important. An analysis of gross profit margin should be carried out in the light of information relating to purchasing, increasing or reducing the sales price of goods sold by mark up and mark downs, credit and collections and merchandising policies. x 100 x 100
A higher ratio may be the result of one or all of the following: 1. Increase in the selling price of goods sold without any corresponding increase in the cost of goods sold.
90
2. Decrease in the cost of goods sold without corresponding decrease in selling price. 3. Both selling price and cost of goods sold may have changed, the combined effect being increase in gross margin. 4. Out of sales-mixes, product having higher gross profit margin, should have been sold in larger quantity. 5. Under-valuation of opening stock or over-valuation of closing stock. 6. On the other hand, if the gross profit ratio is very low, it may be an indicator of lower and poor profitability. A lower ratio may be the result of the following factors: 1. Decrease in the selling price of goods sold, without corresponding decrease in cost of goods sold. 2. Increase in cost of goods sold without any increase in selling price. 3. Unfavorable purchasing policies. 4. Over-valuation of opening stock or under-valuation of closing stock. 5. Inability of management to improve sales volume. Higher ratio is better. A ratio of 25% to 30% may be considered good.
91
Analysis& Interpretation: Particulars Gross Profit Net Sales Ratios 2008 13,81,59,000 1,13,23,19,000 12.2% 2009 20,85,66,000 1,23,39,34,000 16.9% 2010 17,67,00,000 1,42,54,31,000 12.39%
The gross profit of the company is showing consistency for all the three years. The company has an ideal gross profit ratio. The ratios are 12.2%, 16.9% and 12.39% for the respective three years. This may be due to changes in economic factors like increase in selling price without any corresponding proportionate increase in costs incurred or decrease in cost without any decrease in selling price.
b. Net profit ratio: It establishes the relationship between net profit (after tax) and sales and indicates the efficiency of the management in manufacturing, selling, administrative and other activities of the firm. This ratio is used to measure the overall profitability and it is calculated as:
Net profit Net profit ratio = Net sales x 100
92
This ratio indicates the firms capacity to face adverse economic conditions such as price competition, low demand, etc., Higher the ratio, the better is the profitability.
93
CALCULATION OF THE RATIO FOR THE COMPANY FOR 2008-10 Particulars Net Profit After 2008 1,89,12,000 1,13,23,19,20 0 1.67% 2009 4,77,44,000 1,23,39,34,00 0 3.86% 2010 5,01,27,000 1,42,54,31,40 0 3.51%
Tax Net Sales Ratios
Note: Ratios in percentage
Analysis & Interpretation: The company ratio of the company for all the three financial years is on a healthier side as it is showing favorable trend of growth to the outsiders about the percentage net profit after tax on its net sales this ratio reveals the true picture of companys financial position.
c. Operating ratio: This ratio establishes the relationship between total operating expenses and sales. Total operating expenses include cost of goods, administrative expenses, financial expenses and selling expenses. Cost of goods sold is also known as direct operating expenses. Operating ratio is generally expressed in percentages.
Cost of goods sold + Operating expenses Operating ratio = Net sales 94 x 100
Cost of goods sold = operating stock + purchase closing stock Operating expenses = administrative expenses + financial expenses + Selling expenses
95
CALCULATION OF THE RATIO FOR THE COMPANY FOR 2008-10 Particulars Cost Of Goods Sold+ Operating Exp Net Sales Ratios 2008 1,04,02,91,40 0 1,13,23,19,30 0 91.87% 2009 1,08,33,26,70 0 1,23,39,34,10 0 87.79% 2010 1,31,04,22,40 0 1,42,54,31,40 0 91.93%
Note: Ratios in percentage Analysis & Interpretation: The company is having a healthy operating ratio as the ratio for all the three years is almost near to 10% except for the year 2009 where it is 12% and thus the graph depicts the financial soundness of the company.
e. Return on capital employed ratio: This is also known as return on investment or rate of return. The prime objective of making investments in any business is to obtain satisfactory return on capital invested. It indicates the percentage of return on the capital employed in the business and it can be used to show the efficiency of the business as a whole. Operating profit Return on capital employed = Capital employed x 100
96
The term capital employed refers to long-term funds supplied by the creditors and owners of the firm. It can be computed in two ways. First, it is equal to non-current liabilities (long-term liabilities) plus owners equity. Alternatively, it is equivalent to net working capital plus fixed assets. Thus, the capital employed basis provides a test of profitability related to the sources of long-term funds. A comparison of this ratio with similar firms, with the industry average and over time would provide sufficient insight into how efficiently the long-term funds of owners and creditors are being used. The higher the ratio, the more efficient use of the capital employed.
97
CALCULATION OF THE RATIO FOR THE COMPANY FOR 2008-10 Particulars Operating Profit Capital employed Ratios 2008 9,20,27,800 40,95,30,100 22.47% 2009 15,06,07,400 52,61,04,200 28.62% 2010 11,50,09,000 66,18,49,800 17.37%
Note: Ratios in percentage
Analysis & Interpretation: The operating ratio is showing a favorable trend and is considered to be a good ratio as the company is a manufacturing undertaking. This shows that the company has enough funds from its margin to cover interest, income tax, dividends and reserves. This reveals the operating efficiency of the company.
98
f. Return on owners fund ratio: This ratio establishes the profitability from the shareholders point of view. Net profit Return on owners fund = Shareholders fund x 100
The term net profit as used here means net income after payment of interest and tax including net non-operating income (i.e. non-operating income minus nonoperating expenses). It is the final income that is available for distribution as dividends to shareholders. Shareholders funds include both preference and equity share capital and all reserves and surplus belonging to shareholders. For the purpose of the study, only that ratio concerning working capital and fund flows has been considered and analysis and interpretation has been done in the next chapters.
99
CALCULATION OF THE RATIO FOR THE COMPANY FOR 2008-10 Particulars Net Profit After Tax Shareholders funds Ratios 2008 1,89,12,300 11,94,80,400 15.82% 2009 4,77,44,000 16,81,24,200 28.39% 2010 5,01,27,000 21,71,25,100 23.08%
Analysis and Interpretation The ratio of return on capital employed of the company for all the three financial years are fluctuating and unstable as the percentage of increase or decrease in operating profit differs from the percentage of inc\crease or decrease in the capital employed for all the three years. The ratio for the year 2009 is highest and this is the period when the company has earned more on its capital employed.
FUND FLOW STATEMENT

Techniques of analysis & interpretation of financial statements: The following methods are generally used for the purpose of analysis and interpretation of financial statements: 1. 2. 3. 4. 5. 6. Comparative Statement Common Size Statements Trend Analysis Ratio Analysis Cash flow statements Fund flow statements
10 0
Fund Flow Statement The fund flow statement is a statement, which shows the movement of funds and is a report of the financial operations of the business undertaking. The fund flow statement shows how the attitude of an business organization is financed or how the available financial resources have been used during the particular period of time. It indicates in a summarized form the various means through which the funds were collected during a particular period and the ways in which these funds were employed. Fund flow statement is a widely used tool in the hands of financial executives for analyzing the financial performance of a concern. The fund flow statement is made up of three words, i.e., funds, flow and statement. 'FUND' according to the fund flow statement means: Cash Money Marketable securities Working capital However the concept of fund as working capital is the most popular one and considered appropriate. The study of sources and uses of funds is beneficial to management and organization at large since it reveals the soundness and solvency of the organization. The term FLOW means movement and includes both 'inflow' and 'outflow'. The term 'flow of funds' means transfer of economic values from one asset of equity to another. The fund flow statement is a method by which we study changes in the financial position of a business enterprise and financial statements ending date. It is a Statement showing sources and uses of funds for a given period of time. A fund flow statement is an essential tool for the financial analysis and is of primary importance to the financial management. The basic purpose of a fund flow statement is to reveal the changes in the working capital on the two balance sheet
10 1
dates. It reveals how the expansion and development activity of an enterprise is financed also tells the financial needs of the enterprise. Working Capital = Current Assets - Current Liabilities Working Capital = Total Current Assets - Total Current Liabilities Current Assets: It refers o cash and other assets or resources commonly identified as those, which are reasonably expected to be realized in cash or sold or consumed during the normal operating period of the company. Current Liabilities: It refers to all obligations which are likely to mature within one year in the normal course of business operations and which are cleared off by creating current liabilities or out of the current assets. Components of Current Assets and Current Liabilities Current assets Cash Balance Bank Balance Inventory/Stock of goods Temporary Investments Pre-paid expenses outstanding incomes Accounts receivable Bill receivable Sundry Debtors Non-Current Assets / Liabilities: It refers to all those assets and liabilities other than current assets and current Liabilities. Components of Non current assets and Non-current Liabilities Non-Current Liabilities Share Capital Long term loans Non-Current assets Fixed Assets Fictitious Assets like goodwill Patents Rights, Trade Current Liabilities Accounts payable / Bills payable Sundry creditors Bank overdraft Outstanding expenses Unclaimed dividend Provision for taxation Proposed dividend Short-term loan Any provision against current assets
10 2
Debentures Share premium A/c. Forfeited shares A/c.
Marks Long term Investments Profit and Loss A/c. (Debit balance) Discount on issue of shares and
Debentures Profit and Loss A/c (Credit Deferred expenditures like preliminary Expenses, balance) advertising expenses Appropriation of profits Provisions like provision for tax, Provision for deprecations Capital reserve It helps in analysis of financial operations The financial statements reveal the net effect of various transactions on the operational and financial position of a concern. The Balance Sheet gives a static time. But it does not disclose the cause for changes in the assets and liabilities between two different points. The fund flow statement explains the causes for such changes and also effects of such changes on the liquidity position of the company. It helps in the formation of a realistic dividend policy. Sometimes a firm has sufficient profits available for distribution as dividend but yet it may not be advisable to distribute dividend for lack of liquid or cash reserves. In such cases, fund flow statement helps to formulate a realistic dividend policy. It helps in proper allocation of funds. The resources of a concern are always limited and it wants to make the best use of these resources. A projected fund flow statement constructed for the future helps in making managerial decisions. It helps in taking corrective action if there is any imbalance between the sources and uses of the funds. Preparation of Fund Flow Statement: The financial information required for preparing the fund flow statement is obtained from the balance sheet of two periods and other required information from the books of accounts of the organization. In the process of fund flow statement these statements are prepared,
10 3
It helps in analysis of financial operations The financial statements reveal the net effect of various transactions on the operational and financial position of a concern. The Balance Sheet gives a static time. But it does not disclose the cause for changes in the assets and liabilities between two different points. The fund flow statement explains the causes for such changes and also effects of such changes on the liquidity position of the company.
It helps in the formation of a realistic dividend policy. Sometimes a firm has sufficient profits available for distribution as dividend but yet it may not be advisable to distribute dividend for lack of liquid or cash reserves. In such cases, fund flow statement helps to formulate a realistic dividend policy.
It helps in proper allocation of funds. The resources of a concern are always limited and it wants to make the best use of these resources. A projected fund flow statement constructed for the future helps in making managerial decisions. It helps in taking corrective action if there is any imbalance between the sources and uses of the funds.
Preparation of Fund Flow Statement: The financial information required for preparing the fund flow statement is obtained from the balance sheet of two periods and other required information from the books of accounts of the organization. In the process of fund flow statement these statements are prepared, 1. Statement of changes in working capital, 2. Statement which indicate funds from operation (for determining funds generated every year through the business activity) 3. Sources and application of funds. Statement of Changes in Working Capital: Statement of changes in the working capital is prepared in order to ascertain the increase or decrease in working capital between two accounting periods. This
10 4
statement is prepared with the help of current assets and current liabilities. The net difference between current assets and current liabilities indicate either increase or decrease in the working capital. The decrease will appear as a source and the increase as an application.
Funds from Operation: The funds from operation form the main source of funds of any organization. The funds from operation will not be equal to profits as shown by profits and loss account. The net profit as per the profit and loss account is the balance arrived at after deducting from revenues, a number of expenses which do not represent current outflow of funds such as depreciation, loss on sale of assets etc. to arrive at precisely the funds from operation an adjusted profit and loss account or a statement of funds from operation is prepared. Statement of Sources and Application of Funds: After the preparation of statement of changes in the working capital the statement of sources and application of funds is prepared. The statement of sources and application of funds saves as a bridge between successive balance sheets. It tiesup the balance sheet and profit and loss account together by using information taken from both statements. This statement contains two main groups of items. One is the mean by which resources are acquired and the other their deployment.
10 5
FUNDS FLOW STATEMENT

Schedule Of Changes In Working Capital For 2009-2010
Particulars Current Assets: 1.)Inventories 2.)S. Debtors 3.) Cash & Bank Balance 4.) Other Current assets 5.) Loans &
2009
2010
Increase in working capital
Decrease in working capital 50708201 -
20033385 2 37046388 0 11841332 7078047 27071078
30863782 9 31975567 9 15569064 10094569 37496224
108303977 3727732 3016522 10425146
Advances Current Liabilities: 1.)Current Liabilities 2.) Provisions Increase Working Capital In
34585953 6 13358500
39808601 2 31021436
52226476
17662936 4875764 125473377 125473377
Profit And Loss Adjustment Account Dr. Particulars Amount Particulars Cr. Amount 10 6
To Transfers to General Reserve To Goodwill written off To Brands written off To Depreciation on factory
(Rs.) 20000000 5208391 4500000 7254095 13785250 906811 34056899 7638256 1876783 669200 288277 2687441 19530170 118401573
By Balance B/d. By funds from operations (b/f)
(Rs.) 4954744 113446829
building To Proposed Dividend To Depreciation on office building To Depreciation on plant and machinery To Depreciation on electric
equipment & instruments To Depreciation on Furniture & Fittings To Depreciation on Vehicles To Depreciation on office equipments To Depreciation on computers To Balance C/d. Total
118401573
FUNDS
FLOW
STATEMENT
Amount (Rs.) 140926 74375 113633345 89423842 Application of funds Dividend paid Land purchased Factory building purchased Office building purchased Amount (Rs.) 13785250 7562943 3034182 18136228
Sources of funds Plant & Machinery Sold Furniture & Fittings Sold Issue of Share capital Secured taken Loans
10 7
Funds operation
from
113446829
Plant & Machinery purchased Electric equipments &
44436101 10943817 13577878 1343892 551930 184636183 3656000 2679149 7500000 4875764 316719317
installations purchased Furniture & fittings purchased Vehicles purchased Office equipments purchased Capital work in progress Computer purchased Unsecured loans paid Investments Increase in Working Capital Total 316719317 Analysis & Interpretation
The statement of changes in the working capital shows net increase for the year 2009-10 by Rs.4875764. The profit percentage has shown a constant growth from the past two years and has also grown at a healthy rate for the accounting year 2009-10 The funds from operation for the year 2009-10 are Rs.113446829. The funds from operation is showing a good sign for the company as out of total funds a major part was raised from funds from operation or cash profit. The company has also paid out its short term loans which show that the solvency position of the company is favorable. The company has also diverted its funds appropriately in proper channels like purchase of various fixed assets, which in turn increases the overall productivity of the organization.
10 8
The company has paid sufficient amount of dividends to its share holders and has also transferred reasonable amount of cash to its reserves & surplus account. To meet its capital expenditures the company has also raised own funds.
10 9
FINDINGS AND SUGGESTIONS FINDINGS:

Medreich Sterilabs limited is an upcoming pharmaceutical industry. In these recent years this company has earned a lot of respect not only in the national arena while competing with the Indian industry but also has survived the competition with the international companies. This company has shown signs of survival and growth this can be inferred from the companys financial position analysis of the recent years, according to the ratio analysis as a tool for financial statements This project is related to the study of the financial position of the company in the three years ranging from 2008-2010.the findings are on the basis of a) b) c) a) liquidity ratios Turnover ratios Profitability ratios Liquidity ratios for the for the financial years 2007-2009 Particulars Current ratio Quick ratio Absolute liquid ratio Inventory to working capital ratio In this concern, the liquidity ratios are showing satisfactory standard, except in the case of absolute liquid ratio where in it is far below the standard limit. The ratio of absolute liquidity also shows that the company is not maintaining ideal proportion of cash and marketable securities. The over all solvency and liquidity position of the company is satisfactory. It shows that the company is utilizing the funds to its optimum extent and the company is utilizing its financial resources properly. 3) Activity or turnover ratios: 2008 1.44:1 0.85:1 0.019:1 1.33:1 2009 1.71:1 1.15:1 0.032:1 0.77:1 2010 1.61:1 0.89:1 0.036:1 1.17:1 Remarks Satisfactory Satisfactory Poor Satisfactory
11 0
Particulars Stock turnover ratio Debtors turnover ratio Debt collection period Creditors turnover ratio Credit payment period Working capital turnover ratio Fixed asset turnover ratio Capital turnover Ratio Total assets turnover ratio
2008 29.47 4.17 88 Days 3.05 119 days 7.06 4.54 2.76 1.46
2009 25.54 3.84 95 Days 2.82 129days 4.79 5.23 2.34 1.39
2010 19.65 4.13 89 Days 3.50 104days 5.43 5.20 2.15 1.30
Remarks Good Satisfactory Poor Average Average Satisfactory Good Good Satisfactory
On analyzing the working capital ratio it is found that the working capital is converted 5.43 times for the year 2009-10 which is better than the previous year. The stock turnover ratio for the company is showing a constant growth of 20 to 23 times which is a good ratio .the debtors turn over ratio and the collection period for the company is not good as it would like to be. The collection period and the payment period are both too high which shows that the company is too liberal for its debtors and that the company is not maintaining the solvency position .the company is utilizing its fixed assets and net worth i.e. the capital employed optimally in converting it into sales. The company is utilizing its total assets to the optimum level.
4) Profitability ratio Particulars Gross profit ratio 2008 (%) 12.2 2009 (%) 16.9 2010 (%) 12.3 9 11 1 Remarks Satisfactory
Net profit ratio Operating profit ratio Operating ratio Return on share holders funds Return on total assets Return on capital employed
1.67 8.12 91.8 7 15.8 2 2.44 22.4 7
3.86 12.2 0 87.7 9 28.3 9 5.29 28.6 2
3.51 8.06 91.9 3 23.0 8 4.59 17.3 7
Good Satisfactory Good Good Satisfactory Satisfactory
The gross profit of the company is satisfactory in terms of growth this may be due to the current market condition which may have prompted the company to face the severe competition. Whereas the net profit. Ratio is good for the entire three years. The-operating ratio and the operating profit ratio is showing satisfactory position for the company. The return of the share holders funds is showing that the company is able to satisfy its share holders by paying constant amount of dividend per share.
SUGGESTIONS
It should implement proper credit policy with regard to collection of debtors
11 2
The company should improve its absolute liquid assets by maintaining large amount of cash and marketable securities.
To adopt better credit policy towards its debtors to recover the debts easily and efficiently.
The company should maintain better cash reserves at its disposal to meet its current obligations at necessary times.
Bibliography
11 3
Books Management accounting Cost &Management accounting Financial Management ---------R.K.Sharma & Gupta S.P.Jain & K.L.Narang S.N.Maheshwari
Website www.medreich.com www.google.com www.msn.com
11 4

Finance Project

Transféré par

Informations du document

Description originale:

Copyright

Formats disponibles

Partager ce document

Partager ou intégrer le document

Options de partage

Avez-vous trouvé ce document utile ?

Ce contenu est-il inapproprié ?

Droits d'auteur :

Formats disponibles

Finance Project

Transféré par

Droits d'auteur :

Formats disponibles

Working Capital Management

SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE

Working Capital Management

SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE

Working Capital Management

SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE

Working Capital Management

SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE

Working Capital Management

SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE

Working Capital Management

CHAPTER 1 CHAPTER 2 CHAPTER 3 CHAPTER 4 CHAPTER 5 CHAPTER 6 CHAPTER 7

SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE

Working Capital Management

SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE

Working Capital Management

Working Capital Management

MEDREICH STERILABS LIMITED

SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE

Working Capital Management

COMPANY & ITS AFFILIATES: Registered office: MEDREICH STERILAB LIMITED

SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE

Working Capital Management

FACILITIES OF THE COMPANY

SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE

Working Capital Management

SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE

Working Capital Management

SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE

Working Capital Management

SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE

Working Capital Management

SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE

Working Capital Management

Working Capital Management

QUALITY POLICY OF THE COMPANY

SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE

Working Capital Management

WORKING CAPITAL MANAGEMENT

SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE

Working Capital Management

SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE

Working Capital Management

SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE

Working Capital Management

SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE

Working Capital Management

SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE

Working Capital Management

SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE

Working Capital Management

Working Capital Management

SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE

Working Capital Management

SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE

Working Capital Management

SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE

Working Capital Management

PRINCIPLES OF WORKING CAPITAL MANAGEMENT:

Working Capital Management

SIKKIM MANIPAL UNIVERSITY, DISTANCE EDUCATION, BANGALORE

Working Capital Management

Total Funds Months 1 required (Rs in Thousand) 2