FM

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“Financial management is the activity conce-rned with planning, raising, controlling and
administering of funds used in the business.” – Guthman and Dougal

Financial Management – Meaning, Objectives, and Functions

Financial Management is a critical topic in business. The reason is that a company cannot function
without the proper use of funds. It might even suffer stunted growth. To understand and apply the
right management practices in the handling and use of funds, one has to know how valuable financial
management is to a business. In this post, we shall discuss financial management, its objectives,
meaning and function in an organization.
What is the Meaning of Financial Management?:Before dividing into the function and objectives of
financial management, let’s define what the term means. Through the definition, one would appreciate
the importance of the concept and why it needs to be considered in the business environment.
The most popular and acceptable definition of financial management as given by S.C.Kushal is
that “Financial Management deals with procurement of funds and their effective utilization in
the business”.
Weston and Brigham: Financial Management “is an area of financial decision-
making, harmonizing individual motives and enterprise goals”.
Joshep and Massie: Financial Management “is the operational activity of a business
that is responsible for obtaining and effectively utilizing the funds necessary for
efficient operations”
Financial Management is critical to any company, whether small or big. It is like the lifeline of the
business. It is also a vital activity that must be performed in any organization.However, financial
management entails the process of planning, organizing, monitoring and also controlling the financial
resources of an organization. The idea for doing such is to be able to achieve the vision or goals of the
company at the stipulated time frame.
Financial Management is a regular practice in a business environment. It involves managing a
company’s financial resources to ensure there is little or no wastage. It controls every single thing
regarding the company’s financial activities which includes the procurement of funds, use of funds,
payments, accounting, risk assessment and other things that are related to finances.
And that is one of the reasons it is considered to be an integral part of the company because, without
proper use of funds, the business can go down. It might also not have what it takes to carry out
production or activities.
The general principles of management are also applied to the financial management of the company
too. But the main focus shouldn’t be to create principles or department to manage the finances of the
business.
Meaning of Financial Management
Financial Management means planning, organizing, directing and controlling the financial activities
such as procurement and utilization of funds of the enterprise. It means applying general
management principles to financial resources of the enterprise.

They must be set up to follow the best practices, use the required financial management tools
and also deploy the right strategies to minimize cost and ensure production or business
activities function smoothly.
In other words, the use of business funds matters. It’s the reason financial management is like the
engine room of the company and can affect every other department if not handled properly. So in
order to eliminate any form of barrier that may hinder the growth of the business, firms must ensure
that the right financial management mechanism is put in place.
The Objectives of Financial Management
There are objectives or reasons firms implement these management strategies to grow their
business.
1. Profit Maximization
One of the reasons a company employs a financial manager is to maximize profit while managing the
finance of the company. The gain can be in the short or long-term. But the main focus is that the
individual or department handling the financial issues of the company must ensure that the company
in **question is making sufficient profit.
2. Proper Mobilization of Finance
The collection of funds to run the business is also an integral part of financial management that the
manager needs to handle appropriately. Once the manager concludes the estimation of the amount
needed for a business process, the required amount can then be requested from any legal sources such
as debenture, shares or even request for a bank loan. But the point is that there should be a proper
balance between the money the firm has and the amount borrowed.
3. The Company’s Survival
The survival of the company is essential. That is one of the reasons the management considers hiring
financial managers in the first place. The manager has to make adequate financial decisions to ensure
the company is successful.
4. Proper CoordinationThere must be a proper understanding and corporation among the various
departments. The finance department must understand and agree with other departments within the
company for the business to function smoothly.
5. Lowers Cost of Capital
Financial managers also try their very best to reduce the cost of capital, which is something that is
vital to the business. They ensure money borrowed attracts little interest rates so the company can
maximize profit.
Financial Management Functions
These are the duties of a fiscal manager. They are there to ensure that everything concerning finances
within a company is in order.
Below are Financial Management Functions:
1. Financial Planning and Forecasting
It is the financial manager’s responsibility to plan and estimate the business’s financial needs. He
needs to provide details regarding the amount of money that would be required to purchase different
assets for the company.
The management through the financial manager needs to know what they need to spend on working
capital and fixed assets for the business too. Another vital duty of the financial manager is to make
futuristic plans for funds that the company would need. And the manner in which the funds will be
realized and used is also of utmost importance to the financial manager.
2. Determination of capital composition
Once the Planning and Forecasting have been made, the capital structure has to be decided. The mix
of debt and equity used to finance the company’s future profitable investment opportunities is referred
to as capital structure.
3. Fund Investment
The financial manager has to ensure that funds made available to the business are used adequately to
grow the business. The cost of acquiring the said fund and value of the returns need to be compared
and balanced. The financial manager also needs to look into the channels of the business that is
yielding higher returns and improve them.
4. Maintain Proper Liquidity
Cash is the best source for maintaining liquidity. The business requires it to buy raw materials, pay
salaries and tackle other financial needs of the company. However, the financial manager has to
determine if there is a demand for liquid assets. He also has to arrange these assets in a manner that
the business won’t experience scarcity of funds.
5. Disposal of Surplus
Selling surplus assets and investing in more productive ways will increase profitability and therefore
increase the ROCE.
6. Financial Controls
Financial control may be construed as the analysis of a company’s actual results, approached from
different perspectives at different times, compared to its short, medium and long-term objectives
and business plans.
Conclusion
The financial management is a hot topic in the business world because of the importance of finance to
the business. The reason for establishing a company is to make a profit and also run for many years.
However, it’s the financial manager’s responsibility that the finances of the company are used
adequately.
ROLES OF FINANCIAL MANAGEMENT
What are the major roles of financial management?
Financial decisions and controls: Financial management and financial managers play a crucial role in
making financial decisions and exercising control over finances in the organization. They make use of
techniques like ratio analysis, financial forecasting, profit and loss analysis, etc.
Financial Planning: The finance managers are responsible for the planning of financial activities and
resources in the organization. To this end, they use available data to understand the needs and priorities
of the organization as well as the overall economic situation and make plans and budgets for the same.
Capital Management: It is the responsibility of financial management to estimate the capital
requirements of the organization from time to time, determines the capital structure and composition
and makes the choice of source of funding for the capital needs.
Allocation and Utilization of financial resources: Financial management ensures that all financial
resources of the organizations are used and invested effectively and efficiently so that the organization
is profitable, sustainable and viable in the long-run.
Cash Flow Management: It is extremely important for organizations to have sufficient working capital
and cash flow to meet their operational expenses and emergencies. Financial management tracks
account payable and receivable to ensure there is sufficient cash flow available at all times.
Disposal of Surplus: The decisions on how the surplus or profits of the organizations is utilized is taken
by the financial managers of the organizations. They decide if dividends should be distributed and how
much as well as the proportion of profits that must be retained and ploughed back into the business.
Financial Reporting: Financial management maintains all necessary reports related to the finance of the
organization and uses this as the database for forecasting and planning financial activities.
Risk Management: Sound financial management prepares the organization to forecast risks, put in place
mitigation plans as well as to meet unforeseen risks and emergencies effectively.
 
GOALS OF FINANCIAL MANAGEMENT
Financial management is a process that enables a business to plan, direct, organize, monitor and
control its current and future financial resources and events. It involves applying the basic principles
of management in financial activities such as purchases, sales, capital expansion, inventory valuation,
financial reporting, and profit distribution. A business organization is organic in nature, and its
successful growth depends on the financial efficiencies of operations and strategies. Therefore, the
primary goals of financial management dwell on both short-term and long-term activities that seek to
maximize value creation from scarce financial resources.
Disseminating
Timely dissemination of monthly, quarterly and annual financial information to internal and external
stakeholders is a significant goal of financial management. It ensures that financial information is
prepared in accordance with accounting principles and International Financial Reporting Standards.
This provides internal stakeholders -- that is, owners and employees -- with reliable information on
the performance and profitability of the business. The financial reports furnish suppliers with the
information they require to determine the stability of the business, and enable the government to
examine the tax obligations of the business.
Planning
Financial plans and forecasts aim at facilitating efficiency in the current and future activities of the
business. The planning process seeks to match the organization’s operational and investment activities
to its overall cash flow capabilities. Current and future cash flow projections determine the scope of
short-term and long-term plans of the business. This goal ensures sufficient funds are sourced in good
time and allocated to different business activities. Financial planning also ensures the business
engages in profitable long-term investments. For example, capital budgeting analyzes the financial
viability and profitability of long-term assets prior to procuring such assets.
Managing Risks
Risk management is a very important goal because it touches on one of the soft underbellies of the
business enterprise. Financial management prescribes the appropriate contingency measures for both
operational and strategic risks. Insurance and automated financial management systems help business
owners and employees to prevent or reduce the risks from theft, fraud and embezzlement. Internal and
external auditing processes also enhance the detection of fraud and other forms of financial
malpractices.
Exerting Controls
The financial management function exerts internal controls over financial resources with the objective
of ensuring efficient resource utilization. These controls enhance scrutiny of financial transactions to
prevent business owners or employees from violating financial principles or undermining
transparency. The goal of enhancing internal financial controls is pursued through oversight by the
senior financial management staff and internal auditors. Failure to exert internal financial controls
could spell unprecedented consequences for the business, as was the case of financial reporting
scandals by Enron, Tyco and WorldCom in the early 2000s.
CHANGING ROLE OF FINANCE MANAGER
1. Estimating the Amount of Capital Required:
This is the foremost function of the financial manager. Business firms require capital for:
(i) purchase of fixed assets,
(ii) meeting working capital requirements, and
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(iii) modernisation and expansion of business.
The financial manager makes estimates of funds required for both short-term and long-term.
2. Determining Capital Structure:
Once the requirement of capital funds has been determined, a decision regarding the kind and
proportion of various sources of funds has to be taken. For this, financial manager has to determine
the proper mix of equity and debt and short-term and long-term debt ratio. This is done to achieve
minimum cost of capital and maximise shareholders wealth.
3. Choice of Sources of Funds:
Before the actual procurement of funds, the finance manager has to decide the sources from which the
funds are to be raised. The management can raise finance from various sources like equity
shareholders, preference shareholders, debenture- holders, banks and other financial institutions,
public deposits, etc.
4. Procurement of Funds:
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The financial manager takes steps to procure the funds required for the business. It might require
negotiation with creditors and financial institutions, issue of prospectus, etc. The procurement of
funds is dependent not only upon cost of raising funds but also on other factors like general market
conditions, choice of investors, government policy, etc.
5. Utilisation of Funds:
The funds procured by the financial manager are to be prudently invested in various assets so as to
maximise the return on investment: While taking investment decisions, management should be guided
by three important principles, viz., safety, profitability, and liquidity.
6. Disposal of Profits or Surplus:
The financial manager has to decide how much to retain for ploughing back and how much to
distribute as dividend to shareholders out of the profits of the company. The factors which influence
these decisions include the trend of earnings of the company, the trend of the market price of its
shares, the requirements of funds for self- financing the future programmes and so on.
7. Management of Cash:
Management of cash and other current assets is an important task of financial manager. It involves
forecasting the cash inflows and outflows to ensure that there is neither shortage nor surplus of cash
with the firm. Sufficient funds must be available for purchase of materials, payment of wages and
meeting day-to-day expenses.
8. Financial Control:
Evaluation of financial performance is also an important function of financial manager. The overall
measure of evaluation is Return on Investment (ROI). The other techniques of financial control and
evaluation include budgetary control, cost control, internal audit, break-even analysis and ratio
analysis. The financial manager must lay emphasis on financial planning as well.
INTRODUCTION
Financial managers are responsible for the financial health of an organization. They
produce financial reports, direct investment activities, and develop strategies and plans for the long-
term financial goals of their organization. Financial managers typically: ...
Help management make financial decisions.
What is a Financial Manager?
Financial managers are responsible for the financial health of an organization. They produce financial
reports, direct investment activities, and develop strategies and plans for the long-term financial goals of
their organization. Financial managers work in many places, including banks and insurance companies.
Financial managers increasingly assist executives in making decisions that affect the organization, a task
for which they need analytical ability and excellent communication skills.
According to Myers,” Financial manager refers to anyone who is responsible for a significant
investment or financing decision.”
TIME VALUE FOR MONEY
Time value of money (TVM) is the idea that money that is available at the present time is worth more
than the same amount in the future, due to its potential earning capacity. This core principle of finance
holds that provided money can earn interest, any amount of money is worth more the sooner it is
received. One of the most fundamental concepts in finance is that money has a time value attached to
it. In simpler terms, it would be safe to say that a dollar was worth more yesterday than today and a
dollar today is worth more than a dollar tomorrow.
 

 
This chapter is a practical approach to the time value of money.  We fully understand that today's
technology provides multiple calculators and applications to help you derive both present value and
future value of money. If you do not take the time to comprehend how these calculations are derived,
you may make critical financial decisions using inaccurate data (because you may not be able to
recognize whether the answers are correct or incorrect).  There are five (5) variables that you need to
know:
Present value (PV) - This is your current starting amount.  It is the money you have in your hand at
the present time, your initial investment for your future. 
Future value (FV) - This is your ending amount at a point in time in the future. It should be worth
more than the present value, provided it is earning interest and growing over time.
The number of periods (N) - This is the timeline for your investment (or debts). It is usually
measured in years, but it could be any scale of time such as quarterly, monthly, or even daily.
Interest rate (I) - This is the growth rate of your money over the lifetime of the investment. It is
stated in a percentage value, such as 8% or .08.
Payment amount (PMT) - These are a series of equal, evenly-spaced cash flows.
 
 
You can calculate the fifth variable if you are given any four of the five (all) variables listed above. A
simple example of this would be: If you invest one dollar (PV) for one year (N) at 6% (I), you will
receive $1.06 (FV). This would be the same as saying the present value of $1.06 you expect to receive
in one year, is only $1.00 (PV).
 OR
Time Value of Money for Financial Management
In this article we will discuss about:- 1. Time Preference for Money 2. Calculation of Simple Interest
3. Calculation of Compound Value 4. Computation of Present Value 5. Uses of Financial Analysis 6.
Ratio Analysis 7. Discounted Cash Flow 8. Break-Even Analysis (BEP) 9. Benefit of Scale of
Production 10. Cash Break-Even Point.
Most financial decisions such as the acquisition of assets or procurement of funds affect cash flow in
different time periods. For example, if a fixed asset is purchased, it will require an immediate cash
outlay and will impact cash flows during many future periods from use of the fixed asset. Similarly, if
the business borrows funds from a bank, it receives cash now and commits an obligation to pay the
interest and return the principal sum in the future.
The recognition of the time value of the money is extremely vital in financial decision making. If the
timing of cash flows is not given due consideration, the business firm may make decisions which may
falter in its objective of maximising the owners’ welfare.
Time Preference for Money:
If an individual behaves rationally, he should not value an opportunity to receive a specific amount of
money now to be equal to the opportunity to have the same amount at some future date. Most
individuals attach more value to the opportunity to receive the money now rather than waiting for one
or more years to receive the same amount.
This phenomenon is referred to as an individual’s time preference for money. The time preference for
money is generally expressed by an interest or discount rate. If the interest rate is, say, 10% then an
individual may be indifferent between Rs 100 now and Rs 110 a year from now, as he considers these
two amounts equivalent in value.
Calculation of Simple Interest:
The formula of simple interest is:
F = P + Pi = P (l + i)
where F is the future value, P is the value of the investment and i is the rate of interest.
Calculation of Compound Value:
The compound value of an amount of investment can be computed by the following formula:
F = P (1 + i)n
where F is the future value, P is the amount invested, i is the rate of interest or discount and n
represents the number of periods of compounding the interest or discount.
If the period is annual, then n will represent number of years. In case the periods are quarterly or half
yearly, the rate of interest or discount has to be divided by 4 or 2, respectively. The period represented
by n should represent the total number of quarters, half years or years for which the amount was
invested.
For example, if Rs 1,000 is invested for 3 years at a rate of interest of 10% with quarterly
compounding, the equation will be as under:
F= P (1 + 10/4)12
Computation of Present Value:
By reversing the above equation, the present value of a future amount or a series of future cash
inflows can be worked out.
For example, while calculating the present value of a lump-sum amount to be received after one year, the
following formula is used:
P = F/(1 + i)
where P is the present value, F is the future value and i is the rate of interest.
The present value of the series of future cash inflows by discounting at a certain rate of interest is
calculated by the following formula:
P = F/(1 + i)n
where P is the present value of investment, F is the lump-sum to be received at the end of n th period. If
the present value so calculated is equal to or more than the amount originally invested, the investment
is considered to be a sound or viable decision.
Uses of Financial Analysis:
Financial analysis is the process of identifying the financial strengths and weaknesses of the business
firm by properly establishing relationships between the items of the Balance Sheet and Profit and Loss
Account. The nature of analysis will differ, depending on the purpose of the analyst. For example,
trade creditors are interested in the fact that the firm should be able to meet their claims over a short
period of time.
Their analysis will, therefore, be confined to the evaluation of the business firm’s liquidity position.
Then banks and financial institutions, on the other hand, are interested in the business firm’s long-
term solvency and survival. They analyse the firm’s profitability over a period of time, its ability to
generate cash, to be able to pay interest and pay their claims.
Banks also analyse the relationships between various sources of funds to determine the gearing
position of the firm, i.e., what is the proportion of outside debts to the owner’s capital. The lenders do
not only analyse the historical financial statements, but require the business firm to supply the
estimated and projected financial statements to make analyses about its future solvency and
profitability.
Therefore, the credit officer of the bank shall obtain the financials including the Balance Sheet and
Profit and Loss Account of the proponent, both actual for last two years and estimates and projections
for the current and following year for the purpose of analysis. In the course of analysis of the
financials, the credit officer is required to work out and evaluate various financial ratios as under.
Ratio Analysis:
The relationship between two accounting figures, expressed mathematically, is known as a financial
ratio or simply ratio. A ratio helps the analyst to make qualitative judgement about the financial
position and performance of the business firm. The easiest way to evaluate the performance of the
business firm is to compare its present ratios with the past ratios. Comparison between the financial
ratios for the last three years gives an indication about the trend of the ‘performance of the business
firm.
In view of the requirements of the various users of ratios, they can be broadly classified into the
following four important categories:
(i) Liquidity ratios,
(ii) Leverage ratios,
(iii) Activity ratios, and
(iv) Profitability ratios.
Liquidity ratios measure the business firm’s ability to meet current obligations. Leverage ratios show
the proportion of debt and the equity base (capital) in financing the firm’s assets. Liquidity and
Leverage ratios are also known as Solvency Ratios. Activity ratios reflect the business firm’s
efficiency in utilising its assets. Profitability ratios measure the overall performance and effectiveness
of the business firm.
(i) Liquidity Ratios:
Current Ratio:
The current ratio is calculated by dividing the current assets by current liabilities.

Interpretation of the Ratio:

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A relatively high value of the current ratio is considered as an indication that the firm is liquid and has
the ability to pay its current obligations. On the other hand, a relatively low value of the current ratio
is considered as an indication that the firm will find difficulty in paying its current debts. As a
conventional rule, a current ratio of 1.33:1 or more is considered to be satisfactory.
Quick or Acid Test Ratio:
This is a more refined measure of the firm’s liquidity. This ratio establishes the relationship between
quick or liquid assets and current liabilities payable in a very short term. An asset is liquid if it can he
converted into cash immediately or reasonably soon without a loss of value. Cash is the most liquid
asset.
The other assets considered to be relatively liquid and included in the quick assets are hook debts and
marketable securities. Stock (Inventories) and prepaid expenses are considered to be less liquid and,
hence, excluded from the current assets for the purpose of quick ratio.
On the liabilities side, if the borrowings from banks and financial institutions are of medium-term
nature, they are excluded from the current liabilities for calculating the quick or acid test ratio. Thus,
the quick ratio can be arrived at by dividing the total of the quick assets by core current liabilities.

Interpretation of the Ratio:

Generally, a quick ratio for 1:1 is considered to be a satisfactory current financial condition.
(ii) Leverage Ratios:
Short-term creditors like bankers and suppliers of materials are more concerned with the business
firm’s current debt paying ability. On the other hand, term lenders (including banks giving term loans)
and long-term creditors are more concerned with the firm’s long-term financial strength. To judge the
long-term financial position of the firm, leverage or capital structure ratios are calculated.
The capital structure of a business firm comprises the equity base and borrowed funds. If the equity
base is thin, the risk taken by the creditors and banks will be high. Here, the medium- and long-term
liabilities of the business firm are considered as the leveraged or borrowed capital. Thus, leverage
ratios are calculated to measure the financial risk and the firm’s ability of using debt for maximising
the benefit of the shareholders.
Debt-Equity Ratio:
The debt-equity ratio is the measure of the relative claims of the creditors and the owners against the
assets of the business firm. This ratio is calculated by dividing the long-term debts (non-current
liabilities) by the owner’s/hare holders’ equity or the equity base. The equity base includes Owner’s
or Shareholders’ Capital + Reserves and Surplus. This ratio is also known as Funded Debt-Equity
Ratio.
Debt-Equity Ratio = Long Term Debt/Owner’s/Shareholders’ Equity
Lower the debt-equity ratio, stronger is the financial position of the business firm.
Bankers often take total outside liabilities, i.e., Current Liabilities + Term liabilities to calculate the
debt-equity ratio which shows the relationship between the equity and the total outside liabilities.
Generally, a ratio of 3:1 is considered to be fairly safe. Higher the ratio more is the gearing or
leveraging of the capital or net worth of the business firm/company.
Interest Coverage Ratio:
The interest coverage ratio is one of the most conventional ratios used to test the debt servicing
capacity of the business firm. This is calculated as under:
Interest Coverage Ratio = Net Profit before Interest and Taxes/Interest Charges
Higher the ratio more is the ability to service the debt by paying interest.
Debt Service Coverage Ratio (DSCR):
This ratio indicates the ability of the business firm to pay interest as well as the principal debt, which
has been borrowed on long-term basis.
This is calculated as under:

A ratio of minimum 1.5:1 is considered satisfactory. Higher the ratio, greater the comfort for the
lenders.
Asset Coverage Ratio:
Banks as secured creditors would like to know the extent of security coverage vis-a-vis their
exposure.
This is calculated as under:

Higher the ratio better is the coverage for security.

(iii) Activity Ratio:
Inventory/Stock Turnover Ratio:
This ratio indicates the efficiency of the business firm’s inventory management.

The inventory turnover shows how rapidly the inventory is turning into receivables through sales.
Generally, a high inventory turnover is indicative of good inventory management and a lower
turnover suggests an inefficient inventory management. A low inventory turnover implies excessive
inventory levels than warranted by production and sales activities or slow moving or obsolete
inventory.
Debtors Turnover Ratio:
A business firm sells goods both on credit and cash basis. When the firm extends credit to its
customers, book-debts or sundry debtors are created in the firm’s accounts. Debtors are expected to be
converted into cash over a short period and, therefore, are included in current assets. The liquidity
position of the firm depends on the quality of debtors to a great extent. A financial analyst employs
two ratios to judge the quality or liquidity of debtors.

The debtors’ turnover indicates the number of times on an average the debtors or receivables turnover
each year. Generally, higher the value of the debtors’ turnover, more efficient is the management of
assets.
Average Collection Period Ratio:
The average collection period ratio brings out the nature of the firm’s credit policy and the quality of
the debtors more clearly. This ratio is calculated as follows:

The period will indicate the number of days credit allowed by the business firm. The average
collection period ratio measures the quality of debtors since it indicates the rapidity or slowness of
their collectability. The shorter the average collection period, the greater is the quality of debtors, as a
short collection period implies the prompt payments by the debtors.
Creditors-Turnover Ratio:

Creditors’ turnover ratio gives an indication about the ability of the business firm to obtain credit from
its suppliers. It is expressed in terms of number of days’ or months’ credit obtained. An increase in the
number of days/months signifies the longer period of credit availed and slowing down of the payment
by the firm.
Capital Employed Turnover:
The capital employed generally means the sum of non-current liabilities and owner’s equity or capital
and reserves. Thus, it represents the long-term funds deployed in the business firm by creditors and
the owners.

This ratio indicates the firm’s ability of generating sales per rupee of long- term investment. Higher
the ratio, the more efficient is the utilisation of the capital employed by the owners and long-term
creditors. This ratio is compared with the industry average to arrive at financial decisions.
(iv) Profitability Ratios:
A business firm should earn profits to survive and grow over a long period of time. Sufficient profits
must be earned to sustain the operations of the business, to be able to obtain funds from banks and
investors for the purpose of expansion and to contribute towards the social overheads for the welfare
of the society.
Gross Profit Margin:
The gross profit margin reflects the efficiency with which the management produces each unit of
product. This ratio indicates the average spread between the cost of goods sold and the sales revenue.
Return on Investment (ROI):
The profitability of a business firm is also measured in relation to investment. The term investment
may refer to total assets or capital employed.
Accordingly, the following two important profitability ratios are calculated by the analysts and
the banks:
(i) Return on Assets (ROA)
(ii) Return on Capital Employed (ROCE)
Return on Assets (ROA):
The return on assets or profit to assets ratio is net profit/total assets. Thus,

while taking total assets, intangible assets to be excluded.

The return on assets is a useful measure of the profitability of all financial resources invested in the
assets of the business firm. The ratio is calculated in terms of percentage and higher the figure, better
is the result.
Return on Capital Employed (ROCE):

The result is shown in terms of percentage.

The return on capital employed indicates how well the management has used the funds supplied by
long-term creditors/banks and owners. Higher the ratio, the more efficient is the firm in using funds
entrusted to it. The ratio should be compared with the ratios of similar business and the industry
average. This comparison will reveal the relative operating efficiency of the business firm.
Payback Period:
When a business unit decides to go for major capital expenditure, the payback period is calculated to
examine as to how soon the amount of capital expenditure can be recovered through generation of
surplus derived from such expenditure.
Payback period is a widely recognised traditional method of evaluating investment proposals. It is
defined as the number of years required to recover the original cash outlay invested in a project. If the
project generates constant annual cash inflows, the payback period can be computed dividing the
amount of cash outlay by the amount of annual cash inflow.

Example:
A project requires an outlay of Rs 500,000 and yields an annual cash inflow of Rs 125,000 for 7
years. The payback period for the project is:

In case of unequal cash inflows, the payback period can be found out by adding up the annual cash
inflows until the total is equal to the initial cash outlay.
Lower the payback period, better is the project as the loans taken for the project can be repaid at the
shortest possible time.
Discounted Cash Flow:
Discounted cash flow method is one of the classic economic methods of evaluating the investment
proposal. By applying the techniques of discounted cash flow (DCF), the net present value of the
future cash inflows is calculated and, thus, the time value of money is explicitly recognised. The cash
inflows arising at different time periods differ in value and are comparable only when their equivalent
present values are found out.
This is done by taking an appropriate rate of interest to discount the future cash inflows back to the
present value. Generally, the appropriate rate of interest is the cost of capital for the business firm or
company. This is also the minimum rate of return expected by the investors to be earned by the
business firm on its investment proposal.
The present value of future cash inflows and the present value of investment outlay are computed
using the cost of capital as the interest or discounting rate. If all cash outflows are made in the initial
year, then their present value will be equal to the amount of cash actually spent. The net present value
(NPV) is derived by subtracting the present value of cash outflows from the total present value of cash
inflows.
For this purpose, the mathematical formula used by the project evaluators is as under:
Present Value = F/(1 + i)n
where F is the future annual cash inflow, i is the rate of interest or discount and n is the period for
number of years for which the future cash inflow is discounted back to present value. Thus, the future
cash inflow of each year is discounted and sooner the aggregate present value of inflows equals the
outflows, better is the project.
Illustration:
If it is asked how much an investor should give up now to get an amount of Re. 1 at the end of 1, 2 or
3 years? Assuming a 10% interest/discount rate, one can calculate the amount to be sacrificed in the
beginning of the year as under:
Amount sacrificed (principal amount) in the beginning is taken as ‘P’ which will grow to ‘F’ (future
value) after one year and the ‘F’ is calculated by applying the formula —F = P( 1 + i) after a year.
From the above formula the value of ‘P’ can be worked out by the following equation:
P = F/(1 + i) or P = Re 1/1.10 = Re 0.909
where, ‘F’ is the future value, ‘P’ is the principal amount or initial investment, ‘i’ is the rate of
interest/discount.
This implies that if the interest/discount rate is 10% the present value of Re 1 to be received after one
year is equivalent to Re 0.909 today. The present values of Re 1 inflow at the end of 2- and 3-year
periods can also be worked out similarly. The amount of ‘P’ deposited today would grow to ‘F’ = P (1
+ i) 2 after 2 years. Similarly, it will be ‘F’ = P( 1 + i ) 3 after 3 years and so on. Thus, the present
value calculations can be done for any number of years and by application of any rate of
interest/discount.
The formula is same P = F/(1 + i)n
However, for getting the present value of same amount after 2/3/4/5 years we need not make the
calculations by applying the above formula which calls for a complicated calculation, particularly
when the number of future years is more than 2. One can refer a pre-calculated present value table
(see the table given below) which gives the present value of Re 1 to be received after’ n’ years at ‘i’
rate of interest/discount.
To find out the present value of any amount, one has to simply find out the appropriate present value
factor (PVF) from the table and multiply the future value amount by that factor. Suppose an investor
wants to find out the present value of Rs 5 lacs to be received after 10 years and his preferred rate of
interest is 8%. First get the present value factor from the table which is available from the 10 th row
and 8% column.
The present value factor is 0.463 and multiplying Rs 5 lacs by this factor we get Rs 231500 as the
present value. Net present value is the difference between the amount initially invested and the
present value of the future cash inflows over a period of a specified number of years. If it is positive it
is a good investment decision and if it is negative the investor has to think over before taking the
investment decision. Present value calculation is also known as discounted cash flow calculation.
Break-Even Analysis (BEP):
Break-even analysis or the Break-even point (BEP) indicates the level of sales at which costs and
sales revenues are in equilibrium. The break-even point may be defined as that point of sales volume
at which the total sales revenue is equal to the total cost. It is a no-profit, no-loss point.
In break-even analysis, the total cost of any product or service is bifurcated into variable cost and
fixed cost. For the break-even point to occur, it is necessary to know the variable costs and fixed costs
of the firm. The break-even point can be computed in terms of units or in terms of money value
(dollars, pounds, rupees, etc.) of sales volume or as a percentage of the estimated capacity of
production.
Before proceeding further, it is necessary to know the following terms used in break-even
analysis:
1. Variable Costs (V)
2. Fixed Costs (F)
3. Sales Volume (S)
4. Contribution (C) being the excess of sales revenue (S) over variable costs (V)
5. Profit (P)
The difference between variable costs and sales price is the contribution which comprises fixed costs
and profit. The contribution initially recovers the fixed costs and any excess thereafter will represent
profit. In case the contribution is less than the fixed cost or fails to recover the entire fixed cost, the
business firm is said to be incurring a loss.
From the above, the following equation can be worked out:
S–V=C
At break-even point C is equal to fixed costs (F)
where S = Sales, V = Variable Costs, F = Fixed Costs and P = Profit ‘C’ over and above ‘F’ =
P(Profit)
Profit Volume Ratio (PV Ratio):
PV ratio, also known as the contribution ratio, expresses the relationship between contribution and
sales. When discussing PV Ratio, it is imperative to understand that so long as the fixed cost is not
fully recovered, the contribution per unit of sales goes on recovering the fixed costs and the moment
the entire fixed cost is recovered, the contribution starts generating profit.
The PV Ratio is calculated by dividing the contribution by sales which may be expressed as under:
PV Ratio = C/S or S – V/S
where, C =Contribution, S = Sales, V = Variable Costs

BEP in Terms of Units Sold:

BEP = F/C per unit
or
Fixed cost divided by Unit Contribution (C). Unit contribution is the difference between unit selling
price and unit variable cost.
BEP in terms of Sales Value can be calculated as under:
BEP = Total Fixed Cost/PV Ratio or Fixed Cost x Total Sales/Total Contribution
Many business firms are interested in computing the break-even point as a percentage of the estimated
or projected sales or capacity. This can be done by dividing the break-even sales by the installed
capacity expressed in terms of percentage.
Graphical Presentation of BEP:

Benefit of Scale of Production:

Fixed cost is considered to be an overhead burden for a manufacturing unit. With increase in
production, the fixed cost gets distributed among more number of products and, hence, the cost per
unit comes down. Consequently, the contribution/profit margin goes up. Here, the manufacturer can
be said to be enjoying the benefit of economies of scale.

Large-scale manufacturing organisations can often avail of such benefit of

scale. The production can be increased to the optimum level so long as the
need for further capital expenditure for capacity expansion does not arise.
Further creation of capacity will increase the fixed cost to a different scale.
Cash Break-Even Point:
The fixed cost includes depreciation as an item of cost, though there is no actual cash outflow on that
account. It is an internal book entry as part of the prudential norm of accounting. To arrive at the cash
break-even point, the amount of depreciation is deducted from fixed costs and the said reduced fixed
cost is divided by contribution or PV Ratio. Cash break-even point is, therefore, at a level below the
general break-even point discussed earlier.
If a business firm is operating below the cash break-even level, it is incurring cash loss from its
operation and it is a matter of serious concern for the business firm.
What Is the Time Value of Money (TVM)?
The time value of money (TVM) is the concept that money you have now is worth more than the
identical sum in the future due to its potential earning capacity. This core principle of finance holds that
provided money can earn interest, any amount of money is worth more the sooner it is received. TVM
is also sometimes referred to as present discounted value.
DEF
1.What is Time Value of Money – Definition
There is no reason for any rational person to delay taking an amount owed to him or her. More than
financial principles, this is basic instinct. The money you have in hand at the moment is worth more
than the same amount you ‘may’ get in future. One reason for this is inflation and another is possible
earning capacity. The fundamental code of finance maintains that, given money can generate interest,
the value of a certain sum is more if you receive it sooner. This is why it is called as the present value.
Basically, the time value of money validates that it is more beneficial to have cash now than later.
Say, if you invest a Rs. 100 today – the returns will be more compared to the same investment made 2
months from now. Moreover, there is always a risk that the borrower might delay even more or not
pay at all in the future.
PRESENT VALUE
Definition: Present value, also known as discounted value, is a financial calculation that measures
the worth of a future amount of money or stream of payments in today's dollars adjusted for interest
and inflation. In other words, it compares the buying power of one future dollar to purchasing power
of one today.
What Is Present Value – PV?
Present value (PV) is the current value of a future sum of money or stream of cash flows given a
specified rate of return. Future cash flows are discounted at the discount rate, and the higher
the discount rate, the lower the present value of the future cash flows. Determining the appropriate
discount rate is the key to properly valuing future cash flows, whether they be earnings or obligations.
Present Value
PV Formula and Calculation
\begin{aligned} &\text{Present Value} = \dfrac{\text{FV}}{(1+r)^n}\\ &\textbf{where:}\\ &\text{FV} =
\text{Future Value}\\ &r = \text{Rate of return}\\ &n = \text{Number of periods}\\ \end{aligned}
Present Value=(1+r)nFVwhere:FV=Future Valuer=Rate of returnn=Number of periods

OR
What is present value? It is today’s value of a payment (or payments) to be received in the future. It is
the value today of a future payment or series of payments, discounted at the appropriate discount rate.
What determines this present value? a) the amount of the payment or payments, of course b) when in
the future the payment(s) is to be made c) The earning power of money over that future period of
time-—the appropriate interest rate to use to discount the future dollar amounts.
Specifically: (other things constant) a) The greater the amount of the payment(s), the greater the
present value. b) The more distant the future payment(s), the lower the present value. c) the higher the
interest/discount rate, the lower the present value
What is Present Value (PV)?
Present value describes how much a future sum of money is worth today. 
RISK AND RETURN IN FINANCIAL MANAGEMENT
Concept of Risk and Return with Diagram
Concept of Risk and Return

Concept of Risk and Return in financial investment, finance, investment, securities, analysis are given in

the diagram below.
Image credits © Manoj Patil.
Risk

In concept of risk and return, every financial decision involves risk. In financial management, the risk is
defined as “the variability of expected returns from an investment”. Risk in investment from investor's
view implies that the actual return may not be as expected. From the point of view of a firm, when the
actual return is not same as estimated, it is considered as risk. Higher the variations in results, higher
is the risk and vice-versa.
Types of Risks that Involved in Investments

Types of risks that involved in investments are given in the diagram below.

Image credits © Manoj Patil.

Capital Risk
Income Risk
Default Risk
Capital Risk

It refers to a capital loss because of fall in the the market price of a security like Equity Shares.
Income Risk

It refers to variations in return from a security. For E.g. In case of Equity Shares dividends vary every
year.
Default Risk

It refers to default in payment of interest or repayment of the principal amount by the company.
The element of risk varies with the type of investment. For E.g.: Business Portfolio risks, Financial
risks, Legal and Statutory risks, Internal process risks, Social, political and economic risks.
Return

In concept of risk and return, return means “the motivating force and the principal reward in the
investment process.” Return can be realized or expected.
In concept of risk and return, realized return refers to the return which was earned or could have been
earned. Expected return refers to the return which the investor expected to earn in the future. The
return is calculated as a percentage on the initial amount invested.
In concept of risk and return, Returns always comes in the given forms:
In concept of risk and return, the investor should get proper and regular payment of interest on a
dividend.
In concept of risk and return, the investor should get safety on the investment that he has invested.
In concept of risk and return, there must be hassle-free deals should be available to the investor in
buying and selling of his investment.
In concept of risk and return, the investor should get liquidity on their investment.
In concept of risk and return, there are possibilities of fund's appreciation.
Concept of Risk and Return Example

Examples on Concept of risk and return are follows:

In concept of risk and return, the simple investment management rule is that higher the risk, greater
should be the return and vice versa For E.g.: Low risk instruments like small savings bring low
returns. High-risk securities like equity shares, bring higher returns.
RETURN
A Return in Finance
By ADAM HAYES
 Reviewed By GORDON SCOTT 
 Updated Mar 24, 2020
What Is a Return?
A return, also known as a financial return, in its simplest terms, is the money made or lost on an
investment over some period of time.
A return can be expressed nominally as the change in dollar value of an investment over time. A
return can also be expressed as a percentage derived from the ratio of profit to investment. Returns
can also be presented as net results (after fees, taxes, and inflation) or gross returns that do not
account for anything but the price change. It even includes a 401(k) investment.
KEY TAKEAWAYS
A return is the change in price on an asset, investment, or project over time, which may be represented
in terms of price change or percentage change.
A positive return represents a profit while a negative return marks a loss.
Returns are often annualized for comparison purposes, while a holding period return calculates the
gain or loss during the entire period an investment was held.
Real return accounts for the effects of inflation and other external factors, while nominal return only is
interested in price change. Total return for stocks includes price change as well as dividend and interest
payments.
Several return ratios exist for use in fundamental analysis.
Understanding Returns
Prudent investors know that a precise definition of return is situational and dependent on the financial
data input to measure it. An omnibus term like profit could mean gross, operating or net, before tax or
after tax revenues or income. An omnibus term like investment could mean selected, average or total
assets, debt or equity.
Below are definitions of return variations common to finance lexicon. The financial metrics
underlying each return must be evaluated on a case-by-case basis to truly understand the meaning of a
particular return.
A holding period return is an investment's return over the time it is owned by a particular investor.
Holding period return may be expressed nominally or as a percentage. When expressed as a
percentage, the term often used is rate of return (RoR).
For example, the return earned during the periodic interval of a month is a monthly return and of a
year is an annual return. Often, people are interested in the annual return of an investment, or year-on-
year (YoY) return which calculates the price change from today to that of the same date one year ago.
Returns over periodic internals of different lengths can only be compared when they have been
converted to same length intervals. It is customary to compare returns earned during year long
intervals. The process of converting shorter or longer return intervals to annual returns is called
annualization.

A positive return is the profit, or money made, on an investment or venture. Likewise, a negative
return represents a loss, or money lost on an investment or venture.
Nominal Return
A nominal return is the net profit or loss of an investment expressed in nominal terms. It can be
calculated by figuring the change in value of the investment over a stated time period plus any
distributions minus any outlays. Distributions received by an investor depend on the type of
investment or venture but may include dividends, interest, rents, rights, benefits or other cash-flows
received by an investor. Outlays paid by an investor depend on the type of investment or venture but
may include taxes, costs, fees, or expenditures paid by an investor to acquire, maintain and sell an
investment. 
 
Total return for a stock includes both capital gains/losses and dividend income, while nominal return
for a stock only depicts its price change.
For example, assume an investor buys $1,000 worth of publicly traded stock, receives no
distributions, pays no outlays, and sells the stock two years later for $1,200. The nominal return in
dollars is $1,200 - $1,000 = $200.
Real Return
A real rate of return is adjusted for changes in prices due to inflation or other external factors. This
method expresses the nominal rate of return in real terms, which keeps the purchasing power of a given
level of capital constant over time. Adjusting the nominal return to compensate for factors such as
inflation allows you to determine how much of your nominal return is real return. Knowing the real
rate of return of an investment is very important before investing your money. That’s because
inflation can reduce the value as time goes on, just as taxes also chip away at it.
Investors should also consider whether the risk involved with a certain investment is something they
can tolerate given the real rate of return. Expressing rates of return in real values rather than nominal
values, particularly during periods of high inflation, offers a clearer picture of an investment's value.
Returns Ratios
Returns ratios are a subset of financial ratios that measure how effectively an investment is being
managed. They help to evaluate if the highest possible return is being generated on an investment. In
general, returns ratios compare the tools available to generate profit, such as the investment in assets
or equity, to net income, the actual profit generated.
Returns ratios make this comparison by dividing selected or total assets or equity into net income. The
result is a percentage of return per dollar invested that can be used to evaluate the strength of the
investment by comparing it to benchmarks like the returns ratios of similar
investments, companies, industries, or markets. For instance, return of capital (ROC) means the
recovery of the original investment.
Return on Investment (ROI)
A percentage return is a return expressed as a percentage. It is known as the Return on Investment
(ROI). ROI is the return per dollar invested. ROI is calculated by dividing the dollar return by the
dollar initial investment. This ratio is multiplied by 100 to get a percentage. Assuming a $200 return
on a $1,000 investment, the percentage return or ROI = ($200 / $1,000) x 100 = 20%.
Return on Equity
Return on Equity (ROE) is a profitability ratio figured as net income divided by average shareholder's
equity that measures how much net income is generated per dollar of stock investment. If a company
makes $10,000 in net income for the year and the average equity capital of the company over the
same time period is $100,000, the ROE is 10%.
Return on Assets
Return on Assets (ROA) is a profitability ratio figured as net income divided by average total assets that
measures how much net profit is generated for each dollar invested in assets. It determines financial
leverage and whether enough is earned from asset use to cover the cost of capital. Net income divided
by average total assets equals ROA.
For example, if net income for the year is $10,000, and total average assets for the company over the
same time period is equal to $100,000, the ROA is $10,000 divided by $100,000, or 10%.
RISK IN FINANCE
Financial Risk is one of the major concerns of every business across fields and geographies. This is
the reason behind the Financial Risk Manager FRM Exam gaining huge recognition among financial
experts across the globe. FRM is the top most credential offered to risk management professionals
worldwide. Financial Risk again is the base concept of FRM Level 1 exam. Before understanding the
techniques to control risk and perform risk management, it is very important to realize what risk is and
what the types of risks are. Let's discuss different types of risk in this post.
Risk and Types of Risks:
Risk can be referred to like the chances of having an unexpected or negative outcome. Any action or
activity that leads to loss of any type can be termed as risk. There are different types of risks that a
firm might face and needs to overcome. Widely, risks can be classified into three types:
Business Risk, Non-Business Risk, and Financial Risk.
Business Risk: These types of risks are taken by business enterprises themselves in order to maximize
shareholder value and profits. As for example, Companies undertake high-cost risks in marketing to
launch a new product in order to gain higher sales.
Non- Business Risk: These types of risks are not under the control of firms. Risks that arise out of
political and economic imbalances can be termed as non-business risk.
Financial Risk: Financial Risk as the term suggests is the risk that involves financial loss to firms.
Financial risk generally arises due to instability and losses in the financial market caused by
movements in stock prices, currencies, interest rates and more.
Types of Financial Risks:
Financial risk is one of the high-priority risk types for every business. Financial risk is caused due to
market movements and market movements can include a host of factors. Based on this, financial risk
can be classified into various types such as Market Risk, Credit Risk, Liquidity Risk, Operational
Risk, and Legal Risk.

 
Market Risk:This type of risk arises due to the movement in prices of financial instrument. Market
risk can be classified as Directional Risk and Non-Directional Risk. Directional risk is caused due to
movement in stock price, interest rates and more. Non-Directional risk, on the other hand, can be
volatility risks.
Credit Risk:
This type of risk arises when one fails to fulfill their obligations towards their counterparties. Credit
risk can be classified into Sovereign Risk and Settlement Risk. Sovereign risk usually arises due to
difficult foreign exchange policies. Settlement risk, on the other hand, arises when one party makes
the payment while the other party fails to fulfill the obligations.
Liquidity Risk:
This type of risk arises out of an inability to execute transactions. Liquidity risk can be classified
into Asset Liquidity Risk and Funding Liquidity Risk. Asset Liquidity risk arises either due to insufficient
buyers or insufficient sellers against sell orders and buys orders respectively.
Operational Risk:
This type of risk arises out of operational failures such as mismanagement or technical failures.
Operational risk can be classified into Fraud Risk and Model Risk. Fraud risk arises due to the lack of
controls and Model risk arises due to incorrect model application.
Legal Risk:
This type of financial risk arises out of legal constraints such as lawsuits. Whenever a company needs
to face financial losses out of legal proceedings, it is a legal risk
PROFIT MAXIMIZATION
Profit Maximisation Theory:
In the neo-classical theory of the firm, the main objective of a business firm is profit maximisation.
The firm maximises its profits when it satisfies the two rules. MC = MR and the MC curve cuts the
MR curve from below Maximum profits refer to pure profits which are a surplus above the average
cost of production.
It is the amount left with the entrepreneur after he has made payments to all factors of production,
including his wages of management. In other words, it is a residual income over and above his normal
profits.
The profit maximisation condition of the firm can be expressed as:
Maximise p (Q)
Where p (Q) = R (Q) – C (Q)
where p (Q) is profit, R(Q) is revenue, С (Q) are costs, and Q are the units of output sold The two
marginal rules and the profit maximisation condition stated above are applicable both to a perfectly
competitive firm and to a monopoly firm.
Assumptions:
The profit maximisation theory is based on the following assumptions:
1. The objective of the firm is to maximise its profits where profits are the difference between the
firm’s revenue and costs.
2. The entrepreneur is the sole owner of the firm.
3. Tastes and habits of consumers are given and constant.
4. Techniques of production are given.
5. The firm produces a single, perfectly divisible and standardised commodity.
6. The firm has complete knowledge about the amount of output which can be sold at each price.
7. The firm’s own demand and costs are known with certainty.
8. New firms can enter the industry only in the long run. Entry of firms in the short run is not possible.
9. The firm maximises its profits over some time-horizon.
10. Profits are maximised both in the short run and the long run.
Given these assumptions, the profit maximising model of the firm can be shown under perfect
competition and monopoly.
Profit Maximisation under Perfect Competition:
Under perfect competition, the firm is one among a large number of producers. It cannot influence the
market price of the product. It is the price-taker and quantity-adjuster. It can only decide about the
output to be sold at the market price.
Therefore, under conditions of perfect competition, the MR curve of a firm coincides with its AR
curve. The MR curve is horizontal to the X-axis because the price is set by the market and the firm
sells its output at that price.
The firm is, thus, in equilibrium when MC = MR = AR (Price). The equilibrium of the profit
maximisation firm under perfect competition is shown in Figure 1. Where the MC curve cuts the MR
curve first at point A.
It satisfies the condition of MC = MR, but it is not a point of maximum profits because after point A,
the MC curve is below the MR curve. It does not pay the firm to produce the minimum output when it
can earn larger profits by producing beyond OM.

It will, however, stop further production when it reaches the OM 1 level of output where the firm
satisfies both conditions of equilibrium. If it has any plans to produce more than OM 1 it will be
incurring losses, for the marginal cost exceeds the marginal revenue after the equilibrium point B.
Thus the firm maximises its profits at M1B price and at the output level OM1.
Profit Maximisation under Monopoly:
There being one seller of the product under monopoly, the monopoly firm is the industry itself.
Therefore, the demand curve for its product is downward sloping to the right, given the tastes and
incomes of its customers. It is a price-maker which can set the price to its maximum advantage. But it
does not mean that the firm can set both price and output. It can do either of the two things.
If the firm selects its output level, its price is determined by the market demand for its product. Or, if
it sets the price for its product, its output is determined by what consumers will take at that price. In
any situation, the ultimate aim of the monopoly firm is to maximise its profits. The conditions for
equilibrium of the monopoly firm are (1) MC = MR< AR (Price), and (2) the MC curve cuts the MR
curve from below.

 
In Figure 2, the profit maximising level of output is OQ and the profit maximisation price is OP
(=QA). If more than OQ output is produced, MC will be higher than MR, and the level of profit will
fall. If cost and demand conditions remain the same, the firm has no incentive to change its price and
output. The firm is said to be in equilibrium.
Criticism of the Profit Maximisation Theory:
The profit maximisation theory has been severely criticised by economists on the following
grounds:
1. Profits uncertain:
The principle of profit maximisation assumes that firms are certain about the levels of their maximum
profits. But profits are most uncertain for they accrue from the difference between the receipt of
revenues and incurring of costs in the future. It is, therefore, not possible for firms to maximise their
profits under conditions of uncertainty.
2. No relevance to internal organisation:
This objective of the firm bears little or no direct relevance to the internal organisation of firms. For
instance, some managers incur expenditures apparently in excess of those that would maximise wealth
or profits of the owners of the firm. Managers of corporations are observed to emphasize growth of
total assets of the firm and its sales as objectives of managerial actions.
Also managers of firms undertake cost reducing, efficiency increasing campaigns when demand falls.
3. No perfect knowledge:
The profit maximisation hypothesis is based on the assumption that all firms have perfect knowledge
not only about their own costs and revenues but also of other firms. But, in reality, firms do not
possess sufficient and accurate knowledge about the conditions under which they operate.
At the most they may have knowledge about their own costs of production, but they can never be
definite about the market demand curve. They always operate under conditions of uncertainty and the
profit maximisation theory is weak in that it assumes that firms are certain about everything.
4. Empirical evidence vague:
The empirical evidence on profit maximisation is vague. Most firms do not rank profits as the major
goal. The working of modem firms is so complex that they do not think merely about profit
maximisation. Their main problems are of control and management.
The function of managing these firms is performed by managers and shareholders rather than by the
entrepreneurs. They are more interested in their emoluments and dividends respectively. Since there is
substantial separation of ownership from control in modern firms, they are not operated so as to
maximise profits.
5. Firms do not bother about MC and MR:
It is asserted that the real world firms do not bother about the calculation of marginal revenue and
marginal cost. Most of them are not even aware of the two terms. Others do not know the demand and
marginal revenue curves faced by them.
Still others do not possess adequate information about their cost structure. Empirical evidence by Hall
and Hitch shows that businessman have not heard of marginal cost and marginal revenue. After all,
they are not greedy calculating machines.
6. Principle of average-cost maximises profits:
Hall and Hitch found that firms do not apply the rule of equality of MC and MR to maximise short
run profits. Rather, they aim at the maximisation of profits in the long run. For this, they do not apply
the marginalistic rule but they fix their prices on the average cost principle.
According to this principle, price equals AVC+AFC+ profit margin (usually 10%). Thus the main aim
of the profit maximising firm is to set a price on the average cost principle and sell its output at that
price.
7. Static theory:
The neo-classical theory of the firm is static in nature. The theory does not tell the duration of either
the short period or the long period. The time-horizon of the neo-classical firm consists of identical and
independent time-periods. Decisions are considered as independent of the time-period.
This is a serious weakness of the profit maximisation theory. In fact, decisions are ‘temporally
interdependent’. It means that decisions in any one period are affected by decisions in past periods
which will, in turn, influence the future decisions of the firm. This interdependence has been ignored
by the neo-classical theory of the firm.
8. Not applicable to oligopoly firm:
As a matter of fact, the profit maximisation objective has been retained for the perfectly competitive,
or monopolistic, or monopolistic competitive firm in economic theory. But it has been abandoned in
the case of the oligopoly firm because of the criticisms levelled against it. Hence the different
objectives that have been put forth by economists in the theory of the firm relate to the oligopoly or
duopoly firm.
9. Varied Objectives:
The basis of the difference between the objectives of the neo-classical firm and the modern
corporation arises from the fact that the profit maximisation objective relates to the entrepreneurial
behaviour while modern corporations are motivated by different objectives because of the separate
roles of shareholders and managers. In the latter, shareholders have practically no influence over the
actions of the managers.
As early as in 1932, Berle and Means suggested that managers have different goals from shareholders.
They are not interested in profit maximisation. They manage firms in their own interests rather than in
the interests of shareholders. Thus modern firms are motivated by objectives relating to sales
maximisation, output maximisation, utility maximisation, satisfaction maximisation and growth
maximisation.
WEALTH MAXIMIZATION
Wealth Maximization Objective is also known as “Value Maximization” or “Net Present Worth
Maximization.” This objective is considered appropriate for decision making. Wealth means wealth of
shareholders. Wealth of shareholders is determined by market value of shares.
Wealth also signifies Net Present Value(NPV) which is the difference between present value of cash
inflows and present value of cash outflows. In this way, wealth maximization objective considers time
value of money and assign different values to cash inflows occurring at different point of time. So,
according to wealth maximization objective, investments should be made in such a way that it
maximizes Net Present Value.
Arguments in favor of Wealth Maximization objective
It is superior: This objective is superior to profit maximization as its main aim is to maximise
shareholder’s wealth.
It is precise and unambiguous: It is based on the concept of cash flows rather than profit. The
concept of profit in the profit maximization objective is vague and ambiguous.
Considers time value of money: Wealth maximization objective takes into account the time value of
money as it considers timing of cash inflows. The cash flows occurring at different period of time are
discounted with appropriate discount rate.
Considers risk: This objective also considers future risk associated with occurrence of cash flows.
This is done with the help of discounting rate. Higher the discount rate, higher the risk and vice-versa.
Ensures efficient allocation of resources: Resources are allocated wisely to increase shareholder’s
wealth.
Ensures economic interest of society: When wealth of shareholder is maximized, it ultimately
upholds economic interest of society.
 
Unfavorable arguments for Wealth Maximization objective
Creates owner-management problem: The concept of wealth maximization creates owner-
management problem as owners want to maximize their profits and management want to maximize
shareholder’s wealth.
Ignores other stakeholders: This objective has been criticized on the ground that it is inclined
towards wealth maximization of shareholders only and ignores other stakeholders such as creditors,
suppliers, employees etc.
Criteria of market value is not fair: The criteria of wealth maximization is based on market value of
shares which is not a correct measure. Because value of shares could increase or decrease due to other
economic factors which are beyond the control of the firm.
It is just another form of profit maximization: Ultimate  aim is to earn maximum profits. Without
earning profits wealth cannot be maximized.
Management alone enjoy certain benefits.
It is not suitable for present-day businesses.
  DIFFERENCE
Basis Wealth Maximization Profit Maximization

 It is defined as the management of financial It is defined as the management of financial

Definition resources aimed at increasing the value of the resources aimed at increasing the profit of the
stakeholders of the company. company.

Focuses on increasing the value of the Focuses on increasing the profit of the company in
Focus
stakeholders of the company in the long term. the short term.

It considers the risks and uncertainty inherent in It does not consider the risks and uncertainty
Risk
the business model of the company. inherent in the business model of the company.

It helps in achieving efficiency in the company’s

It helps in achieving a larger value of a
day-to-day operations to make the business
Usage company’s worth which may reflect in the
profitable
increased market share of the company.
FINANCIAL DECISIONS
Financing Decision
MEAN
The Financing Decision is yet another crucial decision made by the financial manager relating to the
financing-mix of an organization. It is concerned with the borrowing and allocation of funds required
for the investment decisions.
The financing decision involves two sources from where the funds can raise: using a company’s own
money. Such as share capital, retained earnings or borrowing funds from the outside in the form
debenture, loan, bond, etc. The objective of financial decision is to maintain an optimum capital
structure, i.e. a proper mix of debt and equity, to ensure the trade-off between the risk and return to
the shareholders.
The Debt-Equity Ratio helps in determining the effectiveness of the financing decision made by the
company. While taking the financial decisions, the finance manager has to take the following points
into consideration:
MEAN
Financial decisions refer to decisions concerning financial matters to a business concern. Decisions
regarding the magnitude of funds to invest to enable a firm to accomplish its ultimate goal, kind of
assets to acquire. The pattern of capitalization, the pattern of distribution of firm’s income and similar
other matters are including in financial decisions.
These decisions are crucial for the well-being of a firm because they determine the firm’s ability to
obtain plant and equipment. When needed to carry the required amount of inventories and receivables,
to avoid burdensome fixed charges when profits and sales decline and to avoid losing control of the
company.

Definition: The Financing Decision is yet another crucial decision made by the financial manager
relating to the financing-mix of an organization. It is concerned with the borrowing and allocation of
funds required for the investment decisions.
The financing decision involves two sources from where the funds can be raised: using a company’s
own money, such as share capital, retained earnings or borrowing funds from the outside in the form
debenture, loan, bond, etc. The objective of financial decision is to maintain an optimum capital
structure, i.e. a proper mix of debt and equity, to ensure the trade-off between the risk and return to
the shareholders.
 The Debt-Equity Ratio helps in determining the effectiveness of the
financing decision made by the company. While taking the financial decisions, the finance manager
has to take the following points into consideration:
The Risk involved in raising the funds. The risk is higher in the case of debt as compared to the
equity.
The Cost involved in raising the funds. The manager chose the source with minimum cost.
The Level of Control, the shareholders, want in the organization also determines the composition of
capital structure. They usually prefer the borrowed funds since it does not dilute the ownership.
The Cash Flow from the operations of the business also determines the source from where the funds
shall be raised. High cash flow enables to borrow debt as interest can be easily paid.
The Floatation Cost such as broker’s commission, underwriters fee, involved in raising the securities
also determines the source of fund. Thus, securities with minimum cost must be chosen.
Thus, a company should make a judicious decision regarding from where, when, how the funds shall
be raised, since, more use of equity will result in the dilution of ownership and whereas, higher debt
results in higher risk, as fixed cost in the form of interest is to be paid on the borrowed funds.
Investment Decision
These are also known as Capital Budgeting Decisions. A company’s assets and resources are rare and
must be put to their utmost utilization. A firm should pick where to invest in order to gain the highest
conceivable returns.This decision relates to the careful selection of assets in which funds will be invested
by the firms. The firm puts its funds in procuring fixed assets and current assets. When choice with
respect to a fixed asset is taken it is known as capital budgeting decision.
Factors Affecting Investment Decision
Cash flow of the venture: When an organization starts a venture it invests a huge capital at the start. Even
so, the organization expects at least some form of income to meet everyday day-to-day expenses.
Therefore, there must be some regular cash flow within the venture to help it sustain.
Profits: The basic criteria for starting any venture is to generate income but moreover profits. The most
critical criteria in choosing the venture are the rate of return it will bring for the organization in the
nature of profit for, e.g., if venture A is getting 10% return and venture В is getting 15% return then
one must prefer project B.
Investment Criteria: Different Capital Budgeting procedures are accessible to a business that can be
utilized to assess different investment propositions. Above all, these are based on calculations with
regards to the amount of investment, interest rates, cash flows and rate of returns associated with
propositions. These procedures are applied to the investment proposals to choose the best proposal.

source: badjunko
Financing Decision
Financial decision is important to make wise decisions about when, where and how should a business
acquire fund. Because a firm tends to profit most when the market estimation of an organization’s share
expands and this is not only a sign of development for the firm but also it boosts investor’s wealth.
Consequently, this relates to the composition of various securities in the capital structure of the company.
Factors affecting Financing Decisions
Cost: Financing decisions are all about allocation of funds and cost-cutting. The cost of raising funds
from various sources differ a lot. The most cost-efficient source should be selected.
Risk: The dangers of starting a venture with the funds from various sources differ. Larger risk is linked
with the funds which are borrowed, than the equity funds. This risk assessment is one of the main
aspects of financing decisions.
Cash flow position: Cash flow is the regular day-to-day earnings of the company. Good or bad cash flow
position gives confidence or discourages the investors to invest funds in the company.
Control: In the situation where existing investors need to hold control of the business then finance can
be raised through borrowing money, however, when they are prepared for diluting control of the
business, equity can be utilized for raising funds. How much control to give up is one of the main
financing decisions.
Condition of the market: The condition of the market matter a lot for the financing decisions. During
boom period issue of equity is in majority but during a depression, a firm will have to use debt. These
decisions are an important part of financing decisions.
Dividend Decision
Dividends decisions relate to the distribution of profits earned by the organization. The major alternatives
are whether to retain the earnings profit or to distribute to the shareholders.
Factors Affecting Dividend Decisions
Earnings: Returns to investors are paid out of the present and past income. Consequently, earning is a
noteworthy determinant of the dividend.
Dependability in Earnings: An organization having higher and stable earnings can announce higher
dividend than an organization with lower income.
Balancing Dividends: For the most part, organizations attempt to balance out dividends per share. A
consistent dividend is given every year. A change is made, if the organization’s income potential has
gone up and not only the income of the present year.
Development Opportunity: Organizations having great development openings if they hold more cash out
of their income to fund their required investment. The dividend announced in growing organizations is
smaller than that in the non-development companies.
Other Factors
Cash flow: Dividends are an outflow of funds. To give the dividends, the organization must have
enough to provide them, which comes from regular cash flow.
Shareholders’ Choices: While announcing dividends, the administration must remember the choices of
the investors. Some shareholders want at least a specific sum to be paid as dividends. The
organizations ought to consider the preferences of such investors.
Taxes: Compare tax rate on dividend with the capital gain tax rate that is applicable to increase in
market price of shares. If the tax rate on dividends is lower, shareholders will prefer more dividends
and vice versa.
Stock market: For the most part, an expansion in dividends positively affects the stock market, though, a
lessening or no increment may negatively affect the stock market. Consequently, while deciding
dividends, this ought to be remembered.
Access to Capital Market: Huge and organizations with a good reputation, for the most part, have simple
access to the capital market and, consequently, may depend less on retained earnings to finance their
development. These organizations tend to pay higher dividends than the smaller organizations.
Contractual and Legal Constraints: While giving credits to an organization, once in a while, the lending
party may force certain terms and conditions on the payback of dividends in future. The organizations
are required to guarantee that the profit payout does not abuse the terms of the loan understanding in
any manner.
Certain arrangements of the Companies Act put confinements on payouts as profit. Such arrangements
must be followed while announcing the dividends.
FINANCIAL PLANNING AND FORECASTING
Financial planning involves taking certain important decisions so that funds are continuously
available to the company and are used efficiently. These decisions highlight the scope of financial
planning. The financial plan is generally prepared during the promotion stage. It is prepared by the
Promoters (entrepreneurs) with the help of experienced (practicing) professionals. The promoters
must be very careful while preparing the financial plan. This is because a bad financial plan will lead
to over-capitalization or under-capitalization. It is very difficult to correct a bad financial plan. Hence
immense care must be taken while preparing a financial plan.

Explain are the Nature and Features of Planning in Business!

#Definition of Financial Planning:

Financial planning, also called budgeting, is the process of setting performance goals and organizing
systems to achieve these goals in the future. In other words, planning is the process of developing
business strategies and visions for the future. It’s big picture stuff. Financial Planning is the process of
estimating the capital required and determining its competition. It is the process of framing financial
policies in relation to procurement, investment, and administration of funds of an enterprise.
MEAN
Financial Planning
The process of determining a person's or firm's financial needs or goals for the future and the means to achiev
e them. Financial planning involves deciding what investments and activities would be most appropriate unde
r both personal and broader economic circumstances. All things being equal, short-term financial planning invo
lves less uncertainty than long-term financial planning because, generally speaking, market
trends are more easily predictable in the short term. Likewise, short-term financial plans are more easily amen
dable in case something goes wrong as a result of the short time frame.
Farlex Financial Diction

Objectives of Financial Planning

Ensuring availability of funds: Financial planning majorly excels in the area of generating funds as well
as making them available whenever they are required. This also includes estimation of the funds
required for different purposes, which are, long-term assets and working capital requirements.
Estimating the time and source of funds: Time is a game-changing factor in any business venture.
Delivering the funds at the right time at the right place is very much crucial. It is as vital as the
generation of the amount itself. While time is an important factor, the sources of these funds are
necessary as well.
Generating capital structure: The capital structure is the composition of the capital of a company, that is,
the kind and proportion of capital required in the business. This includes planning of debt-equity ratio
both short-term and long-term.
Avoiding unnecessary funds: It is an important objective of the company to make sure that the firm does
not raise unnecessary resources. Shortage of funds and the firm cannot meet its payment obligations.
Whereas with a surplus of funds, the firm does not earn returns but adds to costs.
Process of Financial Planning
Preparation of sales conjecture.
Decide the number of funds – fixed and working capital.
Conclude the expected benefits and profile ts to decide the number of funds that can be provided
through internal sources.
This causes us to evaluate the requirement from external sources.
Recognize the conceivable sources and set up the money spending plans consolidating these variables.
Importance of Financial Planning
Financial Planning is the procedure of confining company’s targets, policies, techniques, projects
and budget plans with respect to the financial activities lasting for a longer duration. This guarantees
viable and satisfactory financial investment policies. The importance is as follows-
Guarantees sufficient funds.
Planning helps in guaranteeing a harmony between outgoing and incoming of assets with the goal that
stability is kept up.
Guarantees providers of funds to effortlessly put resources into organizations which provokes financial
planning.
Financial Planning supports development and expansion programmes which support in the long-run
sustenance of the organization.
Diminishes vulnerabilities with respect to changing business sector patterns which can be confronted
effortlessly through enough funds.
Financial Planning helps in diminishing the vulnerabilities which can be a deterrent to the development
of the organization. This aids in guaranteeing security and benefits of the organization.
FINANCIAL FORECASTING
Meaning of Financial Forecasting:
‘Forecast’ means to form an opinion beforehand i.e. to make a prediction. Thus financial forecasting
means a systematic projection of the expected action of finance through financial statements.
It is needless to mention that such forecasting needs past records, cash flow and fund-flow behaviour,
the applications of financial ratios etc. along with the industrial economic condition. It is a kind of
plan which will be formulated at a future date for a specified period.
DEF
“A complete planning system begins at the highest level of policy with the firm’s basic goals or
purpose, usually stated in qualitative, mission-oriented, terms. From this it is derived the firm’s
commercial strategy, defining the product or services it will produce and the markets it will serve.
Supporting policies are developed in production, marketing, research and development, accounting
and finance. The extent to which the system formalized with detailed planning and budgeting system
in each area depends in part on the firm’s size and the complexity of its operation.” — E. Solomon
and J. S. Pringle
FINANCIAL FORECASTING METHODS ARE TWO TYPES
A QUALITATIVE
Qualitative Techniques of Financial Forecasting
Executive Opinions:
In this method, the expert opinions of key personnel of various departments, such as production, sales,
purchasing and operations, are gathered to arrive at future predictions. The management team makes
revisions in the resulting forecast, based on their expectations.
Reference Class Forecasting:
This method involves predicting the outcome of a planned action based on similar scenarios in other
times or places. This is used to defy predictions that are arrived at based only on human judgment.
Delphi Technique:
Here, a series of questionnaires are prepared and answered by a group of experts, who are kept
separate from each other. Once the results of the first questionnaire are compiled, a second
questionnaire is prepared based on the results of the first. This second document is again presented to
the experts, who are then asked to reevaluate their responses to the first questionnaire. This process
continues until the researchers have a narrow shortlist of opinions.
Sales Force Polling:
Some companies believe that salespersons have close contact with the consumers and could provide
significant insights regarding customer behavior. In this method of forecasting, the estimates are
derived based on the average of sales force polling.
Consumer Surveys:
Businesses often conduct market surveys of consumers. The data is collected via telephonic
conversations, personal interviews or survey questionnaires, and extensive statistical analysis is
conducted to generate forecasts.
Scenario Writing:
In this method, the forecaster generates different outcomes based on diverse starting criteria. The
management team decides on the most likely outcome from the numerous scenarios presented.
Quantitative Techniques of Financial Forecasting
Proforma Financial Statements:
Proforma statements use sales figures and costs from the previous two to three years after excluding
certain one-time costs. This method is mainly used in mergers and acquisitions, as well as in cases
where a new company is forming and statements are needed to request capital from investors.
Time-Series Forecasting:
Time-series forecasting is a popular quantitative forecasting technique, in which data is gathered over
a period of time to identify trends. Time-series methods are one of the simplest methods to deploy and
can be quite accurate, particularly over the short term. Some techniques that fall within this method
are simple averaging and exponential smoothing.
Cause-Effect Method:
Here, the forecaster examines the cause-and-effect relationships of the variable with other relevant
variables such as changes in consumers’ disposable incomes, the interest rate, the level of consumer
confidence, and unemployment levels.  This method uses past time series on many relevant variables
to produce the forecast for the variable of interest.
Financial forecasting is tough and selection of the appropriate forecasting method is crucial to achieve
the desired results. One needs to remember that the chosen method for one program may differ for
another. While complex techniques may give accurate predictions in special cases, simpler techniques
tend to perform just as well. Whatever may be the case, financial forecasting always helps to predict
future performance and aids decision makers.
B TIME SERIES
These methods derive forecasts based on historical patterns in the data that are observed over
equally spaced time intervals. The assumption is that there is a recurring pattern in the data that
will repeat in the future. Three examples of time series methods are:
Rule of thumb . This is based on a simplified analysis rule, such as copying forward the historical
data without alteration. For example, sales for the current month are expected to be the same as
the sales generated in the immediately preceding month.
Smoothing . This approach uses averages of past results, possibly including weightings for more
recent data, thereby smoothing out irregularities in the historical data.
Decomposition . This analysis breaks down the historical data into its trend , seasonal , and cyclical
components, and forecasts each one.
Objectives of Financial Plan:
A financial plan has the following main objectives:
1. Adequate Funds:
ADVERTISEMENTS:
A financial plan would ensure the availability of sufficient funds to achieve enterprise goals.
2. Balancing of Costs and Risks:
There should be a balancing of costs and risks so as to protect the investors.
3. Flexibility:
ADVERTISEMENTS:
A financial plan should ensure flexibility so as to adjust as per the requirements. It should be
adjustable as per the changing conditions.
4. Simplicity:
The financial structure should not be complicated by issuing a variety of securities. The number of
securities should be less so that it is easily understood.
5. Long-term View:
A financial plan should take a long-term view. The needs for funds in the near future and over a
longer period should be considered while selecting the pattern of financing.
6. Liquidity:
The liquidity of funds should always be kept in mind while preparing a financial plan. During periods
of depression it is the liquidity which can keep a concern going.
7. Optimum use:
A financial plan should ensure sufficient funds for genuine needs. Neither the plans should suffer due
to shortage of funds nor there should be wasteful use of them. The funds should be put to their
optimum use.
8. Economy:
The cost of raising the funds should be minimum. It should not impose disproportionate burden on the
company. It can be ensured by a proper debt-equity mix.
Characteristics of a Sound Financial Plan:
A Financial manager should consider the following factors while finalising a financial plan:
1. Simplicity:
A financial plan should be so simple that it may be easily understood even by a layman. A
complicated financial structure creates complications and confusion.
2. Based on Clear-cut Objectives:
Financial planning should be done by keeping in view the overall objectives of the company. It should
aim to procure funds at the lowest cost so that profitability of the business is improved.
3. Less Dependence on Outside Sources:
A long-term financial planning should aim to reduce dependence on outside sources. This can be
possible by retaining a part of profits for ploughing back. The generation of own funds is the way of
financial operations. In the beginning, outside funds may be a necessity but financial planning should
be such that dependence on such funds may be reduced in due course of time.
4. Flexibility:
The financial plan should not be rigid. It should allow a scope for adjustments as and when new
situations emerge. There may be a scope for raising additional funds if fresh opportunities occur.
Similarly, idle funds, if any, may be invested in short-term and low-risk bearing securities. Flexibility
in a plan will be helpful in coping with the demands of the future.
5. Solvency and Liquidity:
Financial planning should ensure solvency and liquidity of the enterprise. Solvency requires that
short-term and long-term payments should be made on dates when these are due. This will ensure
credit worthiness and goodwill to the concern.
Solvency will be possible when liquidity of assets is maintained. There should be sufficient funds
whenever payments are to be made. Proper forecasting of future payments will be helpful in planning
liquidity.
6. Cost:
The cost of raising capital is an important consideration in selecting a financial plan. The selection of
various sources should be such that the cost burden should be mimimum. As and when possible
interest bearing securities should be returned so that this burden is reduced.
7. Profitability:
A financial plan should adjust various securities in such a way that profitability of the enterprise is not
adversely affected. The interest bearing securities and other liabilities should be so adjusted that
business is able to improve its profitability.

FINANCIAL FORECASTING PROCESS

1. Identify the Problem
Defining the problem can seem simple at first because it looks like you are simply asking how will the
market react to a new product, or how the company’s sales will look like in a few months. Even more
so if you have a good forecasting tool for small business.
However, this step is quite tricky because there aren’t actually any tools that can help here. It requires
you to know who the forecast is directed too, how the market works, and what your customer base
and competition are.
You should spend some time evaluating these issues together with the people who will be responsible
for maintaining databases and gathering the data.
2. Collect Information
We say information here, and not data, because data may not be available yet if for example the
forecast is aimed at a new product. Having said this, the information comes essentially in two ways:
the knowledge gathered by experts and actual data.
If no data is yet available, the information must come from the judgments made by experts in the area.
If the forecast is based solely on judgment and no actual data, we are in the field of qualitative
forecasting.
If data is available on the subject, a model is used to analyze the data and predict future values. This is
called quantitative forecasting. A good example is predicting the sales for a given product in order to
replenish stocks accordingly. This can even be done on a daily basis if you use a good forecasting tool
for small business.
3. Perform a Preliminary Analysis
An early analysis of the data may tell you right away if the data is usable or not. It may also reveal
patterns or trends that can then be helpful, for example, in choosing the model that best fits it.
Another thing that can be done here is to check for redundant data and cut it down or make some
educated assumptions. By reducing the amount of data to analyze you can greatly simplify the entire
process.
4. Choose the Forecasting Model
Once all the information is collected and treated, you may then choose the model you think will give
you the best prediction possible. There is not one single model that works best in all situations, it all
depends on the availability and nature of the available data.
Qualitative Forecasting
As we’ve seen before, we may not even have any historical data, in which case we have to use
qualitative forecasting.
Two models that are commonly used in qualitative forecasting are a market research and the Delphi
method. A market research is performed by enquiring a large number of people about their
willingness to purchase a possible product or service.
The Delphi method consists of gathering forecasts from several different experts in a given area, and
then compiling all that information into a single forecast. It relies on the assumption that a collective
forecast is more accurate than that of a single person.
Quantitative Forecasting
If sufficient data is available, the human factor can be removed from the equation and a raw data
analysis can be performed to predict future values. A lot of mathematical values exist to do these
predictions, including regression models, exponential smoothing models, Box-Jenkins ARIMA
models and others.
Some forecasting tools for small business, like DataQlick, use an Exponential Moving Average
Calculation model to predict product sales.
5. Data analysis
This step is simple. After choosing a suitable model, run the data through it.
6. Verify Model Performance
When the time comes, it is very important to compare your forecast to the actual data. This allows you
to evaluate the accuracy of not only the model, but the entire process, and change each step
accordingly. Hopefully, if you use a good forecasting tool for small business, there won’t be much
tweaking needed!
UNIT 2
FINANCIAL LEVERAGES
Financial Leverage
Table of Contents [show]
Financial Leverage – Meaning
Financial leverage simply means the presence of debt in the capital structure of a firm. Similarly, in
other words, we can also call it the existence of fixed-charge bearing capital which may include
preference shares along with debentures, term loans etc. There are basically three leverages; operating
leverage, financial leverage, combined leverage. The objective of introducing leverage to the capital is
to achieve maximization of wealth of the shareholders.
Financial leverage deals with the profit magnification in general. It is also well known as gearing or
‘trading on equity’. The concept of financial leverage is not just relevant to businesses but it is equally
true for individuals. Debt is an integral part of the financial planning of anybody whether it is an
individual, firm or a company. We will try to understand it from the business point of view.
In a business, debt (short or long term) is acquired not only on the grounds of ‘need for capital’ but
also taken to enlarge the profits accruing to the shareholders. Let me clarify it further. An introduction
of debt in the capital structure will not have an impact on the sales, operating profits etc but it will
increase the share of the equity shareholders, the ROE % (Return on Equity).
Measures of Financial Leverage
There are various measures of Financial Leverage
Debt Ratio: It is the ratio of debt to total assets of the firm which means what percentage of total
assets is financed by debt.
Debt Equity Ratio: It is the ratio of debt to equity which signifies how many dollars of debt is taken
per dollar of equity.
Interest Coverage Ratio: It is the ratio of profits to interest. This ratio is also represented in times. It
represents how many times of the interest is the available profit to pay it off. Higher such ratio, higher
is the interest paying capacity. The reciprocal of it is income gearing.
MEAN
Financial Leverage Definition
Financial leverage is the use of debt to buy more assets . Leverage is employed to increase the
return on equity . However, an excessive amount of financial leverage increases the risk of failure,
since it becomes more difficult to repay debt.
The financial leverage formula is measured as the ratio of total debt to total assets. As the
proportion of debt to assets increases, so too does the amount of financial leverage. Financial
leverage is favorable when the uses to which debt can be put generate returns greater than the
interest expense associated with the debt. Many companies use financial leverage rather than
acquiring more equity capital, which could reduce the earnings per share of existing shareholders .
Definition of Financial Leverage
Financial leverage which is also known as leverage or trading on equity, refers to the use of debt to
acquire additional assets.
The use of financial leverage to control a greater amount of assets (by borrowing money) will cause
the returns on the owner's cash investment to be amplified. That is, with financial leverage:
an increase in the value of the assets will result in a larger gain on the owner's cash, when the loan
interest rate is less than the rate of increase in the asset's value
a decrease in the value of the assets will result in a larger loss on the owner's cash
Types of Leverages as Studied in Financial Management
Types of Leverages – Financial, Operating and Combined Leverages (with Formula)
Type # 1. Financial Leverage:
Financial Leverage is a tool with which a financial manager can maximise the returns to the equity
shareholders. The capital of a company consists of equity, preference, debentures, public deposits and
other long-term source of funds. He has to carefully select the securities to mobilise the funds. The
proper blend of debt to equity should be maintained.
The ratio through which he balances the mix of debt applied on the capital mix offers benefits to the
equity shareholders is known as Trading on Equity. As the debt is associated with the cost of interest
that can be directly charged to profit and loss account or charged against the profit can reduce the
burden of income tax. The benefit so gained will be passed on to the equity shareholders. In such
circumstances the EPS will be more.
If the company prefers to raise the amount of debt instead of equity, it will lose the opportunity of
charging the interest directly against the profit, as a result of this, it had to pay more tax to the
government and in turn earnings available to equity shareholders would reduce. Hence, in other
words, financial leverage refers to the use of fixed charge securities in the capitalisation of company
to produce more gains for the equity shareholders.

Thus, the financial leverage signifies the relationship between the earning power on equity capital and
rate interest on borrowed capital. If the earnings of the company has more amount of fixed cost of
interest (which would arise due to more debt capital), the overall returns of a company get reduced
and financial risk increases. This may be an unfavourable situation for business concern and
practically not advocated. The more accepted ratio between debt to equity is 2:1. This ratio favours
leverage effect on equity shares and would get higher percentage of earnings.
The two quantifiable tools, viz., operating and financial leverage are adopted to know the earnings per
share and also which shows the market value of the share. (Price earning ratio by EBIT) Thus,
financial leverage is a better tool compared to operating leverage. Change in EPS due to changes in
EBIT results in variation in market price.
Therefore, financial and operating leverages act as a handy tool to the analyst or to the financial
manager to take the decision with regard to capitalisation. He can identify the exact relationship
between the EPS and EBIT and plan accordingly. High leverage indicates high financial risks which
would signal the finance manager to select the securities carefully.
Type # 2. Operating Leverage:
There are two major classification of costs in the organisation. They are- (a) Fixed cost, (b) Variable
cost.The operating leverage has a bearing on fixed costs. There is a tendency of the profits to change,
if the firm employs more of fixed costs in its production process, greater will be the operating cost
irrespective of the size of the production. The operating leverage will be at a low degree when fixed
costs are less in the production process.
Operating leverage shows the ability of a firm to use fixed operating cost to increase the effect of
change in sales on its operating profits. It shows the relationship between the changes in sales and the
charges in fixed operating income. Thus, the operating leverage has impact mainly on fixed cost,
variable cost and contribution.
It indicates the effect of a change in sales revenue on the operating profit (EBIT). Higher the
operating leverage indicates higher the amount of fixed cost and reduces the operating profit and
increases the business risks.
In the previous illustration, we have learnt that 25,000 units of production will not yield any operating
profit or the company has reached the break-even. Any units which are produced beyond 25,000 units
yields operating profits. Therefore, any increases in sales, fixed costs remaining same, increases
operating profit. The increase in percentage operating income due to percentage, of increase in sales is
called as “Degree of operating leverage”.
This is calculated as follows:

Type # 3. Combined Leverage:

This leverage shows the relationship between a change in sales and the corresponding variation in
taxable income. If the management feels that a certain percentage change in sales would result in
percentage change to taxable income they would like to know the level or degree of change and hence
they adopt this leverage. Thus, degree of leverage is adopted to forecast the future study of sales
levels and resultant increase/decrease in taxable income. This degree establishes the relationship
between contribution and taxable income.
Example:
A company, has a sales of Rs.2 lakh. The variable costs are 40 per cent of the sales and fixed expenses
are Rs.60,000. The interest on borrowed capital is assumed to be Rs.20, 000. Compute the combined
leverage and show the impact on taxable income when sales increases by 10 per cent.
Solution:
It should be observed that the leverage is ascertained from a particular sales point. When different
levels of sales are adopted, different degrees of composite leverages are obtained. When the volume
of sales increases, fixed expenses remains same, the degree of leverage falls. This happens because of
existence of fixed charges in the cost structure.
Significance of Operating and Financial Leverage:
These two leverages are used to know the impact on earnings per share and the price-earning ratio. As
the financial leverage is more effective on EPS, it is popularly used than operating leverage. The
different combination of debt to equity helps the management to maximise the earnings to the equity
shareholders. This helps the management to achieve wealth maximisation in the long run.
Continuous increase in the size of the debt increases the financial risks. The majority of earnings will
directly goes to meet the interest cost on borrowings. It adversely affects the overall performance of
the organisation. Hence, he should evaluate the different mix of capital involving financial risk to the
firm.
Operating leverage is based on the principle of marginal costing, where BEP can be calculated at
different level of sales. Any increase of sales beyond BEP sales will yield higher operating profit,
(fixed cost remain constant). Any change in sales due to the change in operating cost results in higher
operating profits. Therefore, operating leverage is said to be “First phase Leverage” which magnifies
the profit due to change in sales volume.
The financial leverage is said to be a “Second phase Leverage” as it starts off at the point where the
operating leverage stops. These two leverages are properly blended to have profit maximisation and
wealth maximisation which are the two objectives of financial management.
Financial Risk:
Financial leverage not only maximises the returns to shareholders but also exposes a firm to high
financial risk, (if it is unplanned). The theory says ‘leverage effect can be enjoyed only up to a
particular point of time or stage’, (if all other things are favourable). If it crosses the expected line
(more debt and less equity), increases the financial risk (interest burden) and ultimately it leads to
insolvency. Capital structure only through equity is also not favourable to the company, as it reduces
EPS. (Because of nonexistence debt capital). The entire earnings of the company will become taxable,
as a result of this, it has to declare lower percentage of dividend, in the long run, and it would directly
affect the market value of shares.
Business Risk:
Business risk is related to the investment decisions or assets mix of the firm. Business risk may be
defined as the variability in return on assets. Such a variability is the result of internal and external
environment, in which the firm has to operate. Given the environment in which firm has to operate,
business risk is an unavoidable risk. Therefore, it is the basic duty of the financial executives to take
both the risks in taking financial as well as investment decisions.
The first aspect of financial risk, viz., the relatively higher variability in the shareholders’ earnings
can be measured by calculating coefficient of variation of the shareholders’ expected earnings. The
coefficient of variation of the expected earnings from total assets, defined business risk.
Where (σ = standard deviation about the probability distribution of expecting earnings and X̅ =
average expected earnings). If the expected earnings of the firm and the expected earnings of the
shareholders would be equal in the case of debt free firm. But the financial risk derived for a levered
firm as the coefficient of variation of its shareholder’s earnings would be greater than that of an
identical debt free firm.
Example:
The expected future average annual net operating incomes of firms A and B are Rs.40, 000 with the
standard deviation of Rs.10, 000. First A is debt free while Firm A is debt free while firm B has 10
debentures of Rs.60, 000 ignoring taxation, ascertain which firm is risky from the shareholder’s point
of view?
Solution:

Since coefficient of variation of Firm B is greater than that of A, Firm B is more risky from the
shareholder’s point of view.
Difference between Operating and Financial Leverage:
Operating Average:
1. Operating leverage is related to the investment activities (capital expenditure decision).
2. The fluctuation in the EBIT can be predicated with the help of operating leverage.
3. Financial manager uses the operating leverage to identify the items of assets side of the Balance.
4. Operating leverage is used to predict Business risk.
Financial Average:
1. Financial leverage is more concerned with financial matters (Mixing of debt Equity in. Capital
structure).
2. The changes of EPS due to D:E Mix is predicted by financial leverage.
3. The uses financial leverage to make decisions in the liability side of the Balance Sheet.
4. Financial leverage is used to analyse the financial risk.

Types of Leverages: With Features, Computations, Calculations and Application 

1. Operating Leverage:
Operating leverage arises due to the presence of fixed operating costs in the cost structure of a
company. Operating leverage is the use of fixed operating costs to magnify the effect of change in
sales on operating profit. Thus, Operating leverage implies that a given % change in sales results into
a more than proportionate change in the operating profit (Earnings Before interest and taxes or EBIT)
of the company in the same direction.
Operating Leverage measures the sensitivity of a company’s operating income to a given change in
sales. A company will not have operating leverage if it does not have any fixed operating costs. At the
same time the higher the fixed operating costs, the higher will be operating leverage.
Operating leverage is concerned with the capital budgeting decision of a company. This is because
fixed assets give rise to fixed operating costs which in turn results into operating leverage.
Operating leverage gives rise to ‘Operating Risk’. Operating Risk or Business Risk is the risk of not
being able to meet fixed operating costs. The higher the fixed operating costs, the higher will be
operating leverage and the higher will be operating risk of the business.
Features of Operating Leverage:
Following are the features of operating leverage:
i. It is concerned with fixed operating costs or fixed assets of a company.
ii. It measures the relationship between sales revenue and operating profit.
iii. It gives rise to operating risk or business risk in a business.
iv. It is higher in a manufacturing company having huge amount of fixed operating costs than a
trading company which has less amount of fixed assets.
Computation of Operating Leverage:
Degree of Operating Leverage (DOL) is the percentage change in a company’s operating profit
(EBIT) resulting from a percentage change in sales.
Therefore, Degree of Operating Leverage (DOL) can be calculated as below:

i. Fixed operating costs are those operating costs which are independent of output. These costs remain
constant irrespective of the production and sales data. The examples are—building rent, depreciation
etc. Variable costs are costs which vary proportionately with output. Example – wages, utilities,
materials etc.
ii. Contribution = Sales Revenue – Variable Costs.
iii. Earnings Before Interest and Taxes (EBIT) = Contribution – Fixed operating Costs.
Interpretation of Operating Leverage:
1. If DOL = 1 then a given % change in sales will result in the same % change in operating profit in
the same direction i.e. 1% increase in sales will result in 1% increase in operating profit. Similarly
196 decrease is sales will result in 1% decrease in operating profit. In such a case there in effectively
NO OPERATING LEVERAGE.
2. A company should have operating leverage only if its contribution margin is higher than its fixed
operating costs. Otherwise it will result into more harm to the company.
3. If DOL > 1 for example if DOL =1.5 then 1% increase in sales will result in 1.5% increase in
operating profit. Similarly 1% decrease is sales will result in 1.5% decrease in operating profit. In this
case there is OPERATING LEVERAGE. The higher the value of DOL, the higher will be operating
leverage.
4. Operating leverage is favourable when sales are increasing because then the operating profits will
increase by a higher proportion. Operating leverage is unfavourable when sales are decreasing
because then the operating profits will decrease by a higher proportion.
5. When comparing two or more companies, the company with the highest DOL is the company the
profits of which are most “sensitive” to changes in sales.
Operating Risk (or Business Risk):
Operating risk is the risk of not being able to meet fixed operating costs like depreciation, rent etc.
This risk is a function of the amount of fixed assets which involve fixed operating costs. The higher
the proportion of fixed operating costs in the cost structure of a company, the higher will be operating
risk.
Operating risk is also defined as variability in operating profits (EBIT) due to changes in sales. Hence
there is a positive relationship between operating leverage and operating risk. The higher the
operating leverage the higher is the operating risk of a company.
Significance of Operating Leverage:
If a company has higher degree of operating leverage, then even a small change in sales levels will
have a significantly higher effect on EBIT in the same direction. A small increase in sales will
significantly increase the operating profit (EBIT). At the same time, a small decrease in sales will also
significantly decrease the operating profits (EBIT).
Therefore, a company should always try to avoid having higher operating leverage if it is not sure
about the stability of its sales. If the sales are fluctuating and highly vulnerable then a high DOL
condition is a highly risky proposition.
Applications of Operating Leverage:
Operating leverage is used for the following purposes:
i. For selection of Investment projects – A company should be careful while selecting investment
projects. A company should select a project with lower operating leverage if all other things remain
same.
ii. Operating leverage is important for long term profit planning and budgeting as one can easily
compute the effect of a change in sales revenue on operating profit.
iii. DOL indicates operating or Business Risk of a company – Business Risk is the risk of not being
able to meet fixed operating cost obligations. It can be measured as the variability of a company’s
operating profit (EBIT). One of the main sources of variability in operating profits is change in sales
which is very well captured by the degree of operating leverage. Hence degree of operating leverage
in a way indicates the operating risk or business risk level of a company. The higher the DOL the
higher will be business risk.
iv. Capital structure decision i.e. the mix of debt and equity capital, is also effected by the company’s
operating leverage. Generally when operating leverage is high, companies should avoid excessive use
of debt.
2. Financial Leverage:
Another type of leverage in financial management is ‘Financial Leverage’. Financial leverage arises
due to the presence of fixed Financial Costs (such as interest) in the cost structure of a company.
Financial leverage is the use of fixed Financial Costs to magnify the effect of change in operating
profit (EBIT) on Earnings per share (EPS). Thus, Financial leverage implies that a given % change in
EBIT results into a more than proportionate change in EPS (Earnings per share) of the company in the
same direction.
Financial Leverage measures the sensitivity of a company’s EPS to a given change in its operating
profit (EBIT). A company will not have Financial Leverage if it does not have any fixed Financial
Costs. At the same time the higher the fixed Financial costs, the higher will be Financial Leverage.
Fixed financial costs result from the use of debt capital in the capital structure of a company.
Therefore Financial Leverage is concerned with the capital structure decision of a company. This is
because debt capital gives rise to fixed Financial Costs which in turn results into Financial Leverage.
Financial Leverage gives rise to ‘Financial Risk’. Financial Risk is the risk of not being able to meet
fixed Financial Costs such as interest and hence it may force a company into bankruptcy. The higher
the fixed Financial Costs, the higher will be Financial Leverage and the higher will be Financial Risk
of the business.
Features of Financial Leverage:
Following are the features of Financial Leverage:
i. It is concerned with fixed Financial Costs or debt capital of a company.
ii. It measures the relationship between operating profit (EBIT) and earnings per share (EPS).
iii. It gives rise to Financial Risk in a business.
iv. It is higher in a company using high amount of debt.
Computation of Financial Leverage:
Degree of Financial Leverage (DFL) measures the percentage change in EPS for a given percentage
change in operating income or earnings before interest and taxes (EBIT).

When there is No Preference Dividend then the following formula can also be used for the
calculation of DFL:

Important Note:
However when there is preference dividend as well, then it is better to use the first formula. This is
because while interest expenses are tax deductible, preference dividend is not tax deductible in nature.
Hence earnings available to equity shareholders get reduced further by the amount of preference
dividend which is fixed.
i. Fixed Financial costs are those Financial Costs which are to be paid irrespective of the amount of
profit or loss. These costs remain constant irrespective of the amount of operating profits. The
examples are interest on bonds and debentures, interest on bank loans etc.
ii. EBIT = Sales Revenue – Variable Costs – Fixed operating costs.
iii. Earnings Before Taxes (EBT) = EBIT – Interest. EBT is also known as Profit before Tax (PBT).
Interpretation of Financial Leverage:
1. If DFL = 1 then a given % change in EBIT will result in the same % change in EPS in the same
direction i.e. 1 % increase in EBIT will result in 1% increase in EPS. Similarly 1% decrease is EBIT
will result in 1% decrease in EPS. In such a case there is effectively no financial leverage.
2. A company should have Financial Leverage only if its operating profit is higher than its interest
costs. Otherwise it will result into more harm to the EPS of the company.
3. If DFL > 1, for example if DFL = 1.5 then 1% increase in EBIT will result in 1.5% increase in EPS.
Similarly 1% decrease is EBIT will result in 1.5% decrease in EPS. In such a case there is
FINANCIAL LEVERAGE.
4. The higher the value of DFL, the higher will be financial leverage.
5. Financial Leverage is favourable when operating profits are increasing because then the EPS will
increase by a higher proportion. Financial leverage is unfavourable when operating profits are
decreasing because then the EPS will decrease by a higher proportion.
6. When comparing two or more companies, the company with the highest DFL is the company the
EPS of which is most “sensitive” to changes in operating profits.
7. A company should use high financial leverage if its ROI is higher than the cost of debt. In that case
the effect on EPS will be magnified.
Financial Risk:
Financial risk is the risk of not being able to meet fixed financial obligations like payment of interest
on debt. This risk is a function of the relative amount of long term debt that a company uses to finance
its assets.
The higher the proportion of debt capital in the total capitalization of a company, the higher will be
degree of financial leverage and the higher will be the probability of the company of not being able to
service the debt capital, which in turn means higher financial risk.
Hence there is a positive relationship between financial leverage and financial risk.
Application of Financial Leverage:
Financial leverage emerges out of the capital structure decision of a company. A finance manager can
decide whether the company should use more financial leverage or not. For deciding on whether to
further use debt in the capital structure or not the finance manager should compare the cost of debt
financing with the company’s average Return on Investment (ROI).
i. If ROI > Cost of Debt:
This implies that the company will earn a return on its invested debt capital which is more than the
cost of those debt funds. Hence, use of debt will result in positive net benefits to shareholders and
therefore more debt should be employed. This situation is also known as Favourable Financial
Leverage or Trading on Equity.
ii. If ROI = Cost of Debt:
This implies that the company will earn a return on debt which equals the cost of those debt funds.
Hence, use of debt will not provide any additional net benefit to shareholders. Instead use of more
debt will only increase financial risk. Hence, more leverage should not be used.
iii. If ROI < Cost of Debt:
This implies that the company will earn a return on invested debt capital which is less than the cost of
those debt funds. Hence, use of debt will result into net loss to the company and earnings to equity
shareholders will decline. So in this case, company should not use any more debt.
Significance of Financial Leverage:
i. Financial leverage leads to more than proportionate increase in EPS if operating profits of the
company are increasing. This provides additional benefits to equity shareholders. However, it can also
cause a manifold decline in EPS when EBIT declines. So, it is important to use financial leverage
judiciously.
ii. Debt is a cheaper source of funds than equity and preference capital. Hence, use of more debt
reduces the overall or weighted average cost of capital (WACC) of the company. This contributes to
the objective of shareholders’ wealth maximization.
iii. Most companies use WACC as discount rate in capital budgeting decisions. A reduction in WACC
due to the use of financial leverage means that more projects will be profitable and can be selected.
3. Combined Leverage:
Operating leverage explains the business risk complexion of the company whereas financial leverage
deals with the financial risk of the company. But what matters for a company is its ‘Total Risk’. Total
risk of a company is captured by the ‘Combined leverage’ of the company. Hence, Combined
Leverage is a measure of total risk of a company. Operating leverage shows the effect of change in
sales revenue on EBIT and financial leverage shows the effect of change in EBIT on EPS.
So, a company having both operating leverage and financial leverage will have to see the effect of
change in sales revenue on its EPS. Combined leverage shows the effect of change in sales revenue on
EPS of a company. Combined leverage is calculated as the multiplication of Operating leverage and
Financial Leverage.

Interpretation of Combined Leverage:

i. If DCL = 1 then there is no combined risk of the company.
ii. If DCL > 1 then there is combined risk. Let us assume that DCL = 2.25 then it means that 1%
increase or decrease in sales revenue will result into 2.25% increase or decrease in company’s EPS. In
a generalised way we can say that if DCL = K then an X% increase or decrease in Sales will produce
a K*X% increase or decrease respectively in EPS. For Example – If DCL = 4, then a 1% increase in
sales will result in a 4% increase in EPS.
iii. DCL measures the total or combined risk of a company. Total or combined company risk is the
variability in EPS. Total company risk = business risk X financial risk. Thus risk in a company is
multiplicative in nature and not additive.
iv. Combined leverage or combined risk can be managed by managing operating leverage and
financial leverage. If a company has higher operating leverage then it should use low financial
leverage so that combined leverage does not increase manifold. If a company has lower operating
leverage then it may afford to have higher financial leverage.
v. A company with relatively high level of DCL is seen as riskier than a company with less combined
leverage, as high DCL means more fixed costs to the company.
The impact of different combinations of operating and financial leverage on combined leverage
is shown in the Table:
Types of Leverages – Operating Leverage, Financial Leverage and Combined Leverage (with
Formula)
There are three types of leverages, such as- (1) Operating leverage, and (2) Financial leverage. (3)
Combined Leverage.
Now let us discuss the different types of leverages in detail. 
1. Operating Leverage:
Operating leverage is present anytime in a firm when it has operating (fixed) costs regardless of the
level of production. These fixed costs do not vary with sales, they must be paid regardless of the
amount of revenue available. Hence, operating leverage may be defined as the firm’s ability to use
operating costs to magnify the effects of changes in sales on its earnings before interest and taxes.
Operating leverage is associated with investment (assets acquisition) activities. Hence, operating
leverage results from the presence of fixed operating expenses with firm’s income stream.
The operating costs are categorised into three- First – fixed costs, which do not vary with the level of
production, they must be paid regardless of the amount of revenue available. For example,
depreciation on plant and machinery, buildings, insurance, etc., Second- variable costs, raw materials,
direct labour costs, etc. that vary directly with the level of production. Third – Semi-variable costs,
which partly vary and partly fixed.
The degree of operating leverage may be defined as the change in the percentage of operating income
(EBIT), for a given change in percentage of sales revenue. The degree of operating leverage at any
level of output is arrived at by dividing the percentage change in EBIT with percentage change in
sales.
Symbolically:
Operating leverage may be favourable or unfavourable. High degree of operating leverage indicates
higher degree of risk. It is good when revenues are rising and bad when they are falling. Operating
risk (business risk) is the risk of the firm not being able to cover its fixed operating costs. The larger
the magnitude, the larger the volume of sales required to cover all fixed costs.
Before going to workout the problems, there is a need to know how to compute the earnings available
to the equity shareholders from the sales revenue. The following format clearly gives a picture about
the calculation of earnings available to the ordinary shareholders.
Applications of Operating Leverage:
i. It is helpful to know how operating profit would change with a given change in units produced.
ii. It will be helpful in measuring business risk.
2. Financial Leverage:
Firms may need long-term funds for long-term activities like expansion, diversification,
modernisation, etc., Finance manager’s job is to raise the required funds with different composition of
sources. The required funds may be raised by two sources – equity and debt. Use of various sources to
compose capital is known as capital structure. The use of fixed charges, sources of funds such as debt
and preference share capital along with the equity share capital in capital structure is described as
financial leverage.
According to Lawrence, financial leverage is the ability of the firm to use fixed financial charges to
magnify the effects of changes in EBIT on the firm’s earnings per share. In other words, financial
leverage may be defined as the payment of fixed rate of interest for the use of fixed interest bearing
securities to magnify the rate of return as equity shares. It is also known as “trading as equity”.
Hence, financial leverage results from the presence of fixed financial charges in the income statement.
Financial leverage associates with financing activities. The fixed charges do not vary with the firm’s
EBIT. They must be paid regardless of the amount of EBIT available to the firm. It indicates the
effect on EBIT created by the use of fixed charge securities in the capital structure of a firm.
Financial leverage is computed by the following formula:
Financial leverage may be positive or negative, favourable leverage occurs when the firm earns more
on the assets purchased with the funds, than the cost of their use and vice versa. Higher the degree of
financial leverage leads to high financial risk. The financial risk refers to the risk of the firm not being
able to cover its fixed financial costs. Hence, financial manager should take into consideration the
level of EBIT and fixed charges while preparing the firm’s financial plan.
Application of Financial Leverage:
(i) It is helpful to know how EPS would change with a change in operating profit.
(ii) It is helpful in measuring financial risk.
3. Combined Leverage:
The operating leverage has its effects on operating risk and is measured by the percentage change in
EBIT due to the percentage change in sales. The financing leverage has its effects on financial risk
and is measured by the percentage change in EPS due to the percentage change in EBIT.
Since, both these leverages are closely related with the ascertainment of the firm’s ability to cover
fixed charges (fixed operating costs in the case of operating leverage and fixed financial costs in the
case of financial leverage), the sum of them gives us the total leverage or combined leverage and the
risk associated with combined leverage is known as total risk. The degree of combined leverage may
be defined as the percentage change in EPS due to the percentage change in sales.
Thus, the combined leverage is:

Types of Leverages – Operating, Financial and Combined 

Leverage is of three types:
1. Operating Leverage,
2. Financial Leverage, and
3. Combined Leverage.
Type # 1. Operating Leverage:
Operating leverage may be defined as the tendency of the operating profit to vary disproportionately
with the volume of sales. It occurs when a firm has fixed costs that must be paid regardless of volume
of sales. In other words, with fixed costs, the percentage change in operating profits is greater than the
percentage change in sales. This tendency is called operating leverage. The degree of operating
leverage depends upon the proportion of fixed costs as compared to variable costs.
If the proportion of fixed costs is higher than the variable costs, it will have a higher degree of
operating leverage. On the other hand, if the proportion of fixed costs is lower than the variable costs,
it will have a lower operating leverage. In case of higher degree of operating leverage, the operating
profits will increase at a higher rate as compared to the rate of increase in sales and vice versa.
Computation:
The operating leverage can be calculated as:

Operating leverage may be favourable or unfavourable. It will be favourable when contribution (i.e.
sales less variable cost) exceeds the fixed cost and it will be unfavourable when contribution is lower
than the fixed cost.
Degree of Operating Leverage:
The degree of operating leverage may be defined as the percentage change in operating profits
resulting from a percentage change in sales.

Implications of Operating Leverage:
It can be said that higher is the operating leverage, higher will be the fluctuations in the operating
profit as a result of change in sales. In case of high leverage, if the sale increases, operating profits
will increase more than proportionately. On the other hand, if the sales decline, the operating profits
will decline more than proportionately. Thus high leverage means exceptionally large operating
profits in case of exceptionally large sales and exceptionally large losses in case of large decline in
sales.
Significance of Operating Leverage:
The analysis of degree of operating leverage helps the financial management in making a
number of financial decisions as follows:
(i) Selection of an Appropriate Technology of Production:
A firm with an automated production technology has to make large investment in fixed assets. As a
result, its fixed costs and consequently operating leverage will be higher. On the other hand, if a firm
employs labour intensive technology, the investment in fixed assets will be lesser and hence, its
operating leverage will be lower. The financial manager has to make a choice between high operating
leverage (i.e., automated production technology) and low operating leverage (i.e., labour intensive
technology).
Choice between the two depends upon the behaviour of the sales volume of the firm in future. If the
firm expects large volume of sales, it would be better to operate under high operating leverage and
consequently the firm would choose automated production technology. On the other hand, if the firm
expects lower sales volume, it should have lower operating leverage and the firm should choose
labour intensive technology of production.
(ii) Fixation of Selling Price:
A firm with high operating leverage may sell its products at reduced prices because of presence of
lower variable cost per unit. Reduction in prices leads to increase in the number of units sold which
will adequately compensate the decline in profits due to decrease in selling prices. As a result, the
profit of the firm will increase inspite of decrease in selling prices.
(iii) Useful in Understanding the Change in Operating Profit:
Analysis of operating leverage is useful to the financial manager in understanding the impact of
change in sales on the level of operating profits of the firm. A firm having high operating leverage
will have magnified effect on operating profits for even a small change in sales level. Higher
operating leverage can dramatically result in increase in operating profits whereas a decline in sales
may result in disappearance of operating profits and even give place to operating loss.
(iv) Measurement of Business Risk:
Degree of operating leverage is helpful in the assessment of business risk of a firm. Business risk is
related to fluctuation in the operating profits. The higher the degree of operating leverage, the greater
will be the fluctuations in the operating profits as a result of change in sales volume. Thus, higher
degree of operating leverage implies higher business risk and vice versa.
Therefore, a firm should always try to avoid operating under high operating leverage because it is a
high risk situation and even a small decline in sales can excessively reduce its operating profits. On
the other hand, a firm should try to operate at a level where chances of loss due to decline in sales are
minimized.
Type # 2. Financial Leverage:
Financial leverage arises on account of existence of fixed interest or fixed preference dividend bearing
securities in the total capital structure of the firm. In other words, financial leverage is created on
account of raising of capital from those sources on which fixed return has to be paid, such as debt and
preference capital along with owner’s equity in the capital structure.
The fixed return or fixed charges payable on debt or preference capital do not vary with the earnings
before interest and taxes (EBIT). They are to be paid regardless of the amount of EBIT. After paying
fixed charges out of EBIT, the residual net income belongs to ordinary shareholders.
Financial leverage may be defined as the tendency of the residual net income to vary
disproportionately with EBIT. In other words, the financial leverage indicates the change that takes
place in the residual net income as a result of change in EBIT.
The ratio is expressed as follows:

Favourable and Unfavourable Financial Leverage:

Financial leverage may be favourable or unfavourable depending upon whether the earnings made by
the use of fixed cost securities exceed the fixed cost which the firm has to pay on them. For example,
if a company borrows Rs. 100 at 10% interest p.a., and earns a return of 12%, the leverage will be
considered favourable. Unfavourable or negative leverage occurs when the firm does not earn as
much as the cost of debt. Favourable financial leverage is also known as ‘trading on equity’.
Significance of Financial Leverage:
(i) Understanding Changes in Earning before Tax (EBT):
Financial leverage helps in understanding the changes in Earning before Tax (EBT) as a result of
changes in Earnings before interest and tax (EBIT). For example, financial leverage of 2 means 50%
increase / decrease in EBIT will result in 100% increase / decrease in EBT.
(ii) Planning of Capital Structure for the Firm:
The capital structure is concerned with the raising of long term funds, both from fixed cost funds and
equity capital. Financial leverage helps the finance manager in devising an appropriate ratio between
fixed cost funds and equity share capital. A high financial leverage means high financial costs and
high financial risk. A finance manager must plan the capital structure in a way that the firm is in a
position to meet its fixed financial costs.
(iii) Measurement of Financial Risk:
Financial leverage helps in measuring financial risk. High financial leverage implies high fixed
financial costs and thus high financial risk and low financial leverage implies low fixed financial costs
and low financial risk. The financial risk refers to the risk of the firm not being able to cover its fixed
financial costs. If the firm cannot pay the fixed financial costs, it can be forced into liquidation.
(iv) Profit Planning:
Earning per share (EPS) is affected by the degree of financial leverage. High financial leverage can
increase the EPS of a firm if the earnings before interest and tax (EBIT) is expected to increase in
future. On the contrary, if EBIT is likely to decrease in future, the EPS would decline at a much faster
rate as compared to the rate of decline in EBIT. Hence, by studying the relationship between EBIT
and EPS changes, the firm can plan about the behaviour of EPS in future.
Limitations of Financial Leverage / Trading on Equity:
(i) Double-Edged Weapon:
Financial leverage is a double-edged weapon. It can be successfully employed only when the rate of
earnings of the firm exceeds the rate of interest or preference dividend. For example, if a firm borrows
Rs. 100 at 9% interest p.a., and earns a return of 12%, the balance of Rs. 3 p.a. will belong to the
equity shareholders resulting in increase in earnings per share (EPS). However, if the firm could earn
a return of only 6% on Rs. 100 employed by it, the equity shareholder’s loss would be p.a. resulting in
a decline in EPS.
(ii) Increase in Risk and Rate of Interest:
Every rupee of extra debt goes on increasing the risk of the business and hence the rate of interest on
subsequent borrowings also goes on increasing because subsequent lenders will demand higher rate of
interest.
(iii) Harmful in Case of Fluctuation in Earnings:
High Financial leverage is beneficial only to the firms having regular and stable earnings. The reason
is that interest on borrowings is a fixed burden on the firm and in case the earnings fall, the firm may
not be in a position to meet its fixed interest burden.
(iv) Restrictions from Financial Institutions:
Financial institutions which have lent money to the firm may impose restrictions on the firm if it
resorts to excessive financial leverage. The restrictions are imposed because of increased risk and to
maintain a balance in capital structure of the firm.
Type # 3. Combined or Composite Leverage:
As explained, operating leverage measures the effect of change in sales level on the EBIT level. Thus,
it explains the degree of business risk complexion the firm. Financial leverage measures change in
earning before tax (EBT) on account of change in operating profits (i.e., EBIT). Thus, it explains the
degree of financial risk. Both these leverages are closely concerned with the firm’s capability of
meeting its fixed costs (both operating and financial). In case both the leverages are combined, the
result will depict the effect of change in sales level on the earning before tax (EBT).
Therefore, combined leverage depicts the relationship between revenue on account of sales (i.e.,
contribution or sales less variable cost) and the earning before tax. In other words, it reveals the
change in earning before tax on account of change in contribution.
It may be calculated as follows:
Significance of Combined Leverage:
(i) Understanding Changes in EPS:
Combined leverage explains the combined effect of operating leverage and financial leverage of a
firm on its earnings per share (EPS). Thus, it explains the changes in EPS on account of changes in
sales.
(ii) Assessment of Total Risk:
Combined leverage helps us in ascertaining the overall risk assumed by the firm. It depicts a
combined effect of operating risk and financial risk on the EPS of the firm.
(iii) Helpful in Establishing a Proper Combination of Operating and Financial Leverage:
A high degree of operating leverage together with a high degree of financial leverage makes the
position of the firm very risky. High operating leverage results from employing the assets for which it
has to pay higher fixed costs and high financial leverage results from the use of large amount of debt
capital.
In order to keep the overall risk under manageable limits, the firm will have to strive a proper
combination of operating and financial leverage. For this purpose, a firm which has assumed high
operating leverage should employ lower financial leverage and on the other hand, a firm which has
assumed lower operating leverage can afford to employ a higher degree of financial leverage.

EBIT AND EPS ANALYSIS

Definition
EBIT-EPS analysis is a technique used to determine the optimal capital structure in which the value of
earnings per share (EPS) has the highest amount for a given amount of earnings before interest and
taxes (EBIT). In other words, the objective of EBIT-EPS analysis is to determine the effect of using
different sources of financing on EPS.
Formula
EBIT-EPS indifference point is an important tool used to choose between two alternative financing
plans. The formula to calculate it is as follows:
(EBIT - IA)(1 - T) - (EBIT - IB)(1 - T) -
PDA  = PDB
SA SB
where:
EBIT – earnings before interest and taxes
IA – interest expense in financing plan A
IB – interest expense in financing plan B
T – corporate income tax rate
PDA – preferred dividends payable in financing plan A
PDB – preferred dividends payable in financing plan B
SA – amount of common stock outstanding in financing plan A
SB – amount of common stock outstanding in financing plan B
MEAN
EBIT-EPS analysis gives a scientific basis for comparison among various financial plans and shows
ways to maximize EPS. Hence EBIT-EPS analysis may be defined as ‘a tool of financial planning that
evaluates various alternatives of financing a project under varying levels of EBIT and suggests the
best alternative having highest EPS and determines the most profitable level of EBIT’.
Concept of EBIT-EPS Analysis:
The EBIT-EBT analysis is the method that studies the leverage, i.e. comparing alternative methods of
financing at different levels of EBIT. Simply put, EBIT-EPS analysis examines the effect of financial
leverage on the EPS with varying levels of EBIT or under alternative financial plans.
It examines the effect of financial leverage on the behavior of EPS under different financing
alternatives and with varying levels of EBIT. EBIT-EPS analysis is used for making the choice of the
combination and of the various sources. It helps select the alternative that yields the highest EPS.
We know that a firm can finance its investment from various sources such as borrowed capital or
equity capital. The proportion of various sources may also be different under various financial plans.
In every financing plan the firm’s objectives lie in maximizing EPS.
Advantages of EBIT-EPS Analysis:
We have seen that EBIT-EPS analysis examines the effect of financial leverage on the behavior of
EPS under various financing plans with varying levels of EBIT. It helps a firm in determining
optimum financial planning having highest EPS.
Various advantages derived from EBIT-EPS analysis may be enumerated below:
Financial Planning:
Use of EBIT-EPS analysis is indispensable for determining sources of funds. In case of financial
planning the objective of the firm lies in maximizing EPS. EBIT-EPS analysis evaluates the
alternatives and finds the level of EBIT that maximizes EPS.
Comparative Analysis:
EBIT-EPS analysis is useful in evaluating the relative efficiency of departments, product lines and
markets. It identifies the EBIT earned by these different departments, product lines and from various
markets, which helps financial planners rank them according to profitability and also assess the risk
associated with each.
Performance Evaluation:
This analysis is useful in comparative evaluation of performances of various sources of funds. It
evaluates whether a fund obtained from a source is used in a project that produces a rate of return
higher than its cost.
Determining Optimum Mix:
ADVERTISEMENTS:
EBIT-EPS analysis is advantageous in selecting the optimum mix of debt and equity. By emphasizing
on the relative value of EPS, this analysis determines the optimum mix of debt and equity in the
capital structure. It helps determine the alternative that gives the highest value of EPS as the most
profitable financing plan or the most profitable level of EBIT as the case may be.
Limitations of EBIT-EPS Analysis:
Finance managers are very much interested in knowing the sensitivity of the earnings per share with
the changes in EBIT; this is clearly available with the help of EBIT-EPS analysis but this technique
also suffers from certain limitations, as described below
No Consideration for Risk:
Leverage increases the level of risk, but this technique ignores the risk factor. When a corporation, on
its borrowed capital, earns more than the interest it has to pay on debt, any financial planning can be
accepted irrespective of risk. But in times of poor business the reverse of this situation arises—which
attracts high degree of risk. This aspect is not dealt in EBIT-EPS analysis.
Contradictory Results:
It gives a contradictory result where under different alternative financing plans new equity shares are
not taken into consideration. Even the comparison becomes difficult if the number of alternatives
increase and sometimes it also gives erroneous result under such situation.
Over-capitalization:
This analysis cannot determine the state of over-capitalization of a firm. Beyond a certain point,
additional capital cannot be employed to produce a return in excess of the payments that must be
made for its use. But this aspect is ignored in EBIT-EPS analysis.
Example 5.1:
Ankim Ltd., has an EBIT of Rs 3, 20,000. Its capital structure is given as under:
Indifference Points:
The indifference point, often called as a breakeven point, is highly important in financial planning
because, at EBIT amounts in excess of the EBIT indifference level, the more heavily levered financ-
ing plan will generate a higher EPS. On the other hand, at EBIT amounts below the EBIT indifference
points the financing plan involving less leverage will generate a higher EPS.
i. Concept:
Indifference points refer to the EBIT level at which the EPS is same for two alternative financial
plans. According to J. C. Van Home, ‘Indifference point refers to that EBIT level at which EPS
remains the same irrespective of debt equity mix’. The management is indifferent in choosing any of
the alternative financial plans at this level because all the financial plans are equally desirable. The
indifference point is the cut-off level of EBIT below which financial leverage is disadvantageous.
Beyond the indifference point level of EBIT the benefit of financial leverage with respect to EPS
starts operating.
The indifference level of EBIT is significant because the financial planner may decide to take the debt
advantage if the expected EBIT crosses this level. Beyond this level of EBIT the firm will be able to
magnify the effect of increase in EBIT on the EPS.
In other words, financial leverage will be favorable beyond the indifference level of EBIT and will
lead to an increase in the EPS. If the expected EBIT is less than the indifference point then the
financial planners will opt for equity for financing projects, because below this level, EPS will be
more for less levered firm.
ADVERTISEMENTS:
ii. Computation:
We have seen that indifference point refers to the level of EBIT at which EPS is the same for two
different financial plans. So the level of that EBIT can easily be computed. There are two approaches
to calculate indifference point: Mathematical approach and graphical approach.
Mathematical Approach:
Under the mathematical approach, the indifference point may be obtained by solving equations. Let us
present the income statement given in Table 5.1 with the following symbols in Table 5.4. We are
starting from EBIT only.

Where, N represents number of equity shares.

In case of financing, three types of sources may be opted: Equity, debt and preference shares. So we
may have four possible combinations Equity, Equity-Debt, Equity- Preference Shares and Equity-
Debt-Preference Shares.
So, EPS under various alternatives will be as follows:

Note:
The symbols have their usual meaning.
The indifference point between any two financial plans may be obtained by equalizing the respective
equations of EPS and solving them to find the value of X.
Example 5.2:
Debarathi Co. Ltd., is planning an expansion programme. It requires Rs 20 lakhs of external financing
for which it is considering two alternatives. The first alternative calls for issuing 15,000 equity shares
of Rs 100 each and 5,000 10% Preference Shares of Rs 100 each; the second alternative requires
10,000 equity shares of Rs 100 each, 2,000 10% Preference Shares of Rs 100 each and Rs 8,00,000
Debentures carrying 9% interest. The company is in the tax bracket of 50%. You are required to
calculate the indifference point for the plans and verify your answer by calculating the EPS.
Solution:
Graphical Approach:
The indifference point may also be obtained using a graphical approach. In Figure 5.1 we have
measured EBIT along the horizontal axis and EPS along the vertical axis. Suppose we have two
financial plans before us: Financing by equity only and financing by equity and debt. Different
combinations of EBIT and EPS may be plotted against each plan. Under Plan-I the EPS will be zero
when EBIT is nil so it will start from the origin.
The curve depicting Plan I in Figure 5.1 starts from the origin. For Plan-II EBIT will have some
positive figure equal to the amount of interest to make EPS zero. So the curve depicting Plan-II in
Figure 5.1 will start from the positive intercept of X axis. The two lines intersect at point E where the
level of EBIT and EPS both are same under both the financial plans. Point E is the indifference point.
The value corresponding to X axis is EBIT and the value corresponding to 7 axis is EPS.
These can be found drawing two perpendiculars from the indifference point—one on X axis and the
other on Taxis. Similarly we can obtain the indifference point between any two financial plans having
various financing options. The area above the indifference point is the debt advantage zone and the
area below the indifference point is equity advantage zone.
Above the indifference point the Plan-II is profitable, i.e. financial leverage is advantageous. Below
the indifference point Plan I is advantageous, i.e. financial leverage is not profitable. This can be
found by observing Figure 5.1. Above the indifference point EPS will be higher for same level of
EBIT for Plan II. Below the indifference point EPS will be higher for same level of EBIT for Plan I.
The graphical approach of indifference point gives a better understanding of EBIT-EPS analysis.

Financial Breakeven Point:

In general, the term Breakeven Point (BEP) refers to the point where the total cost line and sales line
intersect. It indicates the level of production and sales where there is no profit and no loss because
here the contribution just equals to the fixed costs. Similarly financial breakeven point is the level of
EBIT at which after paying interest, tax and preference dividend, nothing remains for the equity
shareholders.
In other words, financial breakeven point refers to that level of EBIT at which the firm can satisfy all
fixed financial charges. EBIT less than this level will result in negative EPS. Therefore EPS is zero at
this level of EBIT. Thus financial breakeven point refers to the level of EBIT at which financial profit
is nil.
Financial Break Even Point (FBEP) is expressed as ratio with the following equation:
Example 5.3:
A company has formulated the following financing plans to finance Rs 15, 00,000 which is required
for financing a new project.

EBIT
Earnings Before Interest and Taxes (EBIT)
April 8, 2020
EBIT (earnings before interest and taxes), also referred to as operating income, is a profitability ratio
that determines the operating profits of a company by deducting of the cost of goods sold and
operating from the total revenue. Put simply, EBIT is the amount of money a company makes without
taking into account interest or taxes and is commonly used to this measure operating profits or
operating earnings.
Quick Navigation
EBIT Formula
EBIT Analysis
EBIT Example
EBIT Conclusion
EBIT Calculator
Earnings before interest and tax is a measure of how profitable a company is, and is often used as an
alternative to operating profit. Why does EBIT ignore taxes and interest? EBIT excludes these
because it focuses on the ability of a company to generate earnings from operations. The tax and
capital structure are not relevant to the performance of the company.
You’ll find that EBIT is often used by investors and creditors because it helps them to see how a
company is able to generate enough earnings to be profitable, fund its ongoing operations and pay
down any debts.
EBIT Formula
EBIT = Total\: Revenue - Cost\: of\: Goods\: Sold - Operating\:
ExpensesEBIT=TotalRevenue−CostofGoodsSold−OperatingExpenses
To calculate the earnings before interest and tax of a company, you will need to deduct the cost of
goods sold (COGS) as well as operating expenses from a company’s total revenue.
If you do not have the figures for the COGS, operating expenses, and total revenues, you can still
calculate a company’s EBIT using the net profit method. With this method, you will need to add
interest and taxes to the net profit to get company earnings before paying interest and taxes.
EBIT = Net\: Income + Interest + TaxesEBIT=NetIncome+Interest+Taxes
Using the direct costs method, you will find out what was taken out of the company’s earnings
(COGS and operating expenses) and with the net profit method, you add back interest and taxes to the
net income.
You can only use the net profit method for calculation of EBIT during the end of a given business
period when it has prepared its financial statements and you know the value of the net income.
With the direct cost method, we can use the method to calculate EBIT any time as we can easily
determine and predict total revenue, cost of goods sold, and operating expenses.
EBIT Analysis
Since EBIT determines how a company will generate revenues over a particular period, it can be used
by investors to compare the performances of similar companies in the same industry and determine
which ones are wise to invest in.
That said, EBIT would not be a good measure for comparing companies in different industries.
Manufacturing industries, for example, would have larger COGS as well as other measures compared
to something like the hotel industry.
Investors and creditors can use this value to speculate how a business could run when it has no taxes
or capital structure cost to worry about. This makes it helpful for investors to compare two companies
in the same industry that have different tax rates.
Just as with any financial ratio, EBIT comes with its own limitations that investors need to be aware
of when comparing different companies EBIT figures.
One of the primary limitations is that because EBIT ignores interest, it could artificially inflate the
earnings for a company which has a large amount of debt, which generally also means interest
expenses on that debt.
Not including debt into the analysis is risky because a company could have increased its debt because
of bad performance or a lack of cash flow.
Another factor to consider with EBIT is depreciation, which is included in EBIT. This can lead to
varied results across industries where one has a large number of fixed assets and the other doesn’t.
The depreciation of the fixed assets would reduce the net income of the company and EBIT would
make it look less favorable.
For that type of comparison, you may want to use EBITDA instead, which takes EBIT and also
removes depreciation and amortization expenses when calculating the profitability of the company.
EPS ANALYLSIS
Earnings Per Share – EPS Definition
By JAMES CHEN
 Reviewed By DAVID KINDESS 
 Updated Apr 5, 2020
TABLE OF CONTENTS
EXPAND
What Is Earnings Per Share – EPS?
Formula and Calculation for EPS
Example
Formula and Calculation for EPS
Why EPS Is Important
Basic EPS vs. Diluted EPS
EPS Excluding Extraordinary Items
EPS From Continuing Operations
EPS and Capital
EPS and Dividends
What Is Earnings Per Share – EPS?
Earnings per share (EPS) is calculated as a company's profit divided by the outstanding shares of its
common stock. The resulting number serves as an indicator of a company's profitability. It is common
for a company to report EPS that is adjusted for extraordinary items and potential share dilution. The
higher a company's EPS, the more profitable it is considered.
KEY TAKEAWAYS
Earnings per share (EPS) is a company's net profit divided by the number of common shares it has
outstanding.
EPS indicates how much money a company makes for each share of its stock and is a widely used
metric for corporate profits.
A higher EPS indicates more value because investors will pay more for a company with higher
profits.
EPS can be arrived at in several forms, such as excluding extraordinary items or discontinued
operations, or on a diluted basis.
Earnings Per Share Explained
Formula and Calculation for EPS
The earnings per share value are calculated as the net income (also known as profits or earnings)
divided by the available shares. A more refined calculation adjusts the numerator and denominator for
shares that could be created through options, convertible debt, or warrants. The numerator of the
equation is also more relevant if it is adjusted for continuing operations.
\text{Earnings per Share}=\frac{\text{Net Income }-\text{ Preferred Dividends}}{\text{End-of-Period
Common Shares Outstanding}}Earnings per Share=End-of-
Period Common Shares OutstandingNet Income − Preferred Dividends
To calculate a company's EPS, the balance sheet and income statement are used to find the period-end
number of common shares, dividends paid on preferred stock (if any), and the net income or earnings.
It is more accurate to use a weighted average number of common shares over the reporting term
because the number of shares can change over time.
Any stock dividends or splits that occur must be reflected in the calculation of the weighted average
number of shares outstanding. Some data sources simplify the calculation by using the number of
shares outstanding at the end of a period.
Example
The calculation of EPS for three companies at the end of the 2017 fiscal year follows:
Understanding Earnings per Share
The earnings per share metric are one of the most important variables in determining a share's price. It
is also a major component used to calculate the price-to-earnings (P/E) valuation ratio, where the E in
P/E refers to EPS. By dividing a company's share price by its earnings per share, an investor can see
the value of a stock in terms of how much the market is willing to pay for each dollar of earnings.
EPS is one of the many indicators you could use to pick stocks. If you have an interest in stock
trading or investing, your next step is to choose a broker that works for your investment style.
Comparing EPS in absolute terms may not have much meaning to investors because ordinary
shareholders do not have direct access to the earnings. Instead, investors will compare EPS with the
share price of the stock to determine the value of earnings and how investors feel about future growth.
Basic EPS vs. Diluted EPS
The formula used in the table above calculates the basic EPS of each of these select companies. Basic
EPS does not factor in the dilutive effect of shares that could be issued by the company. When the
capital structure of a company includes items such as stock options, warrants, restricted stock units
(RSU), these investments—if exercised—could increase the total number of shares outstanding in the
market.
To better illustrate the effects of additional securities on per-share earnings, companies also report
the diluted EPS, which assumes that all shares that could be outstanding have been issued.
For example, the total number of shares that could be created and issued from NVIDIA's convertible
instruments for the fiscal year ended in 2017 was 33 million. If this number is added to its total shares
outstanding, its diluted weighted average shares outstanding will be 599 million + 33 million = 632
million shares. The company's diluted EPS is, therefore, $3.05B / 632 million = $4.82.
Sometimes an adjustment to the numerator is required when calculating a fully diluted EPS. For
example, sometimes a lender will provide a loan that allows them to convert the debt into shares
under certain conditions. The shares that would be created by the convertible debt should be included
in the denominator of the diluted EPS calculation, but if that happened, then the company wouldn’t
have paid interest on the debt. In this case, the company or analyst will add the interest paid on
convertible debt back into the numerator of the EPS calculation so the result isn’t distorted.
EPS Excluding Extraordinary Items
Earnings per share can be distorted, both intentionally and unintentionally by several factors. Analysts
use variations fo the basic EPS formula to avoid the most common ways that EPS may be inflated.
Imagine a company that owns two factories that make cell phone screens. The land on which one of
the factories sits has become very valuable as new developments have surrounded it over the last few
years. The company’s management team decides to sell the factory and build another one on less
valuable land. This transaction creates a windfall profit for the firm.
While this land sale has created real profits for the company and its shareholders, it is considered an
“extraordinary item” because there is no reason to believe the company can repeat that transaction in
the future. Shareholders might be misled if the windfall is included in the numerator of the EPS
equation, so it is excluded.
A similar argument could be made if a company had an unusual loss—maybe the factory burned down
—which would have temporarily decreased EPS and should be excluded for the same reason. The
calculation for EPS excluding extraordinary items is:
\text{EPS}=\frac{\text{Net Income }-\text{ Pref.Div. }\left(+or-\right)\text{ Extraordinary Items}}
{\text{Weighted Average Common
Shares}}EPS=Weighted Average Common SharesNet Income − Pref.Div. (+or−) Extraordinary Items
EPS From Continuing Operations
A company started the year with 500 stores and had an EPS of $5.00. However, assume that this
company closed 100 stores over that period and ended the year with 400 stores. An analyst will want
to know what the EPS was for just the 400 stores the company plans to continue with into the next
period.
In this example, that could increase the EPS because the 100 closed stores were perhaps operating at a
loss. By evaluating EPS from continuing operations, an analyst is better able to compare prior
performance to current performance.
The calculation for EPS from continuing operations is:
\
text{EPS}=\frac{\text{N.I. }-\text{ Pref.Div. }\left(+or-\right)\text{ Extra.Items }\left(+or-\right)\text{ Disconti
nued Operations}}{\text{Weighted Average Common
Shares}}EPS=Weighted Average Common SharesN.I. − Pref.Div. (+or−) Extra.Items (+or−) Discontinued Ope
rations
EPS and Capital
An important aspect of EPS that is often ignored is the capital that is required to generate the earnings
(net income) in the calculation. Two companies could generate the same EPS, but one could do so
with fewer net assets; that company would be more efficient at using its capital to generate income
and, all other things being equal, would be a "better" company in terms of efficiency. A metric that
can be used to identify companies that are more efficient is the return on equity (ROE).
EPS and Dividends
While EPS is widely used as a way to track a company’s performance, shareholders do not have direct
access to those profits. A portion of the earnings may be distributed as a dividend, but all or a portion
of the EPS will be retained by the company. Shareholders, through their representatives on the board
of directors, would have to change the portion of EPS that is distributed through dividends in order to
access more of those profits.
Because shareholders can’t access the EPS attributed to their shares, the connection between EPS and
a share’s price can be difficult to define. This is particularly true for companies that pay no dividend.
For example, it is common for technology companies to disclose in their initial public
offering documents that the company does not pay a dividend and has no plans to do so in the future.
On the surface, it is difficult to explain why these shares would have any value to shareholders.
The actual notional value of EPS also seems to have a relatively indirect relationship with the share
price. For example, the EPS for two stocks could be identical, but the share prices may be wildly
different. For example, in October 2018, Southwestern Energy Company (SWN) earned $1.06 per
share in diluted earnings from continuing operations, with a share price of $5.56. However, Mellanox
Technologies (MLNX) had an EPS of $1.02 from continuing operations with a share price of $70.58.
On the surface, it seems like SWN is the better deal because an investor is only paying $5.25 per
dollar of earnings ($5.56 share price / $1.06 EPS = $5.25). Investors in MLNX are paying $69.20 per
dollar of earnings ($70.58 share price / $1.02 EPS = $69.20). This ratio is also known as the earnings
multiple or Price/Earnings (PE) ratio.
Although the comparison between MLNX and SWN is extreme, investors will generally find a
comparison of EPS and share prices between industry groups to be difficult to compare. Stocks that
are expected to grow (e.g., technology, retail, industrial) will have a larger price-to-EPS (PE) ratio
than those that are not expected to grow (e.g., utilities, consumer staples).
EPS and Price-To-Earnings
Making a comparison of the P/E ratio within an industry group can be helpful, though in unexpected
ways. Although it seems like a stock that costs more relative to its EPS when compared to peers might
be “overvalued,” the opposite tends to be the rule. Investors are willing to pay more for a stock,
regardless of its historical EPS, if it is expected to grow or outperform its peers. In a bull market, it is
normal for the stocks with the highest PE ratios in a stock index to outperform the average of the other
stocks in the index. (For related reading, see "Understanding P/E Ratio vs. EPS vs. Earnings Yield")
COST OF CAPITAL
What Is 'Cost of Capital?'
Cost of capital is the required return necessary to make a capital budgeting project, such as building a
new factory, worthwhile. When analysts and investors discuss the cost of capital, they typically mean
the weighted average of a firm's cost of debt and cost of equity blended together.
The cost of capital metric is used by companies internally to judge whether a capital project is worth
the expenditure of resources, and by investors who use it to determine whether an investment is worth
the risk compared to the return. The cost of capital depends on the mode of financing used. It refers to
the cost of equity if the business is financed solely through equity, or to the cost of debt if it is financed
solely through debt.
Many companies use a combination of debt and equity to finance their businesses and, for such
companies, the overall cost of capital is derived from the weighted average cost of all capital sources,
widely known as the weighted average cost of capital (WACC).
Cost Of Capital
What Does the Cost of Capital Tell You?
Cost of capital represents a hurdle rate that a company must overcome before it can generate value, and
it is used extensively in the capital budgeting process to determine whether a company should proceed
with a project.
The cost of capital concept is also widely used in economics and accounting. Another way to describe
the cost of capital is the opportunity cost of making an investment in a business. Wise company
management will only invest in initiatives and projects that will provide returns that exceed the cost of
their capital.
Cost of capital, from the perspective on an investor, is the return expected by whoever is providing the
capital for a business. In other words, it is an assessment of the risk of a company's equity. In doing
this an investor may look at the volatility (beta) of a company's financial results to determine whether a
certain stock is too risky or would make a good investment.
KEY TAKEAWAYS
Cost of capital represents the return a company needs in order to take on a capital project, such as
purchasing new equipment or constructing a new building.
Cost of capital typically encompasses the cost of both equity and debt, weighted according to the
company's preferred or existing capital structure, known as the weighted-average cost of capital
(WACC).
A company's investment decisions for new projects should always generate a return that exceeds the
firm's cost of the capital used to finance the project—otherwise, the project will not generate a return
for investors.
Weighted Average Cost of Capital
A firm's cost of capital is typically calculated using the weighted average cost of capital formula that
considers the cost of both debt and equity capital. Each category of the firm's capital is weighted
proportionately to arrive at a blended rate, and the formula considers every type of debt and equity on
the company's balance sheet, including common and preferred stock, bonds and other forms of debt.
Finding the Cost of Debt
Every company has to chart out its financing strategy at an early stage. The cost of capital becomes a
critical factor in deciding which financing track to follow—debt, equity, or a combination of the two.
Early-stage companies seldom have sizable assets to pledge as collateral for debt financing, so equity
financing becomes the default mode of funding for most of them. Less-established companies with
limited operating histories will pay a higher cost for capital than older companies with solid track
records since lenders and investors will demand a higher risk premium for the former.
The cost of debt is merely the interest rate paid by the company on its debt. However, since interest
expense is tax-deductible, the debt is calculated on an after-tax basis as follows:
\begin{aligned} &\text{Cost of debt}=\frac{\text{Interest expense}}{\text{Total debt}} \times (1 - T) \\
&\textbf{where:}\\ &\text{Interest expense}=\text{Int. paid on the firm's current debt}\\ &T=\text{The
company’s marginal tax rate}\\ \end{aligned}Cost of debt=Total debtInterest expense
×(1−T)where:Interest expense=Int. paid on the firm’s current debtT=The company’s marginal tax rate
The cost of debt can also be estimated by adding a credit spread to the risk-free rate and multiplying
the result by (1 - T).
Finding the Cost of Equity
The cost of equity is more complicated since the rate of return demanded by equity investors is not as
clearly defined as it is by lenders. The cost of equity is approximated by the capital asset pricing
model as follows:
\begin{aligned} &CAPM(\text{Cost of equity})= R_f + \beta(R_m - R_f) \\ &\textbf{where:}\\
&R_f=\text{risk-free rate of return}\\ &R_m=\text{market rate of return}\\ \end{aligned}
CAPM(Cost of equity)=Rf+β(Rm−Rf)where:Rf=risk-free rate of returnRm=market rate of return
Beta is used in the CAPM formula to estimate risk, and the formula would require a public company's
own stock beta. For private companies, a beta is estimated based on the average beta of a group of
similar, public firms. Analysts may refine this beta by calculating it on an unlevered, after-tax basis.
The assumption is that a private firm's beta will become the same as the industry average beta.
The firm’s overall cost of capital is based on the weighted average of these costs. For example,
consider an enterprise with a capital structure consisting of 70% equity and 30% debt; its cost of
equity is 10% and the after-tax cost of debt is 7%.
Therefore, its WACC would be:
(0.7 \times 10\%) + (0.3 \times 7\%) = 9.1\%(0.7×10%)+(0.3×7%)=9.1%
This is the cost of capital that would be used to discount future cash flows from potential projects and
other opportunities to estimate their net present value (NPV) and the ability to generate value.
Companies strive to attain the optimal financing mix based on the cost of capital for various funding
sources. Debt financing has the advantage of being more tax efficient than equity financing since
interest expenses are tax deductible and dividends on common shares are paid with after-tax dollars.
However, too much debt can result in dangerously high leverage, resulting in higher interest rates
sought by lenders to offset the higher default risk.
The Cost of Capital and Tax Considerations
One element to consider in deciding to finance capital projects via equity or debt is the possibility of
any tax savings from taking on debt since the interest expense can lower a firm's taxable income, and
thus, its income tax liability.
However, the Modigliani-Miller Theorem (M&M) states that the market value of a company is
independent of the way it finances itself and shows that under certain assumptions, the value of
leveraged versus non-leveraged firms are equal, in part because other costs offset any tax savings that
come from increased debt financing.

WHY IS EBIT IMPORTANT?

EBIT is a useful business metric that comes in handy in several scenarios.
For example, when an investor is buying a company, its earning potential is more important to him
than the existing capital structure. Also, Earnings Before Interest & Tax helps an investor or an analyst
in comparing different companies in the same sector. Such a comparison indicates if a lower margin
of a company is due to the slowdown in the industry or it is specific to the company.
Earnings Before Interest & Tax is also used as an input for calculating other business metrics, like in
ratio analysis. Further, creditors also closely monitor the EBIT as it gives them an idea about the pre-
tax cash that the company generates to pay the debt and creditors.
EBIT can also be used as a proxy for the FCF (free cash flow) in industries with consistent capital
expenditures. FCF is an important input in the valuation of a business.
EBIT MARGIN
While comparing companies on the basis of EBIT, a more effective metric is EBIT margin. It is the
ratio of Earnings before Interest and Taxes to operating sales or net revenue. Since it is in the form of
a ratio or percentage; comparing it with other companies is easier.
EBIT Margin = (EBIT/ Net Revenue)
It is also a measure of a company’s earnings ability. The higher the EBIT margin, the better it is. A
higher margin would indicate more efficient cost management and better sales. If a company fails to
generate a positive margin over time, it must rethink its business model and strategy.
One can easily use EBIT margin for cross-industry and international comparisons. However, the
margin varies greatly among industries. For instance, the retail industry has a small margin, but high
volume. Other industries may have small volume, but margins would be high.
SHOULD YOU USE EBIT OR EBITDA?
Like EBIT, EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization) is also a crucial
measure of a company’s profitability. While the former excludes only interest and taxes for
calculating profitability, EBITDA excludes depreciation and amortization as well.
Since EBITDA does not include depreciation, it overestimates the profit of a company. But, we can
say that EBITDA is more closely tied to the operations of the business as it removes all non-cash
expenses from the operating income.
Deciding which of the two is more important is a tricky question. Both are equally important, and
their use often depends on the type of analysis of the company or the purpose of the analysis. For
instance, EBITDA’s usage is usually for highly capital-intensive and leveraged companies. Since
these companies have high debt and more fixed assets, it often leads to poor earnings.
So, using EBITDA gives a good idea of the profitability of such companies. Analysts also prefer
EBITDA for valuing such companies as negative earnings make the things complicated.
EPS ANALYSIS
Definition of 'Earnings Per Share (eps)'
Definition: Earnings per share or EPS is an important financial measure, which indicates the
profitability of a company. It is calculated by dividing the company’s net income with its total number
of outstanding shares. It is a tool that market participants use frequently to gauge the profitability of a
company before buying its shares.

Description: EPS is the portion of a company’s profit that is allocated to every individual share of the
stock. It is a term that is of much importance to investors and people who trade in the stock market.
The higher the earnings per share of a company, the better is its profitability. While calculating the
EPS, it is advisable to use the weighted ratio, as the number of shares outstanding can change over
time.

Earnings per share can be calculated in two ways:

1) Earnings per share: Net Income after Tax/Total Number of Outstanding Shares

2) Weighted earnings per share: (Net Income after Tax - Total Dividends)/Total Number of
Outstanding Shares

A more diluted version of the ratio also includes convertible shares as well as warrants under
outstanding shares. It is considered to be a more expanded version of the basic earnings per share
ratio.

For an investor who is primarily interested in a steady source of income, the EPS ratio can tell him/her
the room a company has for increasing its existing dividend. Although, EPS is very important and
crucial tool for investors, it should not be looked at in isolation. EPS of a company should always be
considered in relation to other companies in order to make a more informed and prudent investment
decision.
Earnings per share (EPS) ratio measures how many dollars of net income have been earned by each
share of common stock during a certain time period. It is computed by dividing net income less
preferred dividend by the number of shares of common stock outstanding during the period. It is a
popular measure of overall profitability of the company and is expressed in dollars.
Formula:
Earnings per share ratio (EPS ratio) is computed by the following formula:

The numerator is the net income available for common stockholders (i.e., net income less preferred
dividend) and the denominator is the average number of shares of common stock outstanding during
the year. The denominator does not include preferred shares.
The formula of EPS ratio is similar to the formula of return on common stockholders’ equity ratio except
the denominator of EPS ratio formula is the number of average shares of common stock outstanding
rather than the average common stockholders’ equity in dollar amount.
Examples
Example 1 – EPS computation without preferred stock:
Abraham Company had a net income of $600,000 for the year 2019. The weighted average number of
shares of common stock outstanding for the year were 200,000. What was the earnings per share ratio
of Abraham Company?
Solution
Earnings per share = Net income/Weighted average number of shares outstanding
=$600,000/200,000
= $3.00 per share
Example 2 – EPS computation with cumulative preferred stock:
Following data has been extracted from the financial statements of Peter Electronics Limited. You are
required to compute the earnings per share ratio of the company for the year 2016.
Net income for the year 2016: $1,500,000
6% cumulative preferred stock outstanding on December 31, 2016: $3,000,000
$15 par value common stock outstanding on December 31, 2016: $2,376,000
The number of shares of both types of stock are same as they were on January 01, 2016 because the
company has not issued any new shares of common or preferred stock during the year 2016.
Solution:
From the above data, we can compute the earnings per share (EPS) ratio as follows:
= ($1,500,000 – $180,000*)/158,400
= $1,320,000/158,400
= 8.33 per share
The EPS ratio of Peter Electronics is 8.33 which means every share of company’s common stock has
earned 8.33 dollars of net income during the year 2016.
* Dividend on preferred stock: $3000,000 × 0.06 = $180,000
Impact of preferred dividends on computation of earnings per share (EPS)
The dividends on cumulative and non-cumulative preferred stock impact the computation of earnings
per share differently. The dividend on cumulative preferred stock for current period is always
deducted from net income while computing current period’s EPS even if management does not
declare any divided during the period. However, in case of non-cumulative preferred stock, the
dividend is not deducted from current period’s net income unless it is declared by management.
In example 2 above, notice that no information regarding declaration of dividend has been provided.
Since the preferred stock given in the example is cumulative, we have deducted the preferred stock
dividend of $180,000 (= $3000,000 × 0.06) from net income to obtain the net income available for
common stockholders (i.e., $1,320,000).
The dividends in arrears on cumulative preferred stock for previous periods are not deducted from
current period’s net income while computing earnings per share of current period. It is because those
dividends should have been deducted from the net income of previous periods for computing EPS of
those periods.
Significance and Interpretation:
The shares are normally purchased to earn dividend or sell them at a higher price in future. EPS figure
is extremely important for actual and potential common stockholders because the payment of dividend
and increase in the value of stock in future largely depends on the earning power of the company. EPS
is the most widely quoted and relied figure by analysts, stockholders and potential investors. In many
countries, the public companies are legally required to report this figure on the income statement. It is
usually reported below the net income figure.
There is no rule of thumb to interpret earnings per share of a company. The higher the EPS figure, the
better it is. A higher EPS is the sign of higher earnings, strong financial position and, therefore, a
reliable company for investors to invest their money.
EPS figure for only a single accounting period does not reveal the real earning potential of the
business and should not be considered enough for making an investment decision. For a meaningful
analysis, the analyst or investor should calculate the EPS figure for a number of years and also
compare it with the EPS figure of other similar companies in the industry. A consistent improvement
in the EPS figure year after year is the indication of continuous improvement in the earning power of
the company.
Analysts, investors and potential stockholders prefer to use earnings per share ratio in conjunction
with other relevant ratios. For example, EPS figure is often compared with company’s per share price
by computing price earnings ratio (usually abbreviated as P/E ratio). The P/E ratio comparison of
different companies reveals the reasonability of the market price of a company’s stock. It indicates
whether a particular company’s stock at a certain market price is cheap or expensive in relation to
similar companies’ stocks trading in the market. Other matrices that are mostly considered along with
earnings per share ratio to judge the justification of stock price include dividend yield ratio and annual
dividend per share.
COST OF CAPITAL MEASUREMENTS
Cost of Capital: Useful notes on Cost of Capital | Financial Management
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The cost of capital is the minimum rate of return required on the investment projects to keep the
market value per share unchanged.
In other words, the cost of capital is simply the rate of return the funds used should produce to justify
their use within the firm in the light of the wealth maximisation objective.
Future cost and Historical cost:
It is commonly known that, in decision-making, the relevant costs are future costs are not the
historical costs. The financial decision-making is no exception. It is future cost of capital which is
significant in making financial decisions.
Specific cost and combined cost:
The cost of each component of capital (ex-common shares, debt etc.,) is known as specific cost of
capital. The combined or composite cost of capital is an inclusive: cost of capital from all sources. It
is, thus, the weighted average cost of capital.
Explicit cost and implicit cost:
The explicit cost of capital is the internal rate of return of the financial opportunity and arises when
the capital is raised. The implicit of capital arises when the firm considers alternative uses of the funds
rained. The methods of calculating the specific costs of different sources of funds are discussed.
1. Cost of debt:
It is relatively easy to calculate cost of debt, it is rate of return or the rate of interest specified at the
time of debt issue. When a bond or debenture is issued at full face value and to be redeemed after
some period, then the before tax cost of debt is simply the normal rate of interest.
Before tax cost of debt, Kd = Interest/ Principal
2. Cost of preference capital:
The measurement of the cost of preference capital poses some conceptual difficulty. In the case of
debt, there is a binding legal obligation on the firm to pay interest and the interest constitutes the basis
to calculate the cost of debt.
However, when reference to the preference capital, it may be stated that the payment of dividends on
preference capital is not legally binding on the firm and even if the dividends are paid, it is not a
charge on earnings, rather it is a distribution or appropriation of earnings to a class of owners. It may,
therefore, be concluded, that the dividends on preference capital do not constitute cost. This is not
true.
The cost of preference capital is a function of the dividend expected by investors; preference capital is
never issued with an intention not to pay dividends. Although it is not legally binding upon the firm to
pay dividends on preference capital, yet it is generally paid when the firm makes sufficient profits.
The preference share may be treated as a perpetual security it is irredeemable. Thus, its cost is given
by the following equation.
Where Kp is the cost of preference share, Dp represents the fixed dividend per preference share and P
is the price per- preference share.
3. Cost of equity capital:
It is sometimes argued that tine equity capital is free of cost. This is not true. The reason for
advancing such an argument is that it is not legally binding on the company to pay dividends to the
common shareholders. Also, unlike the interest rate on debt or the rate of dividend on preference
capital, the dividend rate to the common shareholders is not fixed. However, the shareholders invest
their money in common shares with an expectation of receiving dividends.
The market value of the share depends on the dividends expected by the shareholders. Therefore, the
required rate of return which equates the present value of the expected dividends with the market
value of share is the equity capita).
For the purpose of measuring the cost of equity, the equity capital will be divided into two parts a)
external equity b) retained earnings.
a) External equity:
The minimum rate of return which is required on the new investment, financed by the new issue of
common shares, to keep the market value of the share unchanged is the cost of new issue of common
shares (or external equity).
b) Retained earnings:
The companies are not required to pay any dividends on retained earnings. Therefore, it is sometimes
observed that this source of finance is cost free. But retained earnings is the dividend foregone by the
share holders.
The cost of retained earnings is measured by the following equation:
Kr = D/Po + g
Where Kr = Cost of retained earnings
D = Dividend
g = growth rate
Po =Market price of the share
4. Cost of convertible securities:
In recent times, companies are raising finance by a new financial instrument called the “convertible
security”. It may be a bond or a debenture or a preference share. Convertible security is considered as
a means of deferred equity, financing and its cost should, therefore, be treated so.
The expected stream of receipts from a convertible security will consist of interest/ dividend plus the
expected conversion price. The expected conversion price can be represented by the expected future
market price per equity share at some future date times the number of shares into which the security is
convertible.
The cost of a convertible security, therefore is the discount rate which equates the after tax interest or
preference dividend plus the expected conversion price with the issue price of the convertible security.
If it is assumed that all investors will convert their bonds on the same day, the cost of a convertible
bond can be found by the following equation.
Therefore, there are various approaches to calculate cost of equity capital, as shown in Figure-
3:

The explanation of these approaches (as shown in Figure-3) is as follows:

Dividend Price Approach:
The dividend price approach describes the investors’ view before investing in equity shares.
According to this approach, investors have certain minimum expectations of receiving dividend even
before purchasing equity shares. An investor calculates present market price of the equity shares and
their rate of dividend.
The dividend price approach can be mathematically calculated by using the following formula:
KE = (Dividend per share/Market price per share) * 100
KE = Cost of equity capital
However, the dividend price approach is criticized on certain grounds, which are as follows:
a. Does not take into consideration the appreciation in the value of capital. The dividend price
approach is based on the assumption that investors expect some dividend on their shares. It
completely ignores the fact that some investors also consider the chances of capital appreciation,
which increases the value of their shares.
b. Ignores the impact of retained earnings, which affect both the market price of shares and the
amount of dividend paid. For example, suppose if an organization keeps major portion of its profit as
retained earnings then it would pay low dividend, which may decrease the market price of its shares.
Earnings Price Ratio Approach:
The earnings price ratio approach suggests that cost of equity capital depends upon amount of fixed
earnings of an organization. According to the earnings price ratio approach, an investor expects that a
certain amount of profit must be generated by an organization.
Investors do not always expect that the organization distribute dividend on a regular basis.
Sometimes, they prefer that the organization invests the amount of dividend in further projects to earn
profit. In this way, the organization’s profit would increase, which in turn increases the value of its
shares in the market.
The formula to calculate cost of capital through the earnings price ratio approach is as follows:
KE = E/MP
Where,
E = Earnings per share
MP = Market price
However, this approach is criticized on the following grounds:
a. Assumes that EPS would remain constant
b. Assumes that market price per share would remain constant
c. Ignores the fact that all the earnings of an organization are not distributed in the form of dividend.
However, some part of earnings may be kept in form of retained earnings.
Dividend Price plus Growth Approach:
The dividend price plus growth approach refers to an approach in which the rate of dividend grows
with the passage of time. In the dividend price plus growth approach, investors not only expect
dividend but regular growth in the rate of dividend. The growth rate of dividend is assumed to be
equal to the growth rate in EPS and market price per share.
In the dividend price plus growth approach, cost of capital can be calculated mathematically by
using the following formula:
KE = [(D/MP) + GJ * 100
Where,
D = Expected dividend per share, at the end of period
G = Growth rate in expected dividends
This approach is considered as the best approach to evaluate the expectations of investors and
calculate the cost of equity capital. For example, your company’s share is quoted in the market at Rs.
20 currently. The company pays as dividend of Re. 1 per share and the investor’s market expects a
growth rate of 5% year.
a. Compute the company’s equity cost of capital.
b. If the anticipated growth rate is 6% p.a., calculate the indicated market price per share.
c. If the company’s cost of capital is 8% and the anticipated growth rate is 5% p.a., calculate the
indicated market price if the dividend of Re. 1 per share is to be maintained.
Solution:
The equity cost of capital is as follows:
a. KE = [{D/MP) + G] * 100
= [(1/20) + 0.05] * 100= 10%
b. MP = [{D + (G * MP)}/KE] * 100 = [{1 + (0.06 * MP)}/0.10] * 100 = Rs. 16.94
c. MP = [{D + (G * MP)}/KE] * 100 = [{1 + (0.05 * MP)}/0.08] * 100 = Rs. 20.32
Realized Yield Approach:
In the realized yield approach, an investor expects to earn the same amount of dividend, which the
organization has paid in past few years. In this approach, the growth in dividend is not considered as
major factors for deciding the cost of capital.
This approach is based on the following assumptions:
a. Risk factor remains constant in an organization. Returns in the given risk remain the same as per
the expectations of shareholders.
b. Realized yield is equivalent to the reinvestment opportunity rate for shareholders.
According to the realized yield approach, cost of capital can be calculated mathematically by
using the following formula:
KE = [{(D-P)/p} – 1] * 100
Where,
P = Price at the end of the period,
p = Price per share to day
Capital Asset Price Model (CAPM):
CAPM helps in calculating the expected rate of return from a share of equivalent risk in the capital
market. The cost of shares that carry risk would be equal to cost of lost opportunity. For example, an
investor has two investment options- to buy the shares of either X Ltd. or Y Ltd. If the investor
decides to buy the shares of X Ltd. then the cost of shares of Y Ltd. would be the cost of lost
opportunity.
CAPM is based on the following assumptions:
a. A rationale investor would always avoid risk
b. A rationale investor would always wish to maximize the expected yield
c. All investors would have similar expectations
d. All investors can lend freely on the riskless rates of return
e. Capital market is in good condition and there is no existence of tax
f. Capital market is competitive in nature
g. Securities are completely divisible and there is no transaction cost
The computation of cost of capital using CAPM is based on the condition that the required rate of
return on any share should be equal to the sum of risk less rate of interest and premium for the risk.
According to CAPM, cost of capital can be calculated mathematically by using the following
formulae:
E = R1 +β {E (R2) – R1}
Where,
E = Expected rate of return on asset
β = Beta coefficient of assets
R1 = Risk free rate of return
E (R2) = Expected return from market portfolio
This value can be calculated by analyzing data of usually five years.
Formula used to calculate beta value is as follow:
β = PIM (SD1) (SDM)/SD2M
Where,
β = Beta of stock
PIM = Correlation coefficient between the returns on stock, I and the returns on market portfolio, M.
SD1 = Standard deviation of returns on assets
SDM = Standard deviation of returns on the market portfolio
SD2M = Variance of market returns
Bond Yield plus Risk Premium Approach:
The bond yield plus risk premium approach states that the cost on equity capital should be equal to the
sum of returns on long-term bonds of an organization and risk premium given on equity shares. The
risk premium is paid on equity shares because they carry high risk.
Mathematically, the cost of capital is calculated as:
Cost of equity capital= Returns on long-term bonds + Risk premium
The bond yield plus risk premium approach is based on the fact that a risky organization would have
high financial leverage. As a result of this, it would be earning higher profit. Therefore, the equity
shareholders due to higher risks on their investments expect higher returns in the form of risk
premium.
Gordon Model:
The Gordon model was proposed by Myron Gordon to calculate cost of equity capital. As per this
model, an investor always prefers less risky investment as compared to more risky investment.
Therefore, an organization should pay risk premium only on risky investment. The Gordon model also
suggests that an investor would always prefer more of those investments, which would provide them
current income.
The Gordon model is based on the following assumptions:
a. The rate of return on the investments of an organization is constant
b. The cost of equity capital is more than the growth rate
c. The corporation tax does not exist in the economy
d. The organization has perpetual existence
e. The growth rate of the organization is a part of retention ratio and its rate of return
According to the Gordon model, cost of capital can be calculated mathematically by using the
following formula:
P = E (1 -b)/K – br

Where,
P = Price per share at the beginning of the year
E = Earnings per share at the end of the year
b = Fraction of retained earnings
K = Rate of return required by shareholders
r = Rate of return earned on investments made by the organization
For example, assume that the organization pays the corporation tax at the rate of 50%.
SPECIFICS COST OF CAPITAL
Weighted Average Cost Of Capital (WACC)
Equity and Debt Components of WACC Formula
It's a common misconception that equity capital has no concrete cost that the company must pay after
it has listed its shares on the exchange. In reality, there is a cost of equity.
The shareholders' expected rate of return is considered a cost from the company's perspective. That's
because if the company fails to deliver this expected return, shareholders will simply sell off their
shares, which will lead to a decrease in share price and the company’s overall valuation. The cost of
equity is essentially the amount that a company must spend in order to maintain a share price that will
keep its investors satisfied and invested.
One can use the CAPM (capital asset pricing model) to determine the cost of equity. CAPM is a model that
established the relationship between the risk and expected return for assets and is widely followed for
the pricing of risky securities like equity, generating expected returns for assets given the associated
risk and calculating costs of capital.
The debt-linked component in the WACC formula, [(D/V) * Rd * (1-Tc)], represents the cost of
capital for company-issued debt. It accounts for interest a company pays on the issued bonds or
commercial loans taken from bank.
Example of How to Use WACC
Let's calculate the WACC for retail giant Walmart Inc. (WMT).
As of October 2018, the risk-free rate, represented by annual return on 20-year treasury bond was 3.3
percent, beta value for Walmart stood at 0.51, while the average market return, represented by average
annualized total return for the S&P 500 index over the past 90 years, is 9.8 percent.
From the balance sheet, the total shareholder equity for Walmart for the 2018 fiscal year was $77.87
billion (E), and the long term debt stood at $36.83 billion (D). The total for overall capital for
Walmart comes to:
\begin{aligned} &V = E + D = \$114.7 \text{ billion} \\ \end{aligned}V=E+D=$114.7 billion
The equity-linked cost of capital for Walmart is:
\begin{aligned} &( E / V ) \times Re = \frac{ 77.87 }{ 114.7 } \times 6.615\% = 0.0449 \\ \end{aligned}
(E/V)×Re=114.777.87×6.615%=0.0449
The debt component is:
\begin{aligned} ( D / V) \times Rd \times ( 1 - Tc ) &= \frac{ 36.83 }{ 114.7 } \times 6.5\% \times ( 1 -
21\% ) \\ &= 0.0165 \\ \end{aligned}(D/V)×Rd×(1−Tc)=114.736.83×6.5%×(1−21%)=0.0165
Using the above two computed figures, WACC for Walmart can be calculated as:
\begin{aligned} &0.0449 + 0.016 = 0.0609 \text{ or } 6.1\% \\ \end{aligned}0.0449+0.016=0.0609 or 6.1%
On average, Walmart is paying around 6.1% per annum as the cost of overall capital raised via a
combination of debt and equity.
The above example is a simple illustration to calculate WACC. One may need to compute it in a more
elaborate manner if the company is having multiple forms of capital with each having a different cost.
For instance, if the preferred shares are trading at a different price than common shares, if the
company issued bonds of varying maturity are offering different returns, or if the company has a
(combination of) commercial loan(s) at different interest rate(s), then each such component needs to
be accounted for separately and added together in proportion of the capital raised.
Definition of WACC
A firm’s Weighted Average Cost of Capital (WACC) represents its blended cost of capital across all
sources, including common shares, preferred shares, and debt.  The cost of each type of capital is
weighted by its percentage of total capital and they are added together. This guide will provide a
detailed breakdown of what WACC is, why it is used, how to calculate it, and will provide several
examples.
WACC Explained
The WACC is based on a company's capital structure (how it is financed) and is comprised of
both debt financing and equity financing. Cost of capital is how much a firm pays to finance its
operations (either debt or equity).
Included in the cost of capital are common stock, preferred stock, and debt. The cost of capital is how
much interest a company pays on each form of financing.
Some small business firms only use debt financing for their operations. Other small startups only
use equity financing, particularly if they are funded by equity investors such as venture capitalists. As
these small firms grow, it is likely that they will use a combination of debt and equity financing.
Most of the time, WACC is used by investors as a measurement to indicate whether they should
invest in a company.
The formula to calculate the WACC is:
WACC = ( ( E ÷ V ) x Re ) + ( ( ( D ÷ V ) x Rd ) x ( 1 - T ) )
Each of the values has either a formula or value you'll need to calculate or lookup. This information
can be found on a company's balance sheet or financial information websites such as Yahoo Finance
(find the ticker page for the company you are looking for). The values are defined as:
Re=Cost of equity
Rd=Cost of debt
E=Market value of equity, or the market price of a stock (found on ticker page) multiplied by the total
number of shares outstanding (found on balance sheet)
D=Market value of debt, or the total debt of a company (found on balance sheet)
T= Effective tax rate
V=Total market value of combined equity and debt
Cost of Equity
The cost of equity can be a little more complex in its calculation than the cost of debt. It is possible
that the firm could use both common stock and preferred stock to raise money for its operations. This
illustration considers the cost of common stock only.
It is more difficult to estimate the cost of common stock than the cost of debt. Most businesses use the
Capital Asset Pricing Model (CAPM) to estimate the cost of equity. Here are the steps to estimate the
cost of retained earnings:
The risk-free rate is usually estimated by using the rate of return on ten-year U.S. Treasury bills
Estimate the expected return. You can use the historic rate of return from the company's ticker page.
The ticker page lists a company's financial standing, and usually includes historical information
Find the risk of the company's stock as compared to the market. Look for "Beta" on the company's
stock summary page. If a company's risk is greater than the market, its beta is greater than 1.0, and
less than 1.0 if the risk is lower.
Use the CAPM formula to calculate the cost of equity
Risk Free Rate + [ Beta x ( Expected Market Return - Risk Free Rate ) ]
Cost of Debt
Small businesses may use short-term debt only to purchase their assets. For example, they may use
supplier credit in the form of accounts payable. They could also just use short-term business loans,
either from a bank or some alternative source of financing.
Larger businesses may use intermediate or long-term business loans or may even issue bonds to raise
money for financing.
Use the following formula to calculate a company's effective interest:
Effective Interest rate = ( Annual Interest ÷ Total Debt ) x 100
Annual interest is the total amount of interest paid, and total debt is the total amount of debt a
company has.
Then calculate the cost of debt:
Cost of Debt = Effective Interest x ( 1 - Marginal Tax Rate )
Market Value of Equity
The market value of equity refers to the value of the shares that are outstanding (all shares owned by
shareholders or insiders). The formula is:
Market Value of Equity = Current Stock Price x Shares Outstanding
Market Value of Debt
The market value of debt is usually taken from the balance sheet (total debt) for this element of the
WACC formula. You can also calculate the market value of debt if you have the information:
C [ ( 1 – ( 1 ÷ ( ( 1 + Kd )  t  ) ) )  ÷ Kd ] + [ FV ÷ ( (1 + Kd  )  t  ) ]
C= interest rate in dollars
Kd=the current cost of debt (percentage, calculated previously)
t=weighted average maturity (years average to maturity)
FV=total debt
Effective Tax Rate
The effective tax rate is an average of the tax rate a company has paid. Generally, it is calculated by
dividing total tax by their taxable income.
Effective Tax Rate = Income Tax Expense ÷ Earnings Before Taxes (EBT)
Total Market Value of Debt and Equity
Combine the market value of equity and market value of debt (calculated earlier) to arrive at the total
market value of combined equity and debt.
Calculate the Weighted Average Cost of Capital
Once you have calculated the cost of capital for all the sources of debt and equity and gathered the
other information needed, you can calculate the WACC.
WACC = ( ( E ÷ V ) x Re) + ( ( ( D ÷ V ) x Rd ) x ( 1 - T ) )
For example, if you were to find and calculate the following values from company financials:
E=$5,600,000
D=$1,500,000
Re=5%
Rd=4%
T=21%
V=$7,100,000
The calculation would look like this:
( ( $5,600,000 ÷ $7,100,000 ) x .05 ) + ( ( ( $1,500,000 ÷ $7,100,000 ) x .04 ) x ( 1 - .21 ) ) =
.0394 + 0.0066 = .046 or 4.6%
The company you examined would have a WACC of 4.6%. This number represents the amount of
money needed to pay investors per dollar of funding. In this example, it is $.046 per 1$ of funding.
This is the average interest rate of payments to lenders and shareholders.
Taken by itself, the result only means what it says. It needs to be compared to other companies costs
of capital to determine whether it is a worthwhile investment or not. Some investors may have
personal guidelines about investing in a company with a WACC below a certain number, but in the
end it is all up to personal preference and the amount of risk an investor is willing to take.
UNIT 3
CAPITAL STRUCTURE
What is Capital Structure?
Capital Structure refers to the amount of debt and/or equity employed by a firm to fund its operations
and finance its assets.  The structure is typically expressed as a debt-to-equity or debt-to-capital ratio.
Debt and equity capital are used to fund a business’s operations, capital expenditures, acquisitions, and
other investments. There are tradeoffs firms have to make when they decide whether to use debt or
equity to finance operations, and managers will balance the two to find the optimal capital structure.

Meaning and Concept of Capital Structure:

The term ‘structure’ means the arrangement of the various parts. So capital structure means the
arrangement of capital from different sources so that the long-term funds needed for the business are
raised.
Thus, capital structure refers to the proportions or combinations of equity share capital, preference
share capital, debentures, long-term loans, retained earnings and other long-term sources of funds in
the total amount of capital which a firm should raise to run its business.
ADVERTISEMENTS:
Few definitions of capital structure given by some financial experts:
“Capital structure is the combination of debt and equity securities that comprise a firm’s financing of
its assets.”—John J. Hampton.
“Capital structure refers to the mix of long-term sources of funds, such as, debentures, long-term
debts, preference share capital and equity share capital including reserves and surplus.”—I. M.
Pandey.
Capital Structure, Financial Structure and Assets Structure:
The term capital structure should not be confused with Financial structure and Assets structure. While
financial structure consists of short-term debt, long-term debt and share holders’ fund i.e., the entire
left hand side of the company’s Balance Sheet. But capital structure consists of long-term debt and
shareholders’ fund.
So, it may be concluded that the capital structure of a firm is a part of its financial structure. Some
experts of financial management include short-term debt in the composition of capital structure. In
that case, there is no difference between the two terms—capital structure and financial structure.
So, capital structure is different from financial structure. It is a part of financial structure. Capital
structure refers to the proportion of long-term debt and equity in the total capital of a company. On the
other hand, financial structure refers to the net worth or owners’ equity and all liabilities (long-term as
well as short-term).
Capital structure does not include short-term liabilities but financial structure includes short-term
liabilities or current liabilities.
Assets structure implies the composition of total assets used by a firm i.e., make-up of the assets side
of Balance Sheet of a company. It indicates the application of fund in the different types of assets
fixed and current.
Assets structure = Fixed Assets + Current Assets.
Example:

Note:
The term capitalisation means the total amount of long-term funds at the disposal of the company,
whether raised from equity shares, preference shares, retained earnings, debentures, or institutional
loans.
Importance of Capital Structure:
The importance or significance of Capital Structure:
ADVERTISEMENTS:
1. Increase in value of the firm:
A sound capital structure of a company helps to increase the market price of shares and securities
which, in turn, lead to increase in the value of the firm.
2. Utilisation of available funds:
A good capital structure enables a business enterprise to utilise the available funds fully. A properly
designed capital structure ensures the determination of the financial requirements of the firm and raise
the funds in such proportions from various sources for their best possible utilisation. A sound capital
structure protects the business enterprise from over-capitalisation and under-capitalisation.
3. Maximisation of return:
A sound capital structure enables management to increase the profits of a company in the form of
higher return to the equity shareholders i.e., increase in earnings per share. This can be done by the
mechanism of trading on equity i.e., it refers to increase in the proportion of debt capital in the capital
structure which is the cheapest source of capital. If the rate of return on capital employed (i.e.,
shareholders’ fund + long- term borrowings) exceeds the fixed rate of interest paid to debt-holders,
the company is said to be trading on equity.
4. Minimisation of cost of capital:
A sound capital structure of any business enterprise maximises shareholders’ wealth through
minimisation of the overall cost of capital. This can also be done by incorporating long-term debt
capital in the capital structure as the cost of debt capital is lower than the cost of equity or preference
share capital since the interest on debt is tax deductible.
5. Solvency or liquidity position:
A sound capital structure never allows a business enterprise to go for too much raising of debt capital
because, at the time of poor earning, the solvency is disturbed for compulsory payment of interest to
.the debt-supplier.
6. Flexibility:
A sound capital structure provides a room for expansion or reduction of debt capital so that, according
to changing conditions, adjustment of capital can be made.
7. Undisturbed controlling:
A good capital structure does not allow the equity shareholders control on business to be diluted.
ADVERTISEMENTS:
8. Minimisation of financial risk:
If debt component increases in the capital structure of a company, the financial risk (i.e., payment of
fixed interest charges and repayment of principal amount of debt in time) will also increase. A sound
capital structure protects a business enterprise from such financial risk through a judicious mix of debt
and equity in the capital structure.
Factors Determining Capital Structure:
The following factors influence the capital structure decisions:
1. Risk of cash insolvency:
ADVERTISEMENTS:
Risk of cash insolvency arises due to failure to pay fixed interest liabilities. Generally, the higher
proportion of debt in capital structure compels the company to pay higher rate of interest on debt
irrespective of the fact that the fund is available or not. The non-payment of interest charges and
principal amount in time call for liquidation of the company.
The sudden withdrawal of debt funds from the company can cause cash insolvency. This risk factor
has an important bearing in determining the capital structure of a company and it can be avoided if the
project is financed by issues equity share capital.
2. Risk in variation of earnings:
The higher the debt content in the capital structure of a company, the higher will be the risk of
variation in the expected earnings available to equity shareholders. If return on investment on total
capital employed (i.e., shareholders’ fund plus long-term debt) exceeds the interest rate, the
shareholders get a higher return.
On the other hand, if interest rate exceeds return on investment, the shareholders may not get any
return at all.
3. Cost of capital:
Cost of capital means cost of raising the capital from different sources of funds. It is the price paid for
using the capital. A business enterprise should generate enough revenue to meet its cost of capital and
finance its future growth. The finance manager should consider the cost of each source of fund while
designing the capital structure of a company.
4. Control:
The consideration of retaining control of the business is an important factor in capital structure
decisions. If the existing equity shareholders do not like to dilute the control, they may prefer debt
capital to equity capital, as former has no voting rights.
5. Trading on equity:
The use of fixed interest bearing securities along with owner’s equity as sources of finance is known
as trading on equity. It is an arrangement by which the company aims at increasing the return on
equity shares by the use of fixed interest bearing securities (i.e., debenture, preference shares etc.).
If the existing capital structure of the company consists mainly of the equity shares, the return on
equity shares can be increased by using borrowed capital. This is so because the interest paid on
debentures is a deductible expenditure for income tax assessment and the after-tax cost of debenture
becomes very low.
Any excess earnings over cost of debt will be added up to the equity shareholders. If the rate of return
on total capital employed exceeds the rate of interest on debt capital or rate of dividend on preference
share capital, the company is said to be trading on equity.
6. Government policies:
Capital structure is influenced by Government policies, rules and regulations of SEBI and lending
policies of financial institutions which change the financial pattern of the company totally. Monetary
and fiscal policies of the Government will also affect the capital structure decisions.
7. Size of the company:
Availability of funds is greatly influenced by the size of company. A small company finds it difficult
to raise debt capital. The terms of debentures and long-term loans are less favourable to such
enterprises. Small companies have to depend more on the equity shares and retained earnings.
On the other hand, large companies issue various types of securities despite the fact that they pay less
interest because investors consider large companies less risky.
8. Needs of the investors:
While deciding capital structure the financial conditions and psychology of different types of
investors will have to be kept in mind. For example, a poor or middle class investor may only be able
to invest in equity or preference shares which are usually of small denominations, only a financially
sound investor can afford to invest in debentures of higher denominations.
A cautious investor who wants his capital to grow will prefer equity shares.
9. Flexibility:
The capital structures of a company should be such that it can raise funds as and when required.
Flexibility provides room for expansion, both in terms of lower impact on cost and with no significant
rise in risk profile.
10. Period of finance:
The period for which finance is needed also influences the capital structure. When funds are needed
for long-term (say 10 years), it should be raised by issuing debentures or preference shares. Funds
should be raised by the issue of equity shares when it is needed permanently.
11. Nature of business:
It has great influence in the capital structure of the business, companies having stable and certain
earnings prefer debentures or preference shares and companies having no assured income depends on
internal resources.
12. Legal requirements:
The finance manager should comply with the legal provisions while designing the capital structure of
a company.
13. Purpose of financing:
Capital structure of a company is also affected by the purpose of financing. If the funds are required
for manufacturing purposes, the company may procure it from the issue of long- term sources. When
the funds are required for non-manufacturing purposes i.e., welfare facilities to workers, like school,
hospital etc. the company may procure it from internal sources.
14. Corporate taxation:
When corporate income is subject to taxes, debt financing is favourable. This is so because the
dividend payable on equity share capital and preference share capital are not deductible for tax
purposes, whereas interest paid on debt is deductible from income and reduces a firm’s tax liabilities.
The tax saving on interest charges reduces the cost of debt funds.
Moreover, a company has to pay tax on the amount distributed as dividend to the equity shareholders.
Due to this, total earnings available for both debt holders and stockholders is more when debt capital
is used in capital structure. Therefore, if the corporate tax rate is high enough, it is prudent to raise
capital by issuing debentures or taking long-term loans from financial institutions.
15. Cash inflows:
The selection of capital structure is also affected by the capacity of the business to generate cash
inflows. It analyses solvency position and the ability of the company to meet its charges.
16. Provision for future:
The provision for future requirement of capital is also to be considered while planning the capital
structure of a company.
17. EBIT-EPS analysis:
If the level of EBIT is low from HPS point of view, equity is preferable to debt. If the EBIT is high
from EPS point of view, debt financing is preferable to equity. If ROI is less than the interest on debt,
debt financing decreases ROE. When the ROI is more than the interest on debt, debt financing
increases ROE.
OPTIMAL CAPITAL STRUCTURE
What is Optimal Capital Structure?
Home » Accounting Dictionary » What is Optimal Capital Structure?
Definition: Optimal capital structure is a financial measurement that firms use to determine the best
mix of debt and equity financing to use for operations and expansions. This structure seeks to lower
the cost of capital so that a firm is less dependent on creditors and more able to finance its core
operations through equity.
What Does Optimal Capital Structure Mean?
What is the definition of optimal capital structure?  In general, the optimal capital structure is a mix of
debt and equity that seeks to lower the cost of capital and maximize the value of the firm. To calculate
the optimal capital structure of a firm, analysts calculate the weighted average cost of capital (WACC) to
determine the level of risk that makes the expected return on capital greater than the cost of capital.
By calculating the cost of debt and the cost of equity, analysts multiply the cost of debt by the
weighted average cost of debt and the cost of equity by the weighted average cost of equity and add
up the results from each security involved in the total capital of the company.
Let’s look at an example.
Example
Jenny works as a financial analyst at Morgan Stanley. She is asked to create an optimal capital
structure spreadsheet that contains different leverage, interest expenses, tax expenses with a tax rate
35%, the cost of debt, and the cost of equity. Based on the inputs, Jenny calculates the market value of
the firm and the book value of the firm, as follows:
The features of an optimum capital structure:
1. Simplicity:
All businessmen are not educated. A complicated capital structure may not be understood by all; on
the contrary it may raise suspicions and create confusion. A capital structure must be as simple as
possible.
2. Profitability:
An optimum capital structure is one which maximises earning per equity share and minimizes cost of
financing.
3. Solvency:
In a sound capital structure, content of debt will be a reasonable proportion of the total capital
employed in the business. As a result, it has minimum risk of becoming insolvent.
4. Flexibility:
The capital structure of a firm should be such that it can raise funds as when required.
5. Conservatism:
The debt content in the capital structure of a firm should be within its borrowing limits. It should be
free from the risk of insolvency.
6. Control:
The capital structure should be designed in a such a way that it involves minimum risk of loss of
control of the firm.
7. Optimal debt-equity mix:
Optimal debt-equity mix in the capital structure of a company would be that point where the weighted
average cost of capital is minimum. Optimum debt- equity proportion establishes balance between
owned capital and debt capital. The firm should be cautious about the financial risk associated with
the maximum utilisation of debt.
8. Maximisation of the value of the firm:
An optimum capital structure makes the value of the firm maximum.
CAPITAL STRUCTURE THEORIES
The following points will highlight the top four theories of capital structure.
Capital Structure Theory # 1. Net Income (NI) Approach:
According to NI approach a firm may increase the total value of the firm by lowering its cost of
capital.
When cost of capital is lowest and the value of the firm is greatest, we call it the optimum capital
structure for the firm and, at this point, the market price per share is maximised.
The same is possible continuously by lowering its cost of capital by the use of debt capital. In other
words, using more debt capital with a corresponding reduction in cost of capital, the value of the firm
will increase.
The same is possible only when:
(i) Cost of Debt (Kd) is less than Cost of Equity (Ke);
(ii) There are no taxes; and
ADVERTISEMENTS:
(iii) The use of debt does not change the risk perception of the investors since the degree of leverage
is increased to that extent.
Since the amount of debt in the capital structure increases, weighted average cost of capital decreases
which leads to increase the total value of the firm. So, the increased amount of debt with constant
amount of cost of equity and cost of debt will highlight the earnings of the shareholders.
Illustration 1:
X Ltd. presents the following particulars:
EBIT (i.e., Net Operating income) is Rs. 30,000;
The equity capitalisation ratio (i.e., cost of equity) is 15% (K e);
Cost of debt is 10% (Kd);
Total Capital amounted to Rs. 2,00,000.
Calculate the cost of capital and the value of the firm for each of the following alternative leverage
after applying the NI approach.
Leverage (Debt to total Capital) 0%, 20%, 50%, 70% and 100%.
From the above table it is quite clear that the value of the firm (V) will be increased if there is a
proportionate increase in debt capital but there will be a reduction in overall cost of capital. So, Cost
of Capital is increased and the value of the firm is maximum if a firm uses 100% debt capital.
It is interesting to note the NI approach can also be graphically presented as under (with the
help of the above illustration):
The degree of leverage is plotted along the X-axis whereas K e, Kw and Kd are on the Y-axis. It reveals
that when the cheaper debt capital in the capital structure is proportionately increased, the weighted
average cost of capital, Kw, decreases and consequently the cost of debt is K d.
Thus, it is needless to say that the optimal capital structure is the minimum cost of capital if financial
leverage is one; in other words, the maximum application of debt capital.
The value of the firm (V) will also be the maximum at this point.
Capital Structure Theory # 2. Net Operating Income (NOI) Approach:
Now we want to highlight the Net Operating Income (NOI) Approach which was advocated by David
Durand based on certain assumptions.
They are:
(i) The overall capitalisation rate of the firm Kw is constant for all degree of leverages;
(ii) Net operating income is capitalised at an overall capitalisation rate in order to have the total
market value of the firm.
Thus, the value of the firm, V, is ascertained at overall cost of capital (K w):
V = EBIT/Kw (since both are constant and independent of leverage)
(iii) The market value of the debt is then subtracted from the total market value in order to get the
market value of equity.
S – V – T 
(iv) As the Cost of Debt is constant, the cost of equity will be
ADVERTISEMENTS:
Ke = EBIT – I/S
The NOI Approach can be illustrated with the help of the following diagram:

Under this approach, the most significant assumption is that the K w is constant irrespective of the
degree of leverage. The segregation of debt and equity is not important here and the market capitalises
the value of the firm as a whole.
ADVERTISEMENTS:
Thus, an increase in the use of apparently cheaper debt funds is offset exactly by the corresponding
increase in the equity- capitalisation rate. So, the weighted average Cost of Capital K w and Kd remain
unchanged for all degrees of leverage. Needless to mention here that, as the firm increases its degree
of leverage, it becomes more risky proposition and investors are to make some sacrifice by having a
low P/E ratio.
Illustration 2:
Assume:
Net Operating Income or EBIT Rs. 30,000
Total Value of Capital Structure Rs. 2,00,000.
Cost of Debt Capital Kd 10%
Average Cost of Capital Kw 12%
Calculate Cost of Equity, Ke: value of the firm V applying NOI approach under each of the following
alternative leverages:
Leverage (debt to total capital) 0%, 20%, 50%, 70%, and 100%
Although the value of the firm, Rs. 2,50,000 is constant at all levels, the cost of equity is increased
with the corresponding increase in leverage. Thus, if the cheaper debt capital is used, that will be
offset by the increase in the total cost of equity K e, and, as such, both Ke and Kd remain unchanged for
all degrees of leverage, i.e. if cheaper debt capital is proportionately increased and used, the same will
offset the increase of cost of equity.
Capital Structure Theory # 3. Traditional Theory Approach:
It is accepted by all that the judicious use of debt will increase the value of the firm and reduce the
cost of capital. So, the optimum capital structure is the point at which the value of the firm is highest
and the cost of capital is at its lowest point. Practically, this approach encompasses all the ground
between the Net Income Approach and the Net Operating Income Approach, i.e., it may be called
Intermediate Approach.
The traditional approach explains that up to a certain point, debt-equity mix will cause the market
value of the firm to rise and the cost of capital to decline. But after attaining the optimum level, any
additional debt will cause to decrease the market value and to increase the cost of capital.
In other words, after attaining the optimum level, any additional debt taken will offset the use of
cheaper debt capital since the average cost of capital will increase along with a corresponding increase
in the average cost of debt capital.
Thus, the basic proposition of this approach are:
(a) The cost of debt capital, Kd, remains constant more or less up to a certain level and thereafter rises.
(b) The cost of equity capital Ke, remains constant more or less or rises gradually up to a certain level
and thereafter increases rapidly.
(c) The average cost of capital, Kw, decreases up to a certain level remains unchanged more or less
and thereafter rises after attaining a certain level.
The traditional approach can graphically be represented under taking the data from the
previous illustration:

It is found from the above that the average cost curve is U-shaped. That is, at this stage the cost of
capital would be minimum which is expressed by the letter ‘A’ in the graph. If we draw a
perpendicular to the X-axis, the same will indicate the optimum capital structure for the firm.
Thus, the traditional position implies that the cost of capital is not independent of the capital structure
of the firm and that there is an optimal capital structure. At that optimal structure, the marginal real
cost of debt (explicit and implicit) is the same as the marginal real cost of equity in equilibrium.
For degree of leverage before that point, the marginal real cost of debt is less than that of equity
beyond that point the marginal real cost of debt exceeds that of equity.
Illustration 3:

Calculate the cost of capital and the value of the firm under each of the following alternative
degrees of leverage and comment on them:
Thus, from the above table, it becomes quite clear the cost of capital is lowest (at 25%) and the value
of the firm is the highest (at Rs. 2,33,333) when debt-equity mix is (1,00,000 : 1,00,000 or 1: 1).
Hence, optimum capital structure in this case is considered as Equity Capital (Rs. 1,00,000) and Debt
Capital (Rs. 1,00,000) which bring the lowest overall cost of capital followed by the highest value of
the firm.
Variations on the Traditional Theory:
This theory underlines between the Net Income Approach and the Net Operating Income Approach.
Thus, there are some distinct variations in this theory. Some followers of the traditional school of
thought suggest that Ke does not practically rise till some critical conditions arise. Only after attaining
that level the investors apprehend the increasing financial risk and penalise the market price of the
shares. This variation expresses that a firm can have lower cost of capital with the initial use of
leverage significantly.
This variation in Traditional Approach is depicted as:

Other followers e.g., Solomon, are of opinion the K e is being saucer-shaped along with a horizontal
middle range. It explains that optimum capital structure has a range where the cost of capital is rather
minimised and where the total value of the firm is maximised. Under the circumstances a change in
leverage has, practically, no effect on the total firm’s value. So, this approach grants some sort of
variation in the optimal capital structure for various firms under debt-equity mix.
Such variation can be depicted in the form of graphical representation:

Capital Structure Theory # 4. Modigliani-Miller (M-M) Approach:

Modigliani-Miller’ (MM) advocated that the relationship between the cost of capital, capital structure
and the valuation of the firm should be explained by NOI (Net Operating Income Approach) by
making an attack on the Traditional Approach.
The Net Operating Income Approach, supplies proper justification for the irrelevance of the capital
structure. In Income Approach, supplies proper justification for the irrelevance of the capital structure.
In this context, MM support the NOI approach on the principle that the cost of capital is not
dependent on the degree of leverage irrespective of the debt-equity mix. In the words, according to
their thesis, the total market value of the firm and the cost of capital are independent of the capital
structure.
They advocated that the weighted average cost of capital does not make any change with a
proportionate change in debt-equity mix in the total capital structure of the firm.
The same can be shown with the help of the following diagram:

Proposition:
The following propositions outline the MM argument about the relationship between cost of
capital, capital structure and the total value of the firm:
(i) The cost of capital and the total market value of the firm are independent of its capital structure.
The cost of capital is equal to the capitalisation rate of equity stream of operating earnings for its
class, and the market is determined by capitalising its expected return at an appropriate rate of
discount for its risk class.
(ii) The second proposition includes that the expected yield on a share is equal to the appropriate
capitalisation rate of a pure equity stream for that class, together with a premium for financial risk
equal to the difference between the pure-equity capitalisation rate (K e) and yield on debt (Kd). In
short, increased Ke is offset exactly by the use of cheaper debt.
(iii) The cut-off point for investment is always the capitalisation rate which is completely independent
and unaffected by the securities that are invested.
Assumptions:
The MM proposition is based on the following assumptions:
(a) Existence of Perfect Capital Market It includes:
(i) There is no transaction cost;
(ii) Flotation costs are neglected;
(iii) No investor can affect the market price of shares;
(iv) Information is available to all without cost;
(v) Investors are free to purchase and sale securities.
(b) Homogeneous Risk Class/Equivalent Risk Class:
It means that the expected yield/return have the identical risk factor i.e., business risk is equal among
all firms having equivalent operational condition.
(c) Homogeneous Expectation:
All the investors should have identical estimate about the future rate of earnings of each firm.
(d) The Dividend pay-out Ratio is 100%:
It means that the firm must distribute all its earnings in the form of dividend among the
shareholders/investors, and
(e) Taxes do not exist:
That is, there will be no corporate tax effect (although this was removed at a subsequent date).
Interpretation of MM Hypothesis:
The MM Hypothesis reveals that if more debt is included in the capital structure of a firm, the same
will not increase its value as the benefits of cheaper debt capital are exactly set-off by the
corresponding increase in the cost of equity, although debt capital is less expensive than the equity
capital. So, according to MM, the total value of a firm is absolutely unaffected by the capital structure
(debt-equity mix) when corporate tax is ignored.
Proof of MM Hypothesis—The Arbitrage Mechanism:
MM have suggested an arbitrage mechanism in order to prove their argument. They argued that if two
firms differ only in two points viz. (i) the process of financing, and (ii) their total market value, the
shareholders/investors will dispose-off share of the over-valued firm and will purchase the share of
under-valued firms.
Naturally, this process will be going on till both attain the same market value. As such, as soon as the
firms will reach the identical position, the average cost of capital and the value of the firm will be
equal. So, total value of the firm (V) and Average Cost of Capital, (K w) are independent.
It can be explained with the help of the following illustration:
Let there be two firms, Firm ‘A’ and Firm ‘B’. They are similar in all respects except in the
composition of capital structure. Assume that Firm ‘A’ is financed only by equity whereas Firm ‘B’ is
financed by a debt-equity mix.
The following particulars are presented:
-

From the table presented above, it is learnt that value of the levered firm ‘B’ is higher than the
unlevered firm ‘A’. According to MM, such situation cannot persist long as the investors will dispose-
off their holding of firm ‘B’ and purchase the equity from the firm ‘A’ with personal leverage. This
process will be continued till both the firms have same market value.
Suppose Ram, an equity shareholder, has 1% equity of firm ‘B’. He will do the following:
(i) At first, he will dispose-off his equity of firm ‘B’ for Rs. 3,333.
(ii) He will take a loan of Rs. 2,000 at 5% interest from personal account.
(iii) He will purchase by having Rs. 5,333 (i.e. Rs. 3,333 + Rs. 2,000) 1.007% of equity from the firm
‘A’.
By this, his net income will be increased as:

Obviously, this net income of Rs. 433 is higher than that of the firm ‘B’ by disposing-off 1% holding.
It is needless to say that when the investors will sell the shares of the firm ‘B’ and will purchase the
shares from the firm ‘A’ with personal leverage, this market value of the share of firm ‘A’ will decline
and, consequently, the market value of the share of firm ‘B’ will rise and this will be continued till
both of them attain the same market value.
We know that the value of the levered firm cannot be higher than that of the unlevered firm (other
things being equal) due to that arbitrage process. We will now highlight the reverse direction of the
arbitrage process.
Consider the following illustration:

In the above circumstances, equity shareholder of the firm ‘A’ will sell his holdings and by the
proceeds he will purchase some equity from the firm ‘B’ and invest a part of the proceeds in debt of
the firm ‘B’.
For instance, an equity shareholder holding 1% equity in the firm ‘A’ will do the following:
(i) He will dispose-off his 1% equity of firm ‘A’ for Rs. 6,250.

(ii) He will buy 1 % of equity and debt of the firm ‘B’ for the like amount.
(iii) As a result, he will have an additional income of Rs. 86.
Thus, if the investors prefer such a change, the market value of the equity of the firm ‘A’ will decline
and, consequently, the market value of the shares of the firm ‘B’ will tend to rise and this process will
be continued till both the firms attain the same market value, i.e., the arbitrage process can be said to
operate in the opposite direction.
Criticisms of the MM Hypothesis:
We have seen (while discussing MM Hypothesis) that MM Hypothesis is based on some assumptions.
There are some authorities who do not recognise such assumptions as they are quite unrealistic, viz.
the assumption of perfect capital market.
We also know that most significant element in this approach is the arbitrage process forming the
behavioural foundation of the MM Hypothesis. As the imperfect market exists, the arbitrage process
will be of no use and as such, the discrepancy will arise between the market value of the unlevered
and levered firms.
The shortcomings for which arbitrage process fails to bring the equilibrium condition are:
(i) Existence of Transaction Cost:
The arbitrage process is affected by the transaction cost. While buying securities, this cost is involved
in the form of brokerage or commission etc. for which extra amount is to be paid which increases the
cost price of the shares and requires a greater amount although the return is same. As such, the levered
firm will enjoy a higher market value than the unlevered firm.
(ii) Assumption of borrowing and lending by the firms and the individual at the same rate of
interest:
The above proposition that the firms and the individuals can borrow or lend at the same rate of
interest, does not hold good in reality. Since a firm holds more assets and credit reputation in the open
market in comparison with an individual, the former will always enjoy a better position than the latter.
As such, cost of borrowing will be higher in case of an individual than a firm. As a result, the market
value of both the firms will not be equal.
(iii) Institutional Restriction:
The arbitrage process is retarded by the institutional investors e.g., Life Insurance Corporation of
India, Commercial Banks; Unit Trust of India etc., i.e., they do not encourage personal leverage. At
present these institutional investors dominate the capital market.
(iv) “Personal or home-made leverage” is not the prefect substitute for “corporate leverage.”:
MM hypothesis assumes that “personal leverage” is a perfect substitute for “corporate leverage”
which is not true as we know that a firm may have a limited liability whereas there is unlimited
liability in case of individuals. For this purpose, both of them have different footing in the capital
market.
(v) Incorporation of Corporate Taxes:
If corporate taxes are considered (which should be taken into consideration) the MM approach will be
unable to discuss the relationship between the value of the firm and the financing decision. For
example, we know that interest charges are deducted from profit available for dividend, i.e., it is tax
deductible.
In other words, the cost of borrowing funds is comparatively less than the contractual rate of interest
which allows the firm regarding tax advantage. Ultimately, the benefit is being enjoyed by the equity-
holders and debt-holders.
According to some critics the arguments which were advocated by MM, are not valued in the practical
world. We know that cost of capital and the value of the firm are practically the product of financial
leverage.
MM Hypothesis with Corporate Taxes and Capital Structure:
The MM Hypothesis is valid if there is perfect market condition. But, in the real world capital market,
imperfection arises in the capital structure of a firm which affects the valuation. Because, presence of
taxes invites imperfection.
We are, now, going to examine the effect of corporate taxes in the capital structure of a firm along
with the MM Hypothesis. We also know that when taxes are levied on income, debt financing is more
advantageous as interest paid on debt is a tax-deductible item whereas retained earning or dividend so
paid in equity shares are not tax-deductible.
Thus, if debt capital is used in the total capital structure, the total income available for equity
shareholders and/or debt holders will be more. In other words, the levered firm will have a higher
value than the unlevered firm for this purpose, or, it can alternatively be stated that the value of the
levered firm will exceed the unlevered firm by an amount equal to debt multiplied by the rate of tax.
The same can be explained in the form of the following equation:

Illustration 4:
Assume:
Two firms—Firm ‘A’ and Firm ‘B’ (identical in all respects except capital structure)
Firm ‘A’ has financed a 6% debt of Rs. 1,50,000
Firm ‘B’ Levered
EBIT (for both the firm) Rs. 60,000
Cost of Capital is @ 10%
Corporate rate of tax is @ 60%
Compute market value of the two firms.
Thus, a firm can lower its cost of capital continuously due to the tax deductibility of interest charges.
So, a firm must use the maximum amount of leverage in order to attain the optimum capital structure
although the experience that we realise is contrary to the opinion.
In real-world situation, however, firms do not take a larger amount of debt and creditors/lenders also
are not interested to supply loan to highly levered firms due to the risk involved in it.
Thus, due to the market imperfection, after tax cost of capital function will be U-shaped. In answer to
this criticism, MM suggested that the firm would adopt a target debt ratio so as not to violate the
limits of level of debt imposed by creditors. This is an indirect way of stating that the cost of capital
will increase sharply with leverage beyond some safe limit of debt.
MM Hypothesis with corporate taxes can better be presented with the help of the following
diagram:

CAPITAL BUDGETIING
What Is Capital Budgeting?
Capital budgeting is the process a business undertakes to evaluate potential major projects or
investments. Construction of a new plant or a big investment in an outside venture are examples of
projects that would require capital budgeting before they are approved or rejected.
As part of capital budgeting, a company might assess a prospective project's lifetime cash inflows and
outflows to determine whether the potential returns that would be generated meet a sufficient target
benchmark. The process is also known as investment appraisal.
WHAT IS CAPITAL BUDGETING?
Capital budgeting is a company’s formal process used for evaluating potential expenditures or
investments that are significant in amount. It involves the decision to invest the current funds for
addition, disposition, modification or replacement of fixed assets. The large expenditures include the
purchase of fixed assets like land and building, new equipments, rebuilding or replacing existing
equipments, research and development, etc. The large amounts spent for these types of projects are
known as capital expenditures. Capital Budgeting is a tool for maximizing a company’s future profits
since most companies are able to manage only a limited number of large projects at any one time.
Capital budgeting usually involves calculation of each project’s future accounting profit by period, the
cash flow by period, the present value of cash flows after considering time value of money, the
number of years it takes for a project’s cash flow to pay back the initial cash investment, an
assessment of risk, and various other factors.
Capital is the total investment of the company and budgeting is the art of building budgets.
FEATURES OF CAPITAL BUDGETING
1) It involves high risk
2) Large profits are estimated
3) Long time period between the initial investments and estimated returns
CAPITAL BUDGETING PROCESS:
A) Project identification and generation:
The first step towards capital budgeting is to generate a proposal for investments. There could be
various reasons for taking up investments in a business. It could be addition of a new product line or
expanding the existing one. It could be a proposal to either increase the production or reduce the costs
of outputs.
B) Project Screening and Evaluation:
This step mainly involves selecting all correct criteria’s to judge the desirability of a proposal. This
has to match the objective of the firm to maximize its market value. The tool of time value of money
comes handy in this step.
Also the estimation of the benefits and the costs needs to be done. The total cash inflow and outflow
along with the uncertainties and risks associated with the proposal has to be analyzed thoroughly and
appropriate provisioning has to be done for the same. 
C) Project Selection:
There is no such defined method for the selection of a proposal for investments as different businesses
have different requirements. That is why, the approval of an investment proposal is done based on the
selection criteria and screening process which is defined for every firm keeping in mind the objectives
of the investment being undertaken.
Once the proposal has been finalized, the different alternatives for raising or acquiring funds have to
be explored by the finance team. This is called preparing the capital budget. The average cost of funds
has to be reduced. A detailed procedure for periodical reports and tracking the project for the lifetime
needs to be streamlined in the initial phase itself. The final approvals are based on profitability,
Economic constituents, viability and market conditions.

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D) Implementation:
Money is spent and thus proposal is implemented. The different responsibilities like implementing the
proposals, completion of the project within the requisite time period and reduction of cost are allotted.
The management then takes up the task of monitoring and containing the implementation of the
proposals.
E) Performance review:
The final stage of capital budgeting involves comparison of actual results with the standard ones. The
unfavorable results are identified and removing the various difficulties of the projects helps for future
selection and execution of the proposals.

FACTORS AFFECTING CAPITAL BUDGETING:

Availability of Funds Working Capital
Structure of Capital Capital Return
Management decisions Need of the project
Accounting methods Government policy
Taxation policy Earnings
Lending terms of financial Economic value of the
institutions project
CAPITAL BUDGETING DECISIONS:
The crux of capital budgeting is profit maximization. There are two ways to it; either increase the
revenues or reduce the costs. The increase in revenues can be achieved by expansion of operations by
adding a new product line. Reducing costs means representing obsolete return on assets.
Accept / Reject decision – If a proposal is accepted, the firm invests in it and if rejected the firm does
not invest. Generally, proposals that yield a rate of return greater than a certain required rate of return
or cost of capital are accepted and the others are rejected. All independent projects are accepted.
Independent projects are projects that do not compete with one another in such a way that acceptance
gives a fair possibility of acceptance of another.
Mutually exclusive project decision – Mutually exclusive projects compete with other projects in such a
way that the acceptance of one will exclude the acceptance of the other projects. Only one may be
chosen. Mutually exclusive investment decisions gain importance when more than one proposal is
acceptable under the accept / reject decision. The acceptance of the best alternative eliminates the
other alternatives.
Capital rationing decision – In a situation where the firm has unlimited funds, capital budgeting
becomes a very simple process. In that, independent investment proposals yielding a return greater
than some predetermined level are accepted. But actual business has a different picture. They have
fixed capital budget with large number of investment proposals competing for it. Capital rationing
refers to the situation where the firm has more acceptable investments requiring a greater amount of
finance than that is available with the firm. Ranking of the investment project is employed on the
basis of some predetermined criterion such as the rate of return. The project with highest return is
ranked first and the acceptable projects are ranked thereafter.
As the topic is vast we shall cover the techniques / methods with examples and the other relevant aspects
of capital budgeting in the next article.
DEF
Definition:  Capital Budget consists of capital receipts and payments. It also incorporates transactions
in the Public Account.
Risks in Capital Budgeting
Risks in Capital Budgeting are from five different sources. They are:
 
Project-specific risk
Project-specific risk could be traced to something quite specific to the project. Managerial
deficiencies or error in estimation of cash flows or discount rate may lead to a situation of actual cash
flows realised being less than the projected cash flow.
 
Competitive or competition risk
Unanticipated actions of a firm’s competitors will materially affect the cash flows expected from a
project. As a result of this, the actual cash flows from a project will be less than that of the forecast.
 
Industry-specific risk
Industry-specific risks are those that affect all the firms in the particular industry. Industry-specific
risk could be again grouped into technological risk, commodity risk and legal risk. Let us discuss the
groups in industry specific risks, as follows:
Technical risk
Commodity risk
Legal risk
 
International risk
These types of risks are faced by firms whose business consists mainly of exports or those who
procure their main raw material from international markets.
The firms facing such kind of risks are as follows:
The rupee-dollar crisis affected the software and BPOs, because it drastically reduced their
profitability.
Another example is that of the textile units in Tirupur in Tamil Nadu, which exports the major part of
the garments produced. Strengthening of rupee and weakening of dollar, reduced their
competitiveness in the global markets.
The surging crude oil prices coupled with the governments delay in taking decision on pricing of
petro products eroded the profitability of oil marketing companies in public sector like Hindustan
Petroleum Corporation Limited.
Another example is the impact of US sub-prime crisis on certain segments of Indian economy. The
changes in international political scenario also affected the operations of certain firms
 
Market risk
Factors like inflation, changes in interest rates, and changing general economic conditions affect all
firms and all industries. Firms cannot diversify this risk in the normal course of business.
There are many techniques of incorporation of risk perceived in the evaluation of capital budgeting
proposals. They differ in their approach and methodology as far as incorporation of risk in the
evaluation process is concerned.
.
TECHNIQUES OF CAPITAL BUDGETING
is set of techniques used to decide which investments to make in projects. There are a number of
capital budgeting techniques available, which include the following:
Discounted cash flows. Estimate the amount of all cash inflows and outflows associated with a
project through its estimated useful life, and then apply a discount rate to these cash flows to
determine their present value. If the present value is positive, accept the funding proposal.
Internal rate of return. Determine the discount rate at which the cash flows from a project net to
zero. The project with the highest internal rate of return is selected.
Constraint analysis. Examine the impact of a proposed project on the bottleneck operation of the
business. If the proposal either increases the capacity of the bottleneck or routes work around the
bottleneck, thereby increasing throughput, then accept the funding proposal.
Breakeven analysis. Determine the required sales level at which a proposal will result in positive
cash flow. If the sales level is low enough to be reasonably attainable, then accept the funding
proposal.
Discounted payback. Determine the amount of time it will take for the discounted cash flows
from a proposal to earn back the initial investment. If the period is sufficiently short, then accept
the proposal.
Accounting rate of return. This is the ratio of an investment’s average annual profits to the
amount invested in it. If the outcome exceeds a threshold value, then an investment is approved.
Real options. Focus on the range of profits and losses that may be encountered over the course
of the investment period. The analysis begins with a review of the risks to which a project will
be subjected, and then models for each of these risks or combinations of risks. The result may be
greater care in placing large bets on a single likelihood of probability.
When analyzing a possible investment, it is useful to also analyze the system into which the
investment will be inserted. If the system is unusually complex, it is likely to take longer for the
new asset to function as expected within the system. The reason for the delay is that there may
be unintended consequences that ripple through the system, requiring adjustments in multiple
areas that must be addressed before any gains from the initial investment can be achieved.
TRADITIONAL CAPITAL BUDGETING
 Methods of capital budgeting
In earlier articles, we have discussed the capital budgeting and its types. Today we will discuss the
methods of capital budgeting:
(I)Traditional methods
i) Pay back period method: this method means the period in which the total investment in the
permanent assets pays back itself. This method is based upon the concept that every capital
expenditure pays itself back within a certain period of time. Thus, this method measures the period of
time means the time taken where the cost of project is recovered from the earning of the project itself.
Decision rule: the investment with a shorter pay back period is accepted and the one which has a
longer pay back period is rejected.
Pay back period= original cost of asset/ cash inflow
 Advantages of Pay back period method:
it is easy to calculate, simple to understand.
it saves cost.
a firm having less funds can select the shorter time period for pay back
Disadvantages of Pay back period method:
it fails to take in account cash inflow earned after pay back period.
it does not take into account salvage value of asset.
ii) Improvement to traditional approach to pay back method:
a) Post pay back profitability method: the main disadvantage of pay back method is that it fails to take
in account cash inflow earned after pay back period so true profitability of the project can not be
ascertained. An improvement to this method can be done only by taking into account the return
received after the pay back period.
Post pay back profitability= post pay back profit *100/inveastment
 b) Pay back reciprocal method: this method is used to find out the internal rate of return generated by
a project. It is used when equal cash inflow is generated every year.
Pay back reciprocal = annual cash inflow*100/ total investment
c) Post pay back period method: the limitation of the pay back method was that it ignores the life of
the project beyond the pay back period. But this method takes into account the
life of the project beyond the pay back period. Hence the project which gives the greatest post pay
back period is accepted.
d) Discounted pay back method:  the pay back method ignores the time value of money. Discounted
pay back method is an improvement over this method. Under this method the present value of all cash
inflow and cash outflow is calculated at an appropriate discount rate. Discounted pay back period is
the period at which the present value of cash inflow = present value of cash outflow. The project with
the shorter time period is accepted.
iii) Rate of return method or accounting method: this method takes into account the earning
expected from the investment over their whole life. This is called accounting method as it used the
accounting concept of profit after tax and depreciation.
Decision rule: the project with higher rate of return is accepted and the project with the lower rate of
return is rejected.
a) Average rate of return method: under this method average profit after tax and depreciation is
calculated and then it is divided by total investment.
Average rate of return= average annual profit after tax and depreciation*100/net investment
b) Return per unit of investment method: it is slightly different from the above method. under this
method total profit after tax and depreciation is divided by total investment.
Return per unit of investment = total profit after tax and depreciation *100/net investment
c) Average return on average investment: it is a good method of finding out rate of return on
investment.
Average return on average investment = average annual profit after tax and depreciation*100/aveage
investment
Advantages of rate of return method:
1. It is easy to calculate, simple to understand.
2. It gives better view of profitability.
3. It is based upon the accounting concept.
Disadvantages of rate of return method:
1. It fails to take in account cash flow.
2. It does not take into time value of money.

(II)Time adjusted or discounted method:

The main drawback of the traditional method is that it gives equal value to the present and future flow
of incomes and do not take into consideration the time value of money. A rupee earned today has
more value than the rupee earned after five years. This method is also called modern method of
capital budgeting.
i) Net present value method: this method takes into account the time value of money which means
the return on investment is calculated by introducing the time element. This method realizes the
concept that a rupee earned today has more value than the rupee earned after five years. To calculate
net present value the following steps are used:
a) First of all determine the appropriate rate of interest selected as minimum rate of return or discount
rate.
b) Compute the present value of cash outflow at determined discount rate.
c) Compute the present value of cash outflow at determined discount rate.
d) Calculate the net present value of each project by subtracting the present value of cash inflow from
the present value of cash outflow.
Decision rule: if the net present value is positive or zero or than project is accepted otherwise rejected.
NPV is + accepted
NPV is zero accepted
NPV is – rejected
The project having maximum positive value is accepted among various proposals.
Present value = 1/ (1+r)n
 Advantages of net present value method:
1. It takes into account maximum profitability.
2. It gives better view of profitability.
3. It recognizes the time value of money.
Disadvantages of net present value method:
1. It is difficult to understand.
2. It is difficult to determine the discount rate.
ii) Internal rate of return method: this method is also known as time adjusted rate of return,
discounted rate of return, yield method, discounted cash flow, and trial and error method. Under this
method cash flow of a project is discounted at a suitable rate by hit and trial method. It is the rate
where present value of cash inflow= present value of cash outflow. To calculate internal rate of return
the following steps are used:
a) Determine the future net cash flow.
b) Determine the discount rate at which cash inflow = cash outflow.
Decision rule: IRR > minimum required rate of return than accept the proposal
IRR < minimum required rate of return than reject the proposal
IRR = minimum required rate of return than indifferent
Advantages of internal rate of return method:
1. It takes into account maximum profitability.
2. It gives better view of profitability.
3. It recognizes the time value of money.
Disadvantages of internal rate of return method:
1. It is difficult to understand.
2. The result of NPV and IRR differs.
iii) Profitability index or benefit cost ratio: it is the relationship between present value of cash
inflow and present value of cash outflow.
Profitability index = present value of cash inflow/ present value of cash outflow
Or
Profitability index = net present value/ initial cash outlay
Net profitability index = profitability index – 1
Decision rule: if PI > 1 accepts the project
if PI < 1 reject the project
if PI = 1 indifferent.
 Advantages of profitability index method
1. This method takes into consideration all the requirements of sound investment decisions.
2. It recognizes the time value of money.
Disadvantages of profitability index method
1. It is difficult to understand.
2. This method does not take into account size of investment.
DCF TECHQUNES
What Is Discounted Cash Flow (DCF)?
Discounted cash flow (DCF) is a valuation method used to estimate the value of an investment based
on its future cash flows. DCF analysis attempts to figure out the value of an investment today, based on
projections of how much money it will generate in the future. This applies to both financial
investments for investors and for business owners looking to make changes to their businesses, such
as purchasing new equipment.
Discount cash flow (DCF) Method
Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an
investment opportunity. DCF analyses use future free cash flow projections and discounts them, using
a required annual rate, to arrive at present value estimates. A present value estimate is then used to
evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the
current cost of the investment, the opportunity may be a good one.
Types of DCF Techniques:-
There are mainly two types of DCF techniques viz… Net Present Value [NPV] and Internal Rate of
Return [IRR].
(A) Net Present Value Techniques [NPV]:
Net Present Value may be defined as the excess of present value of project cash inflows [stream of
benefits] over that of outflows [cash outlays]. The cash flows of a project are discounted at some
desired rate of return, which is mostly equivalent to the cost of capital.
(B) Internal Rate of Return [IRR]:-
The Internal Rate of Return may be defined as that rate of interest when used to discount the cash
flows of an investment, reduce its NPV to zero. Or it is the
rate of discount, which equates the aggregate discounted benefits with aggregate discounted costs.
IRR is also called as ‘Discounted Cash Flow Method’ or ‘Yield Method’ or ‘Time Adjusted Rate of
Return Method’. This method is used when the cost of investment and the annual cash inflows are
known but the discount rate [rate of return] is not known and is to be calculated.
RISK ANALYSIS IN CAPITAL BUDGETING
RISK ANALYSIS IN CAPITAL BUDGETING
Introduction
Capital budgeting is a process of identifying, analyzing and selecting investment to determine a firm’s
expenditures on assets whose cash flows are expected to extend beyond one year. It’s an important
process because capital expenditures require large investment but limited by the availability of funds
(Capital Rationing), greatly influences a firm’s ability to achieve its financial objectives, and can
become as a tool of control
Capital Budgeting and Risk
Uncertainties can exist when the outcome of an event is not known for certain, and when dealing with
assets whose cash flows are expected to extend beyond one year, certainly, there’s element of risk in
that situation. The evaluation of risk therefore depends, on decision maker ability to identify and
understand the nature of uncertainty surrounding the key variables and on the other, having the tools
and methodology to process its risk implications
Various rules of thumb are often used to make these risk adjustment, one of them is using a
simulation method
Method Used
To compares and contrasts the deterministic and probabilistic methods as a tools for capital budgeting.
The method usually used in capital budgeting is to calculate a “best estimate” based on the available
data and use it as an input in the evaluation model. Capital Budgeting Method used for this paper is
Net Present Value.

NPV is an indicator of how much value an investment adds to the firm. It estimates the future values
of the projected variables. Generally, we utilize information regarding a specific event of the past to
predict a possible future outcome of the same or similar event. If there’s a choice between two
mutually exclusive alternatives, the one yielding the higher NPV should be selected.
But, by relying completely on single values as inputs (see figure 1), it is implicitly assumed that the
values used in the appraisal are certain. The outcome of the project is, therefore, also presented as a
certainty with no possible variance or margin of error associated with it.
Conventional investment appraisal uses one particular type of probability distribution for all the
variables included in the appraisal model. It is called the deterministic probability distribution and is
one that assigns all probability to a single value.
Monte Carlo Simulation is a tool that imitate of some real thing, state of affairs, or process, that
representing certain key characteristics or behaviors of a system using random numbers. Monte Carlo
simulation adds the dimension of dynamic analysis to capital budgeting by making it possible build
up random scenarios which are consistent with the analyst’s key assumptions about risk.
It can modifies the standard NPV calculation from all the alternatives by adjusting NPV input by the
estimated probability, that can be objective data or expert opinion (see figure 2), then simulating it.
The simulation runs stage is the part of the risk analysis process in which the computer takes over.
Once all the assumptions, including correlation conditions, have been set it only remains to process
the model repeatedly (each re-calculation is one run) until enough results are gathered to make up a
representative sample of the near infinite number of combinations possible.
During a simulation the values of the “risk variables” are selected randomly within the specified
ranges and in accordance with the set probability distributions and correlation conditions. The
software records the various scenario of NPV output.
The output is not a single-value but a probability distribution of all possible expected returns. The
results give a complete risk/return profile, showing all the possible outcomes that could result from
the decision.
The use of multi-value instead of deterministic probability distributions for the risk variables to feed
the appraisal model with the data is what distinguishes the simulation from the deterministic (or
conventional) approach. Some of multi-value probability distribution is illustrated in figure 3.

Situation Reviewed
Suppose PT. X plan to invest in new machinery with two options, buy used rapier machine from
Europe manufacturer or buy new rapier machine from China manufacturer. Information and
assumption from each option (table 1 – table 6), can be use as an input for capital budgeting model for
deterministic and probabilistic methods. Deterministic approach only uses most probable estimation
and mean estimation as it input.
Data for first option, buy used rapier machine from Europe manufacturer

Data for second option, buy new rapier machine from China manufacturer
The first option offer more durable machine but riskier in initial installation because there will be no
manual book, difficultness to find spare part replacement, no supporting trained mechanics from
previous owner. The second option, on the other hand, offer more certain initial installation but more
easily damage because of lesser quality of their machine material and spare part.
Deterministic Method Result
Unit sales for 1st year can be calculated by 1st year capacity x 12 months x capacity adjustment for
installation. On the second year we add phase 1 capacity with adjusted phase 2 capacity, then from
year 3, the sales become phase 1 and 2 capacity.
The revenue calculated by multiplied unit sales with unit price. Then every period net cash flow can
be calculated by subtract revenue with fixed cost and variable cost. In starting year and 1 st year, initial
investment and phase 2 investments are also included in cash flow computation. After that we can
calculate the Net Present Value of the selected alternative. Repeat the process for the 2 nd alternative.
The output of the method (figure 4) show that buying new machine from China manufacturer yielding
higher NPV than buying used machine from Europe manufacturer, because of that, the decision is to
select the second option.
Probabilistic Method Result
Probabilistic method is not a substitute of Deterministic method but rather a tool that enhances its
results. A good appraisal model is a necessary base on which to set up a meaningful simulation. Risk
analysis supports the investment decision by giving the investor a measure of the variance associated
with an investment appraisal return estimate.

    
Probabilistic method is not a substitute of Deterministic method but rather a tool that enhances its
results. A good appraisal model is a necessary base on which to set up a meaningful simulation. Risk
analysis supports the investment decision by giving the investor a measure of the variance associated
with an investment appraisal return estimate.
With Monte Carlo simulation, use 5,000 iterations, the 1st option has 95% probability to give positive
NPV, its best scenario approximately yield IDR 17,780,000,000.00 and there is 5% probability that
the option yield negative NPV with its worst scenario approximately IDR (5,000,000,000.00) loss, its
standard deviation approximately 3.5 billion.
The 2nd alternative has 88.9% probability to yield positive NPV and has 11.1 % giving negative
NPV, but the 2nd alternative also has higher min to max range, from approximately IDR
(1,170,000,000.00) to IDR 21,540,000,000.00, and its standard deviation is 4.6 billion.

In this case, using the probabilistic method, buying machine from China can give higher expected
return (IDR 5.79 billion) return and higher loss probability (11.1%) than buying from machine from
Europe manufacturer. Then the decision rests on the risk appetite of the decision makers, whether
he/she is a risk seeker, or a risk averter.
Conclusion
Risk analysis using Monte Carlo simulation is a useful tool to extend the depth of capital budgeting
and enhancing the investment decision. The deterministic approach has the advantage of simplicity
and easy to applied but it has inability to deal with uncertainties, excluding inaccuracies of input data.
On the other hand, the probabilistic method can reduces the weakness in the deterministic method
when dealing with input uncertainties, In example presented above, buying from China manufacturer
using deterministic method yield IDR 6.05 billion, but when the uncertainty factor exist the expected
value of the alternative, using 5,000 iteration, become IDR 5.79 billion with standard deviation IDR
4.68 billion. Therefore probabilistic method can provides more in-depth risk analysis for making
decision under uncertainties like liquidity and repayment problem, bridging communication gap
between the analyst and the decision maker, reduce bias, highlight area that need further investigation,
screen new ideas and help to identify new opportunity. In example above, the decision maker can
further evaluate each alternative, which alternative suite his/her risk appetite, what can he/she do to
mitigate the downside risk of the alternative, or what contingency effect can happen from every
decision alternative.
Regarding of all the superiority, Monte Carlo simulation is not a remedy of all problem. Overlooking
significant inter-relationships among the projected variables can distort the results of risk analysis and
lead to misleading conclusions. The analyst should take due care to identify the major correlated
variables and to adequately provide for the impact of such correlations in the simulation. Risk analysis
also must amplify the predictive ability of sound models of reality. The accuracy of its predictions
therefore can only be as good as the predictive capacity of the model employed.
 
UNIT 4
WORKING CAPITAL MANAGEMENT
What is working capital management?
A company’s working capital essentially consists of current assets and current liabilities. Current
assets refer to those assets that can be converted into cash within one year, like debtors, and stock and
prepaid expenses- expenses that have already been paid for. Current liabilities are the day-to-day
debts incurred by a business in its operation. These could be credit purchases made from vendors
(creditors) and outstanding expenses (expenses that are yet to be paid).

Thus, working capital management refers to monitoring these two components or the short-term
liquidity of your firm.
Three fundamental parameters that help you manage working capital requirements better and indicate
your liquidity standing of your firm are:

1. Working Capital Ratio:

A ratio between the current assets and current liabilities, it signifies the current ability of an
organization to pay off its short-time financial obligations.

2. Collection Period Ratio:

Also known as the debtors or accounts receivables turnover ratio, this ratio is indicative of a
company’s ability to convert its debts into cash. The lesser number of days it takes to realise its
payments from its debtors, the better.

3. Inventory Turnover Ratio:

Also known as the stock turnover ratio, this ratio monitors the time a company takes to converts its
goods into cash. Lower the time taken, higher is the company’s stock efficiency.

Strong working capital management aids a company in having a higher operational efficiency and
hence, higher profitability. For this, Bajaj Finserv offers special working capital loans which will help
your business meet its short-term liquidity smoothly.
WORKING CAPITAL MANAGEMENT DEFINITION
The term ‘working capital management’ primarily refers to the efforts of the management towards
effective management of current assets and current liabilities. Working capital is nothing but the
difference between the current assets and current liabilities. In other words, an efficient working
capital management means ensuring sufficient liquidity in the business to be able to satisfy short-
term expenses and debts.
In a broader view, ‘working capital management’ includes working capital financing apart from
managing the current assets and liabilities. That adds the responsibility for arranging the working
capital at the lowest possible cost and utilizing the capital cost-effectively.
OBJECTIVES OF WORKING CAPITAL MANAGEMENT
The primary objectives of working capital management include the following:
Smooth Operating Cycle: The key objective of working capital management is to ensure a smooth
operating cycle. It means the cycle should never stop for the lack of liquidity whether it is for buying
raw material, salaries, tax payments etc.
Lowest Working Capital: For achieving the smooth operating cycle, it is also important to keep the
requirement of working capital at the lowest. This may be achieved by favorable credit terms with
accounts payable and receivables both, faster production cycle, effective inventory management etc.
Minimize Rate of Interest or Cost of Capital: It is important to understand that the interest cost of
capital is one of the major costs in any firm. The management of the firm should negotiate well with
the financial institutions, select the right mode of finance, maintain optimal capital structure etc.
Optimal Return on Current Asset Investment:  In many businesses, you have a liquidity crunch at one
point of time and excess liquidity at another. This happens mostly with seasonal industries. At the
time of excess liquidity, the management should have good short-term investment avenues to take
benefit of the idle funds.
For a detailed understanding, you may consider referring, Objectives of Working Capital Management.
IMPORTANCE OF EFFECTIVE WORKING CAPITAL MANAGEMENT
Although the importance of working capital is unquestionable in any type of business. Working
capital management is a day to day activity, unlike capital budgeting decisions. Most importantly,
inefficiencies at any levels of management have an impact on the working capital and its
management. Following are the main points that signify why it is important to take the management
of working capital seriously.
Ensures Higher Return on Capital
Improvement in Credit Profile & Solvency
Increased Profitability
Better Liquidity
Business Value Appreciation
Most Suitable Financing Terms
Interruption Free Production
Readiness for Shocks and Peak Demand
Advantage over Competitors
For a detailed and in-depth understanding, you may refer, Importance of Working Capital Management.

DECISIONS IN WORKING CAPITAL MANAGEMENT

If anybody describes the benefits of working capital management in terms of money, it would most
likely be the cost of capital that a business pays on the investment in working capital. The amount of
this cost would depend on two things viz. the quantum of working capital required and the cost of
working capital. The quantum of working capital is decided by the working capital policies of a
company whereas the optimization of the cost of capital is worked out with working capital
management strategies.
WORKING CAPITAL DECIDING FACTORS – LEVEL AND MODE OF FINANCING
The two main factors that decide the quantum of working capital that a business should maintain, are
liquidity and profitability. Let’s understand the impact of both of these factors in details.
Nobody denies the importance of liquidity but most have a question that how much that liquidity
should be? What are the right levels of liquidity? We know that a business can’t sit on unlimited or
too high liquidity because higher liquidity means higher investment in working capital. And higher
investment in working capital means higher cost of capital, interest cost in case financed by bank
finance. Therefore, the higher liquidity has a direct impact on the profitability as the capital cost rises.
In essence, the relation between liquidity and profitability is inverse. On one hand, higher rather
sufficient liquidity is the primary goal of working capital management. Whereas on the other hand,
profitability as an objective aligns with the overall objective of an organization i.e. wealth
maximization.
With that, it is quite clear that a policy that an organization follows would fall between these pillars.
There may be policies that are tilted towards liquidity and others may be towards profitability.  It is
then a management decision where do they want to place their organization’s policy.
WORKING CAPITAL MANAGEMENT POLICIES
Working capital management policies deal with the quantum factor i.e. how much of current assets
should be maintained? These policies, in essence, are different levels of the tradeoff between liquidity
and profitability. Theoretically, following three types of policies are explained whereas they can be n
number of policies depending on where the tradeoff is stricken between the liquidity and profitability.
Relaxed Policy / Conservative policy – This policy has a high level of current assets maintained to
honor the current liabilities. Here, the liquidity is very high and the direct impact on profitability is
also high.
Restricted Policy / Aggressive policy – This policy a lower level of current assets. Here, the liquidity
levels are very low, therefore, the direct impact on profitability is also low.
Moderate Policy – It lies between the conservative and aggressive policy.
For a detailed and in-depth understanding, you may refer, Working Capital Policy – Relaxed, Restricted
and Moderate.
WORKING CAPITAL MANAGEMENT STRATEGIES
Working capital management strategies deal with the cost of capital factor. The question is – How the
costs of capital are optimized? A business has a choice to select between short-term vs. long-term
sources of capital. Normally, the short term funds are cheaper to long-term but risky. Short term funds
are risky in terms of risk of refinancing and risk of rising interest rates. Once they mature, they may
not be refinanced by the same financial institution and there is a possibility of revision in interest rate
every time they are renewed.
Let’s divide a firm’s capital investment into two i.e. investment in fixed assets and investment in
working capital. Let’s safely assume that long-term funds finance the fixed assets. Now remaining is
working capital. Let us further divide working capital into two i.e. permanent and temporary working
capital. The nature of permanent working capital is similar to fixed assets i.e. that level of investment
in working is always present and remaining part keeps fluctuating. The working capital management
strategies define how these two types of working capital are financed.
Hedging (Maturity Matching) Strategy – This strategy follows the principal of finance i.e. long-term
funds to finance long-term assets and vice versa. In this strategy, the maturities of currents are
matched with the maturity of its financing instrument. It does not have any cushion or flexibility in
case of any delay in the realization of current assets. Although it is a very ideal strategy but involves a
high risk of bankruptcy.
Conservative – Its a safer strategy where the apart from financing the whole of the permanent working
capital, it finances a part of temporary working capital also.
Aggressive – It’s a high-risk strategy where the apart from financing the whole of the temporary
working capital, it finances a part of permanent working capital also.
For a detailed and in-depth understanding, you may refer, Working Capital Management Strategies /
Approaches.
ADVANTAGES OF WORKING CAPITAL MANAGEMENT
Working capital management ensures sufficient liquidity when required.
It evades interruptions in operations.
Profitability maximized.
Achieves better financial health.
Develops competitive advantage due to streamlined operations.
DISADVANTAGES OF WORKING CAPITAL MANAGEMENT
It only considers monetary factors. There are non-monetary factors that it ignores like customer and
employee satisfaction, government policy, market trend etc.
Difficult to accommodate sudden economic changes.
Too high dependence on data is another downside. A smaller organization may not have such data
generation.
Too many variables to keep in mind say current ratios, quick ratios, collection periods, etc.
Learn more about the pros and cons of working capital management.
TYPES OF WORKING CAPITAL
 
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Types of Working Capital
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Working capital are of various types. They are explained as follows.

Types of Working Capital

Types of working capital
1. Permanent Working Capital
It is otherwise called as Fixed Working Capital. Tandon committee has referred to this type of working
capital as Hard Core Working Capital.
Permanent working capital implies the base investment amount in all types of current resources which
is respected at all times to carry on business activities. The value of current assets have been increased
or decreased over a period of time. Even though, there is a need of having minimum level of current
assets at all times in order to carry on the business activities effectively.
Features of Permanent Working Capital
a) The gross value of permanent working capital remain constant but the value of components of
current assets is differing from each other.
b) There is a positive correlation between the size of business and the amount of permanent working
capital.
c) Only long term sources of funds are used for permanent working capital.
2. Temporary Working Capital
It is otherwise called as Fluctuating or Variable Working Capital. There is a close relationship
prevailing between temporary working capital and the level of production and sales. There is no
uniform production and sales throughout the year. If heavy order is received for production and there
is a large amount of credit sales, there is a need of more amount of temporary working capital. At the
same time, if production is carried on in anticipation of demand in near future, temporary working
capital is required.
In nutshell, temporary working capital is an extra working capital required to support the changing
production and sales activities.
3. Gross & Net Working Capital
Discussed in previous article here Gross & Net Working Capital.
4. Negative Working Capital
Sometimes, the value of current assets is less than the current liabilities, it shows negative working
capital. If such type of situation arise, the firm is going to meet the financial crisis very shortly.
5. Reserve Working Capital
It is otherwise called as Cushion Working Capital. It refers to the short term financial arrangement
made by the business units to meet uncertain changes or to meet uncertainties. A firm is always
working with the expectation of some risks which may be controllable or uncontrollable. The reserve
working capital can be used in order to meet the uncontrollable risks and sustain in the business world.
6. Regular Working Capital
The minimum amount of working capital to be maintained in normal condition is called Regular
Working Capital.
7. Seasonal Working Capital
Some products have seasonal demand. Seasonal demand arises due to festival. In this way, seasonal
working capital means an amount of working capital maintained to meet the seasonal demand of the
product.
8. Special Working Capital
Special programmes may be conducted for business development. The programmes may
be advertisement campaign, sales promotion activities, product development activities, marketing
research activities, launching of new products, expansion of markets and the like. Therefore, special
working capital means an amount of working capital maintained to meet the expenses of special
programmes of the company.
DETERMINANTS OF WORKING CAPITAL
1. Nature of business:
It is an important factor for determining the amount of working capital needed by various companies.
The trading or manufacturing concerns will require more amount of working capital along-with their
fixed investment of stock, raw materials and finished products.
Public utilities and railway companies with huge fixed investment usually have the lowest needs for
current assets, partly because of cash, nature of their business and partly due to their selling a service
instead of a commodity. Similarly, basic and key industries or those engaged in the manufacture of
producer’s goods usually have less proportion of working capital to fixed capital than industries
producing consumer goods.
2. Length of period of manufacture:
The average length of the period of manufacture, i.e., the time which elapses between the
commencement and end of the manufacturing process is an important factor in determining the
amount of the working capital.
If it takes less time to make the finished product, the working capital required will be less. To give an
example, a baker requires one night time to bake his daily quota of bread. His working capital is,
therefore, much less than that of a shipbuilding concern which takes three to five years to build a ship.
Between these two cases may fall other business concerns with varying periods of manufacture
requiring different amounts of working capital.
3. Volume of business:
Generally, the size of the company has a direct relation with the working capital needs. Big concerns
have to keep higher working capital for investment in current assets and for paying current liabilities.
4. The proportion of the cost of raw materials to total cost:
Where the cost of raw materials to be used in manufacturing of a product is very large in proportion to
the total cost and its final value, working capital required will also be more.
That is why, in a cotton textile mill or in a sugar mill, huge funds are required for this purpose. A
building contractor also needs huge working capital for this reason. If the importance of materials is
less, as for example in an oxygen company, the needs of working capital will be naturally not more.
5. Use of Manual Labour or Mechanisation:
In labour intensive industries, larger working capital will be required than in the highly mechanized
ones. The latter will have a large proportion of fixed capital. It may be remembered, however, that to
some extent the decision to use manual labour or machinery lies with the management. Therefore, it is
possible in most cases to reduce the requirements of working capital and increase investments in fixed
assets and vice versa.
6. Need to keep large stocks of raw materials of finished goods:
The manufacturing concerns generally have to carry stocks of raw materials and other stores and also
finished goods. The larger the stocks (whether of raw materials or finished goods) more will be the
needs of working capital.
In certain lines of business, e.g., where the materials are bulky and have to be purchased in large
quantities, (as in cement manufacturing), stock piling of raw-material is used.
Similarly, in public utilities, which must have adequate supplies of coal to assure regular service,
stock piling of coal is necessary. In seasonal industries finished goods stocks have to be stored during
off seasons. All these require large working capital.
7. Turnover of working capital:
Turnover means the speed with which the working capital is recovered by the sale of goods. In certain
businesses, sales are made quickly and the stocks are soon exhausted and new purchases have to be
made. In this manner, a small amount of money invested in stocks will result in sales of much larger
amount.
Considering the volume of sales, the amount of working capital requirements will be rather small in
such type of business. There are other businesses where sales are made irregularly. For example, in
case of jewellers, a costly jewellery may remain locked up in the show-window for a long period
before it catches the fancy of a rich lady.
In such cases, large sums of money have to be kept invested in stocks. But a baker or a news-hawker
may be able to dispose of his stocks quickly, and may, therefore, need much smaller amounts by way
of working capital.
8. Terms of Credit:
A company purchasing all raw-materials for cash and selling on credit will be requiring more amount
of working capital. Contrary to this, if the enterprise is in a position to buy on credit and sell it for
cash, it will need less amount of working capital. The length of the period of credit has a direct
bearing on working capital.
The essence of this is that the period which elapses between the purchase of materials and sale of
finished goods and receipts of sale proceeds, will determine the requirements of working capital.
9. Seasonal Variations:
There are some industries which either produce goods or make sales only seasonally. For example, the
sugar industry produces practically all the sugar between December and April and the woollen textile
industry makes its sales generally during winter.
In both these cases the needs of working capital will be very large, during few months {i.e., season).
The working capital requirements will gradually decrease as and when the sales are made.
10. Requirements of Cash:
The need to have cash in hand to meet various requirements e.g., payment of salaries, rents, rates etc.,
has an effect on the working capital. The more the cash requirements the higher will be working
capital needs of the company and vice versa.
11. Other Factors:
In addition to the above mentioned considerations there are also a number of other factors which
affect the requirements of working capital. Some of them are given below.
(i) Degree of co-ordination between production and distribution policies.
(ii) Specialisation in the field of distribution.
(iii) Developments of means of transportation and communications.
(iv) The hazards and contingencies inherent in the type of business.
METHODS OF MEASURING WORKING CAPITAL REQUIREMENTS
 METHODS OF ESTIMATING / ANALYZING WORKING CAPITAL ARE AS FOLLOWS
PERCENTAGE OF SALES METHOD:
It is the easiest of the methods for calculating the working capital requirement of a company. This
method is based on the principle of ‘history repeats itself’. For estimating, a relationship of sales and
working capital is worked out for say last 5 years. If it is constantly coming near say 40% i.e. working
capital level is 40% of sales, the next year estimation is done based on this estimate. If the expected
sales are 500 million dollars, 200 million dollars would be required as working capital.
The advantage of this method is that it is very simple to understand and calculate also. Disadvantage
includes its assumption which is difficult to be true for many organizations. So, where there is no
linear relationship between the revenue and working capital, this method is not useful. In new startup
projects also, this method is not applicable because there is no past.

REGRESSION ANALYSIS METHOD:

This statistical estimation tool is utilized by mass for various types of estimation. It tries to establish
trend relationship. We will use it for working capital estimation. This method expresses the
relationship between revenue & working capital in the form of an equation (Working Capital =
Intercept + Slope * Revenue). The slope is the rate of change of working capital with one unit change
in revenue. Intercept is the point where regression line and working capital axis meets (Will not go
deeper into statistical details). At the end of the statistical exercise with past revenue and working
capital  data, we will get an equation like below:
Working Capital = -6.34 + 0.46 * Revenue
To calculate working capital, just put the targeted revenue figure in the above equation, say 200
million dollars.
Working Capital = -6.34 + 0.46 * 200 = -6.34 + 92 = 85.66 ~ 86 Million Dollar.
Therefore, we need 86 million dollars of working capital to achieve revenue of 200 million dollars.
OPERATING CYCLE METHOD:
This is probably the best of the methods because it takes into account the actual business or industry
situation into consideration while giving an estimate of working capital. A general rule can be stated
in this method. Longer the working capital operating cycle, higher would be the requirement of
working capital and vice versa. We would agree to the point also. The following formula can be used
to estimate or calculate the working capital
Working Capital = Cost of Goods Sold (Estimated) * (No. of Days of Operating Cycle / 365 Days) +
Bank and Cash Balance.
If the cost of goods sold (estimated) is $35 million and operating cycle is 75 days and bank balance
required is 1.25 million. Therefore, Working Capital = 35 * 75/365 + 1.25 = $8.44 Million.
In this method, each component can also be calculated. It means bifurcation of $8.44 million can be
done in inventory, cash, accounts receivable, accounts payable etc.
OPERATING CYCLE
Working capital is the life blood of any business, without which the fixed assets are inoperative.
Working capital circulates in the business, and the current assets change from one form to the other.
Cash is used for procurement of raw materials and stores items and for payment of operating
expenses, then converted into work-in-progress, then to finished goods.
When the finished goods are sold on credit terms receivables balances will be formed. When the
receivables are collected, it is again converted into cash. The need for working capital arises because
of time gap between production of goods and their actual realization after sales. This time gap is
called technically called as ‘operating cycle’ or ‘working capital cycle’.

The operating cycle of a company consists of time period between the procurement of inventory and
the collection of cash from receivables. The operating cycle is the length of time between the
company’s outlay on raw materials, wages and other expenses and inflow of cash from sale of goods.
Operating cycle is an important concept in management of cash and management of working capital.
The operating cycle reveals the time that elapses between outlay of cash and inflow of cash. Quicker
the operating cycle less amount of investment in working capital is needed and it improves the
profitability. The duration of the operating cycle depends on the nature of industry and the efficiency
in working capital management.
The above said periods are ascertained as follows:
(a) Raw Material Holding Period:

(b) Work-In-Process Period:

(c) Finished Goods Holding Period:

(d) Receivables Collection Period:

(e) Creditors Payment Period:

The knowledge of operating cycle is essential for smooth running of the business without shortage of
working capital. The working capital requirement can be estimated with the help of duration of
operating cycle. The longer the operating cycle, the larger the working capital requirements. If
depreciation is excluded from expenses in the operating cycle, the net operating cycle represents ‘cash
conversion cycle’.
The length of operating cycle is the indicator of efficiency in management of short-term funds and
working capital. The operating cycle calls for proper monitoring of external environment of the
business. Changes in government policies like taxation, import restrictions, credit policy of central
bank etc. will have impact on the length of operating cycle.
It is the task of Finance manager to manage the operating cycle effectively and efficiently. Based on
the length of operating cycle, the working capital finance is done by the commercial banks. The
reduction in operating cycle will improve the cash conversion cycle and ultimately improve the
profitability of the firm.
 Reasons for Prolonged Operating Cycle:
The following could be the reasons for longer operating cycle period:
(a) Purchase of materials in excess/short of requirements.
(b) Buying inferior, defective materials.
(c) Failure to get trade discount, cash discount.
(d) Inability to purchase during seasons.
(e) Defective inventory policy.
(f) Use of protracted manufacturing cycle.
(g) Lack of production planning, coordination and control.
(h) Mismatch between production policy and demand.
(i) Use of outdated machinery, technology,
(j) Poor maintenance and upkeep of plant, equipment and infrastructure facilities,
(k) Defective credit policy and slack collection policy.
(l) Inability to get credit from suppliers, employees,
(m) Lack of proper monitoring of external environment etc.
How to Reduce Operating Cycle?
The aim of every management should be to reduce the length of operating cycle or the number of
operating cycles in a year, only then the need for working capital decreases. The following remedies
may be used in contrasting the length of operation cycle period.
i. Purchase Management:
The purchase manager owes a responsibility in ensuring availability of right type of materials in right
quantity of right quality at right price on right time and at right place. These six R’s contribute greatly
in the improvement of length of operating cycle. Further, streamlining of credit from supplier and
inventory policy also help the management.
ii. Production Management:
The Production manager affects the length of operating cycle by managing and controlling
manufacturing cycle, which is a part of operating cycle and influences directly. Longer the
manufacturing cycle, longer will be the operating cycle and higher will be the firm’s working capital
requirements.
The following measures may be taken like:
(a) Proper maintenance of plant, machinery and other infrastructure facilities,
(b) Proper planning and coordination at all levels of activity,
(c) Up-gradation of manufacturing system, technology, and
(d) Selection of the shortest manufacturing cycle out of various alternatives etc.
iii. Marketing Management:
The sale and production policies should be synchronized as far as possible. Lack of matching
increases the operating cycle period. Production of qualitative products at lower costs enhances sales
of the firm and reduces finished goods storage period. Effective advertisement, sales promotion
activities, efficient salesmanship, use of appropriate distribution channel etc., reduce the storage
period of the finished products.
iv. Credit Collection Policies:
Sound credit and collection policies enable the Finance manager in minimizing investment in working
capital in the form of book debts. The firm should be discretionary in granting credit terms to its
customers.
In order to see that the receivable conversion period is not increased, the firm should follow a
rationalized credit policy based on the credit standing of customers and other relevant facts. The firm
should be prompt in making collections. Slack collection policies will tie-up funds for long period,
increasing length of operating cycle.
v. External Environment:
The length of operating cycle is equally influenced by external environment. Abrupt changes in basic
conditions would affect the length of operating cycle. Fluctuations in demand, competitors,
production and sales policies, government fiscal and monetary policies, changes on import and export
front, price fluctuations, etc., should be evaluated carefully by the management to minimize their
adverse impact on the length of operating cycle.
vi. Personnel Management:
The Personnel manager by framing sound recruitment, selection, training, placement, promotion,
transfer, wages, incentives and appraisal policies can contrast the length of operating cycle.
Use of Human Resources Development technique in the organization enhances the morale and zeal of
employees thereby reduces the length of operating cycle. Proper maintenance of plant, machinery,
infrastructure facilities, timely replacement, renewals, overhauling etc., will contribute towards the
control of operating cycle.
These measures, if adhered properly, would go a long way in minimizing not only the length of
operating cycle period but also the firm’s working capital requirements.
FINANCING OF WORKING CAPITAL
1. Trade credit/vendor credit
You may already be using this type of financing. If you ever purchase inventory or supplies net 30,
net 60 or net 90 days, that’s an example of trade credit. Getting a short grace period to pay your bills
can make all the difference in your cash flow. You may even be able to find vendors who will let you
maintain a balance, instead of paying your bill in full each month.
Another option is for you and your vendors to use Fundbox Pay. When you make purchases through
Fundbox Pay, your participating suppliers get paid immediately—and you get 60 days (or more) to
pay. (Get the details on how Fundbox Pay works.)
2. Business credit cards
When you need money quickly, the answer to your problems could be right in your wallet. The Small
Business Administration reports that credit cards are one of the top three sources small businesses use
for short-term financing. If you already have a business credit card, there’s no need to apply or wait
for approval, plus you have the option of financing a purchase with your credit card or taking a cash
advance.
Of course, with business credit cards charging interest rates that average 14.16 percent, this can quickly
become a costly financing method — especially if you miss a payment or can’t pay the minimum.
3. Business line of credit
If you can qualify for one, a business line of credit offers lots of advantages as a source of working
capital. It’s unsecured, which means you don’t have to put up any collateral. What’s more, you don’t
have to repay any money until you actually draw on the line of credit. In other words, if you get a line
of credit for $25,000 in January and draw $15,000 to make payroll in June, you won’t have to start
making payments until July.
As you pay back what you borrowed, the available amount of credit increases until it’s back where
you started. There’s got to be a catch, right? There is: Your business will need a track record of
success and an excellent credit score in order to qualify.
4. Merchant cash advance financing
Does your business make a lot of credit card sales? Then merchant cash advance (MCA) financing
might work for you.
With this financing option, you take a cash advance against your business’s future credit card sales.
The lender collects a percentage of your daily credit card sales until the advance and fees are paid off.
No collateral is necessary, and on days when your credit card sales are low, your payment will be, too.
However, fees for merchant cash advances can add up quickly.
Learn all about MCAs in our full guide to business funding.
5. Invoice factoring
A factoring company (also called a “factor”) purchases your business’s outstanding invoices for a
percentage of their face value — typically about 70 percent to 85 percent. The factor then takes over
collecting your invoices; when the factor collects, they give you the rest of the invoice’s face value,
minus their fees. While it is a quick way to get money, you won’t get the full amount you’re owed.
And since the factor takes over your collections, this can cause confusion for your customers.
7. Invoice financing
Although it may sound similar to factoring, invoice financing has a couple of important advantages. If
you choose to finance invoices with Fundbox, you get the full value of your invoices, minus a flat fee.
With invoice financing, you continue to oversee collections on the invoices, so you stay in control,
and your customers never know you used an invoice financing company. If approved, you get the
money right away and pay it back over 12 months, which gives you plenty of time to get paid for the
invoices.
MANAGEMENT OF CASH
What Is Working Capital Management?
Working capital management is a business strategy designed to ensure that a company operates
efficiently by monitoring and using its current assets and liabilities to the best effect. The primary
purpose of working capital management is to enable the company to maintain sufficient cash flow to
meet its short-term operating costs and short-term debt obligations.
Management of Cash
Cash is considered as vital asset and its proper management support company development and
financial strength. An effective cash management program designed by companies can help to realise
this growth and strength. Cash is vital element of any company needed to acquire supply resources,
equipment and other assets used in generating the products and services. Marketable securities also
come under near cash, serve as back pool of liquidity which provides quick cash when needed.

Cash management is the stewardship or proper use of an entity's cash resources. It assists to keep an
organization functioning by making the best use of cash or liquid resources of the organization. Cash
management is associated with management of cash in such a way as to realise the generally accepted
objectives of the firm, maximum productivity with maximum liquidity. It is the management's
capability to identify cash problems before they ascend, to solve them when they arise and having
made solution available to delegate someone carry them out.
The notion of cash management is not new and it has attained a greater significance in the modern
world of business due to change that took place in business operations and ever increasing difficulties
and the cost of borrowing" (Howard, 1953 ). It is the most liquid current assets, cash is the common
denominator to which all current assets can be reduced because the other current assets i.e. receivables
and inventory get eventually converted into cash (Khan, 1983 ). This emphasises the importance of
cash management. The term cash management denotes to the management of cash resource in such a
way that generally accepted business objectives could be accomplished. In this perspective, the
objectives of a firm can be combined as bringing about consistency between maximum possible
effectiveness and liquidity of a firm. Cash management may be defined as the ability of a
management to identify the problems related with cash which may come across in future course of
action, finding appropriate solution to curb such problems if they arise, and lastly delegating these
solutions to the competent authority for carrying them out. Cash management maintains sufficient
quantity of cash in such a way that the quantity denotes the lowest adequate cash figure to meet
business obligations. Cash management involves managing cash flows (into and out of the firm),
within the firm and the cash balances held by a concern at a point of time.
In financial literature, Cash management denotes to wide area of finance involving the collection,
handling, and usage of cash. It involves assessing market liquidity, cash flow, and investments. The
notion of cash management is not novel and it has gained more significance in contemporary business
world due to change that took place in the conduct of business and ever increasing difficulties and the
cost of borrowing.
Objective of Cash Management
To make Payment According to Payment Schedule: Firm needs cash to meet its routine expenses
including wages, salary, taxes etc.
To minimise Cash Balance: The second objective of cash management is to reduce cash balance.
Excessive amount of cash balance helps in quicker payments, but excessive cash may remain unused
& reduces profitability of business. Contrarily, when cash available with firm is less, firm is unable to
pay its liabilities in time. Therefore optimum level of cash should be maintained (Excel Books India,
2008).
An effective management is considered to be important for the following reasons:
Cash management guarantees that the firm has sufficient cash during peak times for purchase and for
other purposes.
Cash management supports to meet obligatory cash out flows when they fall due.
Cash management helps in planning capital expenditure projects.
Cash management helps to organize for outside financing at favourable terms and conditions, if
necessary.
Cash management helps to allow the firm to take advantage of discount, special purchases and
business opportunities.
Cash management helps to invest surplus cash for short or long-term periods to keep the idle funds
fully employed.

General Principles of Cash Management

Harry Gross has recommended certain general principles of cash management.
Determinable Variations of Cash Needs: A reasonable amount of funds, in the form of cash is
required to be kept aside to overcome the period expected as the period of cash shortage. This period
may either be short and temporary or last for a longer duration of time. Normal and regular payment
of cash leads to small cutbacks in the cash balance at periodic intervals. Making this payment to
different workers on different days of a week can balance these reductions. Another practice for
balancing the level of cash is to schedule cash disbursements to creditors during the period when
accounts receivables collected amounts to a large sum but without putting the helpfulness at stake.
Contingency Cash Requirement: There may arise certain cases, which fall beyond the forecast of the
management. These establish unexpected calamities, which are too difficult to be provided in the
normal course of the business. Such contingencies always demand for special cash requirements that
was not assessed and provided for in the cash budget. Denials of wholesale product, huge amount of
bad debts, strikes, and lockouts are some of these contingencies. Only a prior experience and
investigation of other similar companies prove supportive as a customary practice. A useful procedure
is to shield the business from such calamities like bad-debt losses, fire by way of insurance coverage.
Availability of External Cash: This factor also has immense significance in the cash management
which refer to the availability of funds from outside sources. There resources help in providing credit
facility to the firm, which materialized the firm's objectives of holding minimum cash balance. As
such if a firm succeeds in obtaining sufficient funds from external sources such as banks or private
financers, shareholders, government agencies, the need to maintain cash reserves lessens.
Maximizing Cash Receipts: Nearly, all financial managers have objective to make the best possible
use of cash receipts. Cash receipts if tackled carefully results in minimizing cash requirements of a
concern. For this purpose, the comparative cost of granting cash discount to customer and the policy
of charging interest expense for borrowing must be appraised continually to determine the
ineffectiveness of either of the alternative or both of them during that particular period for maximizing
cash receipts. Some techniques proved helpful in this context are mentioned below:

Concentration Banking: In this system, a company launches banking centres for collection of cash in
different areas. Thus, the company instructs its customers of neighbouring areas to send their
payments to those centres. The collection amount is then deposited with the local bank by these
centres as early as possible. Whereby, the collected funds are transferred to the company's central
bank accounts operated by the head office.
Local Box System: Under this system, a company rents out the local post offices boxes of different
cities and the customers are asked to forward their remittances to it. These remittances are picked by
the approved lock bank from these boxes to be transferred to the company's central bank operated by
the head office.
Reviewing Credit Procedures: This type of technique assists to determine the impact of slow payers
and bad debtors on cash. The accounts of slow paying customers should be revised to determine the
volume of cash tied up. Besides this, evaluation of credit policy must also be conducted for
introducing essential modifications. As a matter of fact, too strict a credit policy involves rejections of
sales. Thus, restricting the cash inflow. On the other hand, too lenient, a credit policy would increase
the number of slow payments and bad debts again reducing the cash inflows.
Minimizing Credit Period: Shortening the terms allowed to the customers would definitely quicken
the cash inflow side-by-side reviewing the discount offered would prevent the customers from using
the credit for financing their own operations gainfully.
Others: There is a need to introduce various procedures for managing large to very large remittances
or foreign remittances such as, persona pick up of large sum of cash using airmail, special delivery
and similar techniques to accelerate such collections.
Minimizing Cash Disbursements: The intention to minimize cash payments is the ultimate benefit
derived from maximizing cash receipts. Cash disbursement can be brought under control by stopping
deceitful practices, serving time draft to creditors of large sum, making staggered payments to
creditors and for payrolls.
Maximizing Cash Utilization: It is emphasized by financial experts that suitable and optimum
utilization leads to maximizing cash receipts and minimizing cash payments. At times, a concern finds
itself with funds in excess of its requirement, which lay idle without bringing any return to it. At the
same time, the concern finds it imprudent to dispose it, as the concern shall soon need it. In such
conditions, company must invest these funds in some interest bearing securities. Gitman suggested
some fundamental procedures, which helps in managing cash if employed by the cash management.
These include:

Pay accounts payables as late as possible without damaging the firm's credit rating, but take advantage
of the favourable cash discount, if any.
Turnover, the inventories as quickly as possible, avoiding stock outs that might result in shutting
down the productions line or loss of sales.
Collect accounts receivables as early as possible without losing future loss sales because of high-
pressure collections techniques. Cash discounts, if they are economically justifiable, may be used to
accomplish this objective (Gitman, 1979.).
Function of Cash Management
It is well acknowledged in financial reports and various studies that cash management is concerned
with minimizing fruitless cash balances, investing temporarily excess cash usefully and to make the
best possible arrangements for meeting planned and unexpected demands on the firm's cash (Hunt,
1966). Cash Management must have objective to reduce the required level of cash but minimize the
risk of being unable to discharge claims against the company as they arise. There are five cash
management functions:
Cash Planning: Experts emphases the wise planning of funds that can lead to huge success. For any
management decision, planning is the primary requirement. According to theorists, "Planning is
basically an intellectual process, a mental pre-disposition to do things in an orderly way, to think
before acting and to act in the light of facts rather than of a guess." Cash planning is a practise, which
comprises of planning for and controlling of cash. It is a management process of predicting the future
need of cash, its available resources and various uses for a specified period. Cash planning deals at
length with formulation of necessary cash policies and procedures in order to perform business
process constantly. A good cash planning aims at providing cash, not only for regular but also for
irregular and abnormal requirements.
Managing Cash Flows: Second function of cash management is to properly manage cash flows. It
means to manage efficiently the flow of cash coming inside the business i.e. cash inflow and cash
moving out of the business i.e. cash outflow. These two can be effectively managed when a firm
succeeds in increasing the rate of cash inflow together with minimizing the cash outflow. As observed
accelerating collections, avoiding excessive inventories, improving control over payments contribute
to better management of cash. Whereby, a business can protect cash and thereof would require lesser
cash balance for its operations.
Controlling the Cash Flows: It has been observed that prediction is not an exact knowledge because it
is based on certain conventions. Therefore, cash planning will unavoidably be at variance with the
results actually obtained. Due to this, control becomes an unavoidable function of cash management.
Moreover, cash controlling becomes indispensable as it increases the availability of usable cash from
within the enterprise. It is understandable that greater the speed of cash flow cycle, greater would be
the number of times a firm can convert its goods and services into cash and so lesser will be the cash
requirement to finance the desired volume of business during that period. Additionally, every business
is in possession of some concealed cash, which if traced out significantly decreases the cash
requirement of the enterprise.
Optimizing the Cash Level: It is important that a financial manager must focus to maintain sound
liquidity position i.e. cash level. All his efforts relating to planning, managing and controlling cash
should be diverted towards maintaining an optimum level of cash. The prime need of maintaining
optimum level of cash is to meet all requirements and to settle the obligations well in time.
Optimization of cash level may be related to establishing equilibrium between risk and the related
profit expected to be earned by the company.
Investing Idle Cash: Idle cash or surplus cash is described as the extra cash inflows over cash
outflows, which do not have any specific operations or any other purpose to solve currently. Usually,
a firm is required to hold cash for meeting working needs facing contingencies and to maintain as well
as develop friendliness of bankers.
In banking area, cash management is a marketing term for some services related to cash flow offered
mainly to huge business customers. It may be used to describe all bank accounts (such as checking
accounts) provided to businesses of a certain size, but it is more often used to describe specific
services such as cash concentration, zero balance accounting, and automated clearing house facilities.
Sometimes, private banking customers are given cash management services.
Financial instruments involved in cash management include money market funds, treasury bills, and
certificates of deposit.
Benefits of Cash Management System
In the period of technology progression, the Cash Management System provides following Benefits to
its customers:
Funds availability as per need on day zero, day one, day two, day three etc. i.e. Corporate can plan
their cash flows.
Bank interest saved as instruments are collected faster.
Affordable and competitive rates.
Single point enquiry for all queries.
Pooling of funds at desired locations.
To summarize, Cash Management denotes to the concentration, collection and disbursement of cash.
The major role for managers is to maintain the flow of cash. Cash Management include a series of
activities aimed at competently handling the inflow and outflow of cash. This mainly involves
diverting cash from where it is to where it is needed. It is established that cash management is the
optimization of cash flows, balances and short-term investments.
Management of Receivable
Accounts receivable typically comprise more than 25 percent of a firm's assets. The term receivables
is described as debt owed to the firm by the customers resulting from the sale of goods or services in
the ordinary course of business. There are the funds blocked due to credit sales. Receivables
management denotes to the decision a business makes regarding to the overall credit, collection
policies and the evaluation of individual credit applicants. Receivables Management is also known as
trade credit management. Robert N. Anthony, explained it as "Accounts receivables are amounts
owed to the business enterprise, usually by its customers. Sometimes it is broken down into trade
accounts receivables; the former refers to amounts owed by customers, and the latter refers to
amounts owed by employees and others".
Receivables are forms of investment in any enterprise manufacturing and selling goods on credit
basis, large sums of funds are tied up in trade debtors. When company sells its products, services on
credit, and it does not receive cash for it immediately, but would be collected in near future, it is
termed as receivables. However, no receivables are created when a firm conducts cash sales as
payments are received immediately. A firm conducts credit sales to shield its sales from the rivals and
to entice the potential clienteles to buy its products at favourable terms. Generally, the credit sales are
made on open account which means that no formal reactions of debt obligations are received from the
buyers. This enables business transactions and reduces the paperwork essential in connection with
credit sales.
Accounts Receivables Management denotes to make decisions relating to the investment in the
current assets as vital part of operating process, the objective being maximization of return on
investment in receivables. It can be established that accounts receivables management involves
maintenance of receivables of optimal level, the degree of credit sales to be made, and the debtors'
collection.
Receivables are useful for clients as it increases their resources. It is preferred particularly by those
customers, who find it expensive and burdensome to borrow from other resources. Thus, not only the
present customers but also the Potential creditors are attracted to buy the firm's product at terms and
conditions favourable to them.
Receivables has vial function in quickening distributions. As a middleman would act fast enough in
mobilizing his quota of goods from the productions place for distribution without any disturbance of
immediate cash payment. As, he can pay the full amount after affecting his sales. Likewise, the
customers would panic for purchasing their needful even if they are not in a position to pay cash
immediately. It is for these receivables are regarded as a connection for the movement of goods from
production to distributions among the ultimate consumer.
Maintenance of receivable

Objectives of receivables management: The objective of Receivables Management is to promote

sales and profits until that point is reached where the return on investment in further funding
receivables is less than the cost of funds raised to finance that additional credit i.e. cost of capita.
Management of Accounts Receivables is quite expensive. The following are the main costs related
with accounts receivables management:
Cost of Management of Accounts Receivables

Advantages of accounts receivable management:

Accounts Receivables Management has numerous benefits. These include:
Increased Sales: Offering goods or services on credit enhances sales, by holding old customers and
attraction potential customers.
Increased Market Share: When the firm is able to maintain old customers and attract new customers
automatically market share will be bigger to the extent new sales.
Increase in profits: Increase sales, leads to increase in profits, because it need to produce more
products with a given fixed cost and sales of products with a given sales network in both cost per unit
comes down and the profit will be better.
Management of Inventory
Inventory management is basically related to task of controlling the assets that are produced to be sold
in the normal course of the firm's procedures. In supply chain management, major variable is to
effectively manage inventory. The significance of inventory management to the company depends on
the extent of its inventory investment.
The objectives of inventory management are of twofold:
The operational objective is to uphold enough inventory, to meet demand for product by efficiently
organizing the firm's production and sales operations.
Financial interpretation is to minimize unproductive inventory and reduce inventory, carrying costs.
Effective inventory management is to make good balance between stock availability and the cost of
holding inventory.

Components of inventory management: Inventories exist in different forms in a manufacturing

company. These include:
Raw materials: Raw materials are those inputs that are transformed into completed goods throughout
manufacturing process. Those form a major input for manufacturing a product. In other words, they
are very much needed for uninterrupted production.
Work-in-process: Work-in-process is a stage of stocks between raw materials and finished goods.
Work-in-process inventories are semi-finished products. They signify products that need to undergo
some other process to become finished goods.
Finished products: Finished products are those products which are totally manufactured and company
can immediately sell to customers. The stock of finished goods provides a buffer between production
and market.
Stores and spares: It comprises of office and plant cleaning materials like soap, brooms, oil, fuel,
light, bulbs and are purchased and stored for the purpose of maintenance of machinery.
Component of inventory

Inventory control encompasses managing the inventory that is previously in the warehouse,
stockroom or store. This is to know the type of products are "out there", how many each item and
where it is kept. It means having accurate, complete and timely inventory transactions record and
avoiding differences between accounting and real inventory levels. Two tools commonly used to
ensure inventory accuracy and control are ABC analysis and cycle counting.
The process of Inventory management consists of determining, how to order products and how much
to order as well as identifying the most effective source of supply for each item in each stocking
location. Inventory management contains all activities of planning, forecasting and replenishment.
The main purpose of inventory management is minimize differences between customers demand and
availability of items. These differences have caused by three factors that include customers demand
fluctuations, supplier's delivery time fluctuations and inventory control accuracy.
Types of Inventory
The aim of carrying inventories is to separate the operations of the firm. It means to make each
function of the business independent of each other function so that delays or closures in one area do
not affect the production and sale of the final product. Because production cessations result in
increased costs, and because delays in delivery can lose customers, the management and control of
inventory are important duties of the financial manager. There are many types of inventory. The
common categories of inventory include raw materials inventory, work-in-process inventory, and
finished-goods inventory.
Raw-Materials Inventory: Raw materials inventory include basic materials purchased from other firms
to be used in the firm's production operations. These goods may include steel, lumber, petroleum, or
manufactured items such as wire, ball bearings, or tires that the firm does not produce itself.
Regardless of the specific form of the raw-materials inventory, all manufacturing firms maintain a
raw-materials inventory. The intention is to separate the production function from the purchasing
function that is, to make these two functions independent of each other so delays in the delivery of
raw materials do not cause production delays. If there is a delay, the firm can satisfy its need for raw
materials by liquidating its inventory.
Work-in-Process Inventory: Work-in-process inventory comprises of partly finished goods requiring
additional work before they become finished goods. The more difficult and lengthy the production
process, the larger the investment in work-in-process inventory. The main aim of work-in-process
inventory is to disengage the various operations in the production process so that machine failures and
work stoppages in one operation will not affect other operations.
Finished-Goods Inventory: Finished-goods inventory includes goods on which production has been
completed but that are not yet sold. The purpose of a finished-goods inventory is to separate the
production and sales functions so that it is not required to produce the goods before a sale can occur
and sales can be made directly out of inventory.
Motives of inventory management:
Managing inventories involve lack of funds and inventory holding costs.
Maintenance of inventories is luxurious. Still there is motive to retain inventories. There are three
general motives:
The transaction motive: Firm may hold the inventories in order to facilitate the smooth and
continuous production and sales operations. It may not be possible for the company to obtain raw
material whenever necessary. There may be a time lag between the demand for the material and its
supply. Therefore, it is needed to hold the raw material inventory. Similarly, it may not be possible to
produce the goods instantly after they are demanded by the customers. Hence, it is needed to hold the
finished goods inventory. The need to hold work-in-progress may arise due to production cycle.
The precautionary motive: Firms also prefer to hold them to protect against the risk of unpredictable
changes in demand and supply forces. For example, the supply of raw material may get delayed due to
the factors like strike, transport disruption, short supply, lengthy processes involved in import of the
raw materials.
The speculative motive: Firms may like to buy and stock the inventory in the quantity which is more
than needed for production and sales purposes. It is done to get the advantages in terms of quantity
discounts connected with bulk purchasing or expected price rise.
Merits of Inventory Management
There are several advantages of managing inventory in proper way.

Inventory management guarantees adequate supply of materials and stores to minimize stock outs and
shortages and avoid costly interruption in operations.
It keeps down investment in inventories, inventory carrying costs, and obsolescence losses to the
minimum.
It eases purchasing economies throughout the measurement of requirements on the basis of recorded
experience.
It removes duplication in ordering stock by centralizing the source from which purchase requisition
emanate.
It allows better utilization of available stock by enabling inter-department transfers within a firm.
It offers a check against the loss of materials through carelessness or pilferage.
Perpetual inventory values provide a stable and reliable basis for preparing financial statements a
better utilization.
Demerits of Holding Inventory
Besides several benefits, there are some drawbacks of holding inventory.
Price decline: It is a major disadvantage of inventory holding. Price decline is the result of more
supply and less demand. It can be said that it may be due to introduction of competitive product.
Generally, prices are not controllable in the short term by the individual firm. Controlling inventory is
the only way that a firm can counter act with these risks. On the demand side, a decrease in the
general market demand when supply remains the same may also cause price to increase. This is also
long-lasting management problem, because reduction in demand may be due to change in customer
buying habits, tastes and incomes.
Product deterioration: It is also serious demerits of inventory holding. Holding of finished completed
goods for a long period or shortage under inappropriate conditions of light, heat, humidity and
pressures lead to product worsening.
Product obsolescence: If items are hold for long time, it may become outdated. Product may become
outmoded due to improved products, changes in customer choices, particularly in high style
merchandise, changes in requirements. Then this is a major risk and it may affect in terms of huge
revenue loss. It is costly for the firms whose resources are limited and tied up in slow moving
inventories.
In final words, the notion of inventory management has been one of the many analytical
characteristics of management. It involves optimization of resources available for holding stock of
various materials. If there is shortage of inventory, it leads to stock-outs, causing stoppage of
production and a very high inventory will result in increased cost due to cost of carrying inventory.
Managing Current Liabilities
A current liability is an obligation that is payable within one year. The collection of liabilities
comprising current liabilities is closely watched, a business must have enough liquidity to guarantee
that they can be paid off when due. In accounting area, current liabilities are often understood as all
liabilities of the business that are to be settled in cash within the financial year or the operating cycle
of a given firm, whichever period is longer.
In exceptional cases where the operating cycle of a business is longer than one year, a current liability
is described as being payable within the term of the operating cycle. The operating cycle is the time
period required for a business to acquire inventory, sell it, and convert the sale into cash. In most
cases, the one-year rule will apply.
Since current liabilities are normally paid by liquidating current assets, the presence of a large amount
of current liabilities calls attention to the size and prospective liquidity of the offsetting amount of
current assets listed on a company's balance sheet. Current liabilities may also be settled through their
replacement with other liabilities, such as with short-term debt.
The combined amount of current liabilities is major component of several measures of the short-term
liquidity of a business. That include:
Current ratio. This is current assets divided by current liabilities.
Quick ratio. This is current assets minus inventory, divided by current liabilities.
Cash ratio. This is cash and cash equivalents, divided by current liabilities.
Common examples of Current Liabilities
Accounts payable: These are the trade payables due to suppliers, usually as evidenced by supplier
invoices.
Sales taxes payable: This is the obligation of a business to remit sales taxes to the government that it
charged to customers on behalf of the government.
Payroll taxes payable: This is taxes withheld from employee pay, or matching taxes, or additional
taxes related to employee compensation.
Income taxes payable: This is income taxes owed to the government but not yet paid.
Interest payable: This is interest owed to lenders but not yet paid.
Bank account overdrafts: These are short-term advances made by the bank to offset any account
overdrafts caused by issuing checks in excess of available funding.
Accrued expenses: These are expenses not yet payable to a third party, but already incurred, such as
wages payable.
Customer deposits: These are payments made by customers in advance of the completion of their
orders for goods or services.
Dividends declared: These are dividends declared by the board of directors, but not yet paid to
shareholders.
Short-term loans: This is loans that are due on demand or within the next 12 months.
Current maturities of long-term debt: This is that portion of long-term debt that is due within the next
12 months.
To summarise, financial experts defined current liabilities as "obligations whose liquidation is
reasonably expected to require the use of existing resources properly categorized as current assets or
the certain of current liabilities."

MANAGEMENT OF PROFITS
The term profit has distinct meaning for different people, such as businessmen, accountants,
policymakers, workers and economists.
Profit simply means a positive gain generated from business operations or investment after
subtracting all expenses or costs.
In economic terms profit is defined as a reward received by an entrepreneur by combining all the
factors of production to serve the need of individuals in the economy faced with uncertainties. In a
layman language, profit refers to an income that flow to investor. In accountancy, profit implies
excess of revenue over all paid-out costs. Profit in economics is termed as a pure profit or economic
profit or just profit.
Profit differs from the return in three respects namely:
a. Profit is a residual income, while return is a total revenue
b. Profits may be negative, whereas returns, such as wages and interest are always positive
c. Profits have greater fluctuations than returns
According to modern economists, profits are the rewards of purely entrepreneurial functions.
According to Thomas S.E., “pure profit is a payment made exclusively for bearing risk. The essential
function of the entrepreneur is considered to be something which only he can perform. This
something cannot be the task of management, for managers can be hired, nor can it be any other
function which the entrepreneur can delegate. Hence, it is contended that the entrepreneur receives a
profit as a reward for assuming final responsibility, a responsibility that cannot be shifted on the
shoulders of anyone else.”
For understanding the profit as a business objective, you need to learn two most important concepts,
such as economic profit and accounting profit.
Types of Profit:
Different people have described profit differently. Individuals have associated profit with additional
income revenue, and reward. However, none of the description of profit is said to be right or wrong; it
only depends on the field which the word profit is described.
On the basis of fields, profit can be classified into two types, which are explained as follows:
i. Accounting Profit:
Refers to the total earnings of an organization. It is a return that is calculated as a difference between
revenue and costs, including both manufacturing and overhead expenses. The costs are generally
explicit costs, which refer to cash payments made by the organization to outsiders for its goods and
services. In other words, explicit costs can be defined as payments incurred by an organization in
return for labor, material, plant, advertisements, and machinery.
The accounting profit is calculated as:
Accounting Profit= TR-(W + R + I + M) = TR- Explicit Costs
TR = Total Revenue
W = Wages and Salaries
R = Rent
I = Interest
M = Cost of Materials
The accounting profit is used for determining the taxable income of an organization and assessing its
financial stability. Let us take an example of accounting profit. Suppose that the total revenue earned
by an organization is Rs. 2, 50,000. Its explicit costs are equal to Rs. 10, 000. The accounting profit
equals = Rs. 2, 50,000 – Rs. 10,000 = Rs. 2, 40,000. It is to be noted that the accounting profit is also
called gross profit. When depreciation and government taxes are deducted from the gross profit, we
get the net profit.
ii. Economic Profit:
Takes into account both explicit costs and implicit costs or imputed costs. Implicit that is foregone
which an entrepreneur can gain from the next best alternative use of resources. Thus, implicit costs
are also known as opportunity cost. The examples of implicit costs are rents on own land, salary of
proprietor, and interest on entrepreneur’s own investment.
Let us understand the concept of economic profit. Suppose an individual A is undertaking his own
business manager in an organization. In such a case, he sacrifices his salary as a manager because of
his business. This loss of salary will opportunity cost for him from his own business.
The economic profit is calculated as:
Economic profit = Total revenue-(Explicit costs + implicit costs)
Alternatively, economic profit can be defined as follows:
Pure profit = Accounting profit-(opportunity cost + unauthorized payments, such as bribes)
Economic profit is not always positive; it can also be negative, which is called economic loss.
Economic profit indicates that resources of a business are efficiently utilized, whereas economic loss
indicates that business resources can be better employed elsewhere.
The difference between the accounting profit and economic profit is shown in Table-1:

Theories of Profit:
Profits of businesses depend on the successful management of risks and uncertainties by
entrepreneurs. These risks can be cost risks due to change in wage rates, prices, or technology, and
other market risks. Different economists have presented different views on profit. Some of the most
popular theories of profit are shown in Figure-1:
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The different theories of profit (as shown in Figure-1).
Walker’s Theory:
An American economist, Prof F. A. Walker propounded the theory of profit, known as rent theory of
profit. According to him “as rent is the difference between least and most fertile land similarly, profit
is the difference between earnings of the least and most efficient entrepreneurs.” He advocated that
profit is the rent of exceptional abilities that an entrepreneur possesses over others.
According to Walker; profit is the difference between the earnings of the least and most efficient
entrepreneurs. An entrepreneur with the least efficiency generally strives to cover only the cost of
production. On the other hand, an efficient entrepreneur is rewarded with profit for his differential
ability.
Thus, profit is also said to be the reward for differential ability of the entrepreneur. While formulating
this theory, Walker assumed the condition of perfect competition in which all organizations are
supposed to have equal managerial ability. In this case, there is no pure profit and all the organizations
earn only managerial wages known as normal profit.
The rent theory was mainly criticized for its inability to explain the real nature of profits.
Apart from this, the theory failed on the following aspects:
a. Provides only a measure of profit. The theory does not focus on the nature of profit, which is of
utmost importance.
b. Assumes that profits arise because of the superior or exceptional ability of the entrepreneur, which
is not always true. Profit can also be the result of the monopolistic position of the entrepreneur.
Clark’s Dynamic Theory:
Clark’s dynamic theory was introduced by an American economist, J.B. Clark. According to him,
profit does not arise in a static economy, but arise in a dynamic economy. A static economy is
characterized as the one where the size of population, the amount of capital, nature of human wants,
the methods of production remain the same and there is no risk and uncertainty. Therefore, according
to Clark, only normal profits are earned in the static economy. However, an economy is always
dynamic in nature that changes from time to time.
A dynamic economy is characterized by increase in population, increase in capital, multiplication of
consumer wants, advancement in production techniques, and changes in the form of business
organizations. The dynamic world offers opportunities to entrepreneurs to make pure profits.
According to Clark, the role of entrepreneurs in a dynamic environment is to take advantage of
changes that help in promoting businesses, expanding sales, and reducing costs. The entrepreneurs,
who successfully take advantage of changing conditions in a dynamic economy, make pure profit.
There are internal and external factors that make the world dynamic. The internal changes are changes
that take place within the organization, such as layoff and hiring of employees, product changes, and
changes in infrastructure. The external changes are of two kinds, namely, regular changes and
irregular changes.
Regular changes involve fluctuations in trades that affect profits On the other hand; irregular changes
include contingencies, such fire, earthquake, floods, and war. Thus, according to Clark, profits are a
result of changes and no profit is generated in case of static economy.
However Prof Knight criticized the dynamic theory on the basis that only those changes that cannot
be foreseen yield profits. He further says, “It cannot, then, be change, which is the cause of profit,
since if the law of change is known, as in fact is largely the case, no profits can arise. Change may
cause a situation out of which profit will be made, if it brings about ignorance of the future.”
Hawley’s Risk Theory:
The risk theory of profit was given by F. B. Hawley in 1893. According to Hawley, “profit is the
reward of risk taking in a business. During the conduct of any business activity, all other factors of
production i.e. land, labor, capital have guaranteed incomes from the entrepreneur. They are least
concerned whether the entrepreneur makes the profit or undergoes losses.”
Hawley refers profit as a reward for taking risk. According to him, the greater the risk, the higher is
the expected profit. The risks arise in the business due to various reasons, such as non-availability of
crucial raw materials, introduction of better substitutes by competitors, obsolescence of a technology,
fall in the market prices, and natural and manmade disasters. Risks in businesses are inevitable and
cannot be predicted. According to Hawley, an entrepreneur is rewarded for undertaking risks.
There is a criticism against this theory that profits arise not because risks are borne, but because the
superior entrepreneurs are able to reduce them. The profits arise only because of better management
and supervision by entrepreneurs. Another criticism is that profits are never in the proportion to the
risk undertaken. Profits may be more in enterprises with low risks and less in enterprises with high
risks.
Knight’s Theory:
Prof Knight propounded the theory known as uncertainty-bearing theory of profits. According to the
theory, profit is a reward for the uncertainty bearing and not the risk taking. Knight divided the risks
into calculable and non-calculable risks. Calculable risks are those risks whose probability of
occurrence can be easily estimated with the help of the given data, such as risks due to fire and theft.
The calculable risks can be insured. On the other hand, non-calculable risks are those risks that cannot
be accurately calculated and insured such as shifts in demand of a product. These non-calculable risks
are uncertain, while calculable risks are certain and can be anticipated.
According to Knight, “risks are foreseen in nature and can be insured”. Thus, risk taking is not a
function of an entrepreneur, but of insurance organizations. Therefore, an entrepreneur gets profit as a
reward for bearing uncertainties and not for risks that are borne by insurance organizations.
The theory of uncertainty bearing is criticized on the following grounds:
a. Assumes that profit is the result of uncertainty bearing ability of an entrepreneur, which does not
always hold true. The profit can also be the reward for other aspects, such as strong co-ordination and
market share.
b. Fails to show any relevance with the real world.
Schumpeter’s Innovation Theory:
Joseph Schumpeter propounded a theory called innovation according to which profits are the reward
for innovation He advocated that innovation is the introduction of a new product, new technology,
new method of production, and new sources of raw materials. This helps in lowering the cost of
production or improving the quality of production. Innovation also includes new policy or measure by
an entrepreneur for an organization.
In general, innovation can take place in two ways, which are as follows:
a. Reducing the cost of production and earning high profit. The cost of production can be reduced by
introducing new machines and improving production techniques.
b. Stimulating the demand by enhancing the existing improvement or finding new markets.
According to innovation theory, profit is the cause and effect of innovations. In other words, it acts as
a necessary incentive for making innovation.
Schumpeter’s innovation theory is criticized on two aspects, which are as follows:
a. Ignores uncertainty as a source of profit
b. Denies the role of risk in profit
Functions of Profit:
Profit is the primary objective of all business organizations. The expectation of earning higher profits
of business organizations induces them to invest money in new ventures. This results in large
employment opportunities in the economy which further raises the level of income. Consequently,
there is a rise in the demand for goods and services in the economy. In this way, profit generated by
business organizations play a significant role in the economy.
According to Peter Ducker, there are three main purposes of profit, which are explained as
follows:
i. Tool for measuring performance:
Refers to the fact that profit generated by an organization helps in estimating the effectiveness of its
business efforts. If the profits earned by an organization are high, it indicates the efficient
management of its business. However, profit is not the most efficient measure of estimating the
business efficiency of an organization, but is useful to measure the general efficiency of the
organization.
ii. Source of covering costs:
Helps organizations to cover various costs, such as replacement costs, technical costs, and costs
related to other risks and uncertainties. An organization needs to earn sufficient profit to cover its
various costs and survive in the business.
iii. Aid to ensure future capital:
Assures the availability of capital in future for various purposes, such as innovation and expansion.
For example, if the retained profits of an organization are high, it may invest in various projects. This
would help in the business expansion and success of the organization.
Apart from aforementioned functions, following are the positive results of high profits:
i. Investment in research and development:
Leads to better technology and dynamic efficiency. An organization invests in research and
development activities for its further expansion, if it earns high profit. The organization would lose its
competitiveness, if it does not invest in research and development activities.
ii. Reward for shareholders:
Includes dividends for shareholders. If an organization earns high profits, it would provide high
dividends to shareholders. As a result, the organization would attract more investors, which are crucial
for the growth of the organization.
iii. Aid for economies:
Implies that profits are helpful for economies. If organizations generate high profits, they would be
able to cope with adverse economic situations, such as recession and inflation. This results in stability
of economies even in adverse situations.
iv. Tool to stimulate government finances:
Implies that if the profits generated by organizations are high, they are liable for paying high taxes.
This helps government to earn high revenue and spend for social welfare.
DIVIDEND POLICY
Dividend Policy
September 5, 2019 By Prachi M Leave a Comment
Definition: A dividend policy can be defined as the dividend distribution guidelines provided by the
board of directors of a company. It sets the parameter for delivering returns to the equity shareholders,
on the capital invested by them in the business.
While taking such decisions, the company has to maintain a proper balance between its debt and
equity composition.
Content: Dividend Policy
What is a Dividend?
A dividend is nothing but the return declared to the equity shareholders through the distribution of a
portion of profits earned by the organization.
Factors Affecting Dividend Policy
Many a time we wonder, how a company frames its dividend policy?
These dividend decisions of an organization are dependent upon the following determinants:

Funds Liquidity: It should be framed in consideration of retaining adequate working capital and
surplus funds for the uninterrupted business functioning.
Past Dividend Rates: There should be a steady rate of return on dividends to maintain stability;
therefore previous year’s allowed return is given due consideration.
Earnings Stability: When the earnings of the company are stable and show profitability, the company
should provide dividends accordingly.
Debt Obligations: The organization which has leveraged funds through debts need to pay interest on
borrowed funds. Therefore, such companies cannot pay a fair dividend to its shareholders.
Investment Opportunities: One of the significant factors of dividend policy decision making is
determining the future investment needs and maintaining sufficient surplus funds for any further
project.
Control Policy: When the company does not want to increase the shareholders’ control over the
organization, it tries to portray the investment to be unattractive, by giving out fewer dividends.
Shareholders’ Expectations: The investment objectives and intentions of the shareholders determine
their dividend expectations. Some shareholders consider dividends as a regular income, while the
others seek for capital gain or value appraisal.
Nature and Size of Organization: Huge entities have a high capital requirement for expansion,
diversification or other projects. Also, some business may require enormous funds for working capital
and other entities require the same for fixed assets. All this impacts the dividend policy of the
company.
Company’s Financial Policy: If the company’s financial policy is to raise funds through equity, it will
pay higher dividends. On the contrary, if it functions more on leveraged funds, the dividend payouts
will always be minimal.
Impact of Trade Cycle: During inflation or when the organization lacks adequate funds for business
expansion, the company is unable to provide handsome dividends.
Borrowings Ability: The company’s with high goodwill has excellent credibility in the capital as well
as financial markets. With a better borrowing capability, the organization can give decent dividends to
the shareholders.
Legal Restrictions: In India, the Companies Act 1956 legally abide the organizations to pay dividends
to the shareholders; thus, resulting in higher goodwill.
Corporate Taxation Policy: If the organization has to pay substantial corporate tax or dividend tax, it
would be left with little profit to pay out as dividends.
Government Policy: If the government intervenes a particular industry and restricts the issue of shares
or debentures, the company’s growth and dividend policy also gets affected.
Divisible Profit: The last but a crucial factor is the company’s profitability itself. If the organization
fails to generate enough profit, it won’t be able to give out decent dividends to the shareholders.

Types of Dividend Policy

What patterns do the companies follow while paying out dividends?
The following categories of dividend policies provide the answer to the above question:

Stable Dividend Policy

In this policy, the company decides a fixed amount of dividend for the shareholders, which is paid
periodically. There is no change in the dividend allowed even if the company incurs loss or generates
high profit.

Regular Dividend Policy

Here, a certain percentage of the company’s profit is allowed as dividends to the shareholders. When
the gain is high, the shareholders’ earnings will also hike and vice-versa. It is one of the most
appropriate policy to be adopted for creating goodwill.

Irregular Dividend Policy

Under this changeable policy, the company may or may not pay dividends to the shareholders. The
top management i.e., the board of directors solely take all dividend decisions, as per their priorities.

No Dividend Policy
Here, the company always retain the profits to fund further projects. Moreover, it has no intention of
declaring any dividends to its shareholders. This strategy may seem to be beneficial for business
growth but usually discourages the investors aiming for sustainable income.

Essentials of a Sound Dividend Policy

A company’s dividend decisions and policy signify its future and financial well-being. Therefore, it
needs to be systematically framed and implemented.
Let us see the three essential steps to take flawless dividend decisions:

Lower Dividends in Initial Stage: When the company is at the beginning stage and earns little profit, it
should still provide dividends to the shareholders, though less.
Gradual Increase in Dividends: As the company prosper and grow, the dividend should be kept on
increasing proportionately, to build shareholders’ confidence.
Stability: It is one of the crucial features of a superior dividend policy. When the company can survive
in the market, it should ensure a stable rate of return in the form of dividends to its shareholders. This
leads to retention of shareholders and gains investors interest, all resulting in the enhancement of
shares market value.
Importance of Dividend Policy
Dividend policy provides as a base for all capital budgeting activities and in designing a company’s
capital structure.
Following are some of the reasons for which dividend policy is essential in every business
organization:

Develop Shareholders’ Trust: When the company has a constant net earnings percentage, it secures a
stable market value and pays suitable dividends. The shareholders also feel confident about their
investment decision, in such an organization.
Influence Institutional Investors: A fair policy means a strong reputation in the financial market. Thus,
the company’s strong market position attracts organizational investors who tend to leverage a higher
sum to the company.
Future Prospects: The fund adequacy for next project undertaking and investment opportunities is
planned, decides its dividend policy such that to avoid illiquidity.
Equity Evaluation: The value of stocks is usually determined through its dividend policy since it
signifies the organizational growth and efficiency.
Market Value Stability of Shares: A suitable dividend policy means satisfied investors, who would
always prefer to hold the shares for the long term. This leads to stability and a positive impact on the
stocks’ market value.
Market for Preference Shares and Debentures: A company with the proficient dividend policy may
also borrow funds by issuing preference shares and debentures in the market, along with equity
shares.
Degree of Control: It helps the organization to exercise proper control over business finance. Since, the
company may land up with a shortage of funds for future opportunities, if the company distributes
maximum profit as dividends.
Raising of Surplus Funds: It also creates organizational goodwill and image in the market because of
which the company becomes capable of raising additional capital.
Tax Advantage: The tax rates are less on the qualified dividends, which are received as a capital gain
when compared to the percentage of income tax charged.
Example
A well known Indian company, ‘Tata Chemicals Ltd.’, listed on Bombay Stock Exchange, have a
dividend policy to pay an annual return to its shareholders in the form of dividends.
The company also shares its intention of paying out special dividends on earning extraordinary profits
or other events.
It has also listed all the factors which it considers while dividend decision-making process. These
include past dividend payouts, investment opportunities, debt obligations, earnings, maintaining
reserves for adverse situations, government policy, etc.
DIVIDEND THEORIES
They are as follows:
1. Walter’s model
2. Gordon’s model
3. Modigliani and Miller’s hypothesis
1. Walter’s model:
Professor James E. Walterargues that the choice of dividend policies almost always affects the value
of the enterprise. His model shows clearly the importance of the relationship between the firm’s
internal rate of return (r) and its cost of capital (k) in determining the dividend policy that will
maximise the wealth of shareholders.
Walter’s model is based on the following assumptions:
1. The firm finances all investment through retained earnings; that is debt or new equity is not issued;
2. The firm’s internal rate of return (r), and its cost of capital (k) are constant;
3. All earnings are either distributed as dividend or reinvested internally immediately.
4. Beginning earnings and dividends never change. The values of the earnings pershare (E), and the
divided per share (D) may be changed in the model to determine results, but any given values of E
and D are assumed to remain constant forever in determining a given value.
5. The firm has a very long or infinite life.
Walter’s formula to determine the market price per share (P) is as follows:
P = D/K +r(E-D)/K/K
The above equation clearly reveals that the market price per share is the sum of the present value of two
sources of income:
i) The present value of an infinite stream of constant dividends, (D/K) and
ii) The present value of the infinite stream of stream gains.
[r (E-D)/K/K]
Criticism:
Walter’s model is quite useful to show the effects of dividend policy on an all equity firm under
different assumptions about the rate of return. However, the simplified nature of the model can lead to
conclusions which are net true in general, though true for Walter’s model.
The criticisms on the model are as follows:
1. Walter’s model of share valuation mixes dividend policy with investment policy of the firm. The
model assumes that the investment opportunities of the firm are financed by retained earnings only
and no external financing debt or equity is used for the purpose when such a situation exists either the
firm’s investment or its dividend policy or both will be sub-optimum. The wealth of the owners will
maximise only when this optimum investment in made.
2. Walter’s model is based on the assumption that r is constant. In fact decreases as more investment
occurs. This reflects the assumption that the most profitable investments are made first and then the
poorer investments are made.
The firm should step at a point where r = k. This is clearly an erroneous policy and fall to optimise the
wealth of the owners.
3. A firm’s cost of capital or discount rate, K, does not remain constant; it changes directly with the
firm’s risk. Thus, the present value of the firm’s income moves inversely with the cost of capital. By
assuming that the discount rate, K is constant, Walter’s model abstracts from the effect of risk on the
value of the firm.
2. Gordon’s Model:
One very popular model explicitly relating the market value of the firm to dividend policy is
developed by Myron Gordon.
Assumptions:
Gordon’s model is based on the following assumptions.
1. The firm is an all Equity firm
2. No external financing is available
3. The internal rate of return (r) of the firm is constant.
4. The appropriate discount rate (K) of the firm remains constant.
5. The firm and its stream of earnings are perpetual
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6. The corporate taxes do not exist.
7. The retention ratio (b), once decided upon, is constant. Thus, the growth rate (g) = br is constant
forever.
8. K > br = g if this condition is not fulfilled, we cannot get a meaningful value for the share.
According to Gordon’s dividend capitalisation model, the market value of a share (Pq) is equal to the
present value of an infinite stream of dividends to be received by the share. Thus:
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The above equation explicitly shows the relationship of current earnings (E,), dividend policy, (b),
internal profitability (r) and the all-equity firm’s cost of capital (k), in the determination of the value
of the share (P0).
3. Modigliani and Miller’s hypothesis:
According to Modigliani and Miller (M-M), dividend policy of a firm is irrelevant as it does not affect
the wealth of the shareholders. They argue that the value of the firm depends on the firm’s earnings
which result from its investment policy.
Thus, when investment decision of the firm is given, dividend decision the split of earnings between
dividends and retained earnings is of no significance in determining the value of the firm. M – M’s
hypothesis of irrelevance is based on the following assumptions.
1. The firm operates in perfect capital market
2. Taxes do not exist
3. The firm has a fixed investment policy
4. Risk of uncertainty does not exist. That is, investors are able to forecast future prices and dividends
with certainty and one discount rate is appropriate for all securities and all time periods. Thus, r = K =
Kt for all t.
Under M – M assumptions, r will be equal to the discount rate and identical for all shares. As a result,
the price of each share must adjust so that the rate of return, which is composed of the rate of
dividends and capital gains, on every share will be equal to the discount rate and be identical for all
shares.
Thus, the rate of return for a share held for one year may be calculated as follows:

Where P^ is the market or purchase price per share at time 0, P, is the market price per share at time 1
and D is dividend per share at time 1. As hypothesised by M – M, r should be equal for all shares. If it
is not so, the low-return yielding shares will be sold by investors who will purchase the high-return
yielding shares.
This process will tend to reduce the price of the low-return shares and to increase the prices of the
high-return shares. This switching will continue until the differentials in rates of return are eliminated.
This discount rate will also be equal for all firms under the M-M assumption since there are no risk
differences.
From the above M-M fundamental principle we can derive their valuation model as follows:

Multiplying both sides of equation by the number of shares outstanding (n), we obtain the value of the
firm if no new financing exists.
If the firm sells m number of new shares at time 1 at a price of P^, the value of the firm at time 0 will
be

The above equation of M – M valuation allows for the issuance of new shares, unlike Walter’s and
Gordon’s models. Consequently, a firm can pay dividends and raise funds to undertake the optimum
investment policy. Thus, dividend and investment policies are not confounded in M – M model, like
waiter’s and Gordon’s models.
Criticism:
Because of the unrealistic nature of the assumption, M-M’s hypothesis lacks practical relevance in the
real world situation. Thus, it is being criticised on the following grounds.
1. The assumption that taxes do not exist is far from reality.
2. M-M argue that the internal and external financing are equivalent. This cannot be true if the costs
of floating new issues exist.
3. According to M-M’s hypothesis the wealth of a shareholder will be same whether the firm pays
dividends or not. But, because of the transactions costs and inconvenience associated with the sale of
shares to realise capital gains, shareholders prefer dividends to capital gains.
4. Even under the condition of certainty it is not correct to assume that the discount rate (k) should be
same whether firm uses the external or internal financing.
If investors have desire to diversify their port folios, the discount rate for external and internal
financing will be different.
5. M-M argues that, even if the assumption of perfect certainty is dropped and uncertainty is
considered, dividend policy continues to be irrelevant. But according to number of writers, dividends
are relevant under conditions of uncertainty.
MEANING
What Is Dividend Policy?
Dividend policy is the policy a company uses to structure its dividend payout to shareholders. Some
researchers suggest that dividend policy may be irrelevant, in theory, because investors can sell a
portion of their shares or portfolio if they need funds.
Definition: The Dividend Policy is a financial decision that refers to the proportion of the firm’s
earnings to be paid out to the shareholders. Here, a firm decides on the portion of revenue that is to be
distributed to the shareholders as dividends or to be ploughed back into the firm
UNIT 5
FINANCIAL ANALYSIS
What Is Financial Analysis?
Financial analysis is the process of evaluating businesses, projects, budgets, and other finance-related
transactions to determine their performance and suitability. Typically, financial analysis is used to
analyze whether an entity is stable, solvent, liquid, or profitable enough to warrant a monetary
investment.
What is Financial Analysis?
Financial analysis involves using financial data to assess a company’s performance and make
recommendations about how it can improve going forward. Financial Analysts primarily carry out their
work in Excel, using a spreadsheet to analyze historical data and make projections of how they think
the company will perform in the future. This guide will cover the most common types of financial
analysis performed by professionals. Learn more in CFI’s Financial Analysis Fundamentals Course.
 Def
Financial analysis is the examination of a business from a variety of perspectives in order to
fully understand the greater financial situation and determine how best to strengthen the business.
A financial analysis looks at many aspects of a business from its profitability and stability to its
solvency and liquidity.

TYPES OF RATIOS
Financial Ratio Analysis
Financial ratio analysis is the process of calculating financial ratios, which are mathematical
indicators calculated by comparing key financial information appearing in financial statements of a
business, and analyzing those to find out reasons behind the business’s current financial position and
its recent financial performance, and develop expectation about its future outlook.
For example, net profit margin is a financial ratio which compares a business’s net income with its net
revenue to find out the dollars of profit the business earned per $100 of sales. Net profit margin ratio
helps find out if a business is more profitable than its peers or for example if its profitability has
increased over different periods.
Financial ratio analysis is very useful tool because it simplifies the process of financial comparison of
two or more businesses. Direct comparison of financial statements is not efficient due to difference in
the size of relevant businesses. Financial ratio analysis makes the financial statements comparable
both among different businesses and across different periods of a single business.
There are different financial ratios to analyze different aspects of a business’ financial position,
performance and cash flows. Financial ratios calculated and analyzed in a particular situation depend
on the user of the financial statements. For example, a shareholder is primarily concerned about a
business’s profitability and solvency; a debt-holder is concerned about its solvency, liquidity and
profitability in the descending order of importance; a creditor/supplier is worried mainly about the
business’ liquidity, etc.
Financial ratios can be broadly classified into liquidity ratios, solvency ratios, profitability ratios and
efficiency ratios (also called activity ratios or asset utilization ratios). Other categories include cash
flow ratios, market valuation ratios, coverage ratios, etc.
Liquidity Ratios
Liquidity ratios asses a business’s liquidity, i.e. its ability to convert its assets to cash and pay off its
obligations without any significant difficulty (i.e. delay or loss of value). Liquidity ratios are
particularly useful for suppliers, employees, banks, etc. Important liquidity ratios are:
Current ratio
Quick ratio (also called acid-test ratio)
Cash ratio
Cash conversion cycle
Solvency Ratios
Solvency ratios assess the long-term financial viability of a business i.e. its ability to pay off its long-
term obligations such as bank loans, bonds payable, etc. Information about solvency is critical for
banks, employees, owners, bond holders, institutional investors, government, etc. Key solvency ratios
are:
Debt ratio
Debt to equity ratio
Debt to capital ratio
Times interest earned ratio
Fixed charge coverage ratio
Equity multiplier
Profitability Ratios
Profitability ratios measure the ability of a business to earn profit for its owners. While liquidity ratios
and solvency ratios explain the financial position of a business, profitability ratios and efficiency
ratios communicate the financial performance of a business. Important profitability ratios include:
net profit margin
gross profit margin
operating profit margin
return on assets
return on capital employed
return on equity
earnings per share
Other ratios related to profitability that are used by investors to assess the stock market performance
of a business include:
price to earnings (P/E) ratio
price to book (P/B) ratio
Dividend payout ratio
Dividend yield ratio
Retention ratio
Activity Ratios
Activity ratios assess the efficiency of operations of a business. For example, these ratios attempt to
find out how effectively the business is converting inventories into sales and sales into cash, or how it
is utilizing its fixed assets and working capital, etc. Key activity ratios are:
inventory turnover ratio
days sales in inventory
receivables turnover ratio
days sales outstanding
payables turnover ratio
days payable outstanding
fixed asset turnover ratio
working capital turnover ratio
Cash flow ratios
Cash flow ratios are mainly used to assess the quality of earnings of a business. Since net income
information is based on accrual concept, which is subject to significant management judgment, cash
flows ratios (also called performance ratios) provide a more unbiased assessment. Example
include cash flow per share.
Coverage Ratios
Coverage ratios are supplementary to solvency and liquidity ratios and measure the risk inherent in
lending to the business in long-term. They include EBIDTA coverage ratio, debt coverage ratio, interest
coverage ratio (also known as times interest earned), fixed charge coverage ratio, etc.
CLASSIFICATION AND ANALYSIS THROUGH RATIOS
ompare the results in different line items of the financial statements . The analysis of these ratios is
designed to draw conclusions regarding the financial performance, liquidity, leverage , and asset
usage of a business. This type of analysis is widely used, since it is solely based on the
information located in the financial statements, which is generally easy to obtain. In addition,
the results can be compared to industry averages or to the results of benchmark  companies, to see
how a business is performing in comparison to other organizations.
The categories of financial ratios that are used for analysis purposes are as follows:
Performance ratios . These ratios are derived from the revenue  and aggregate expenses line items
on the income statement , and measure the ability of a business to generate a profit. The most
important of these ratios are the gross profit ratio  and net profit ratio .
Liquidity ratios . These ratios compare the line items in the balance sheet , and measure the ability
of a business to pay its bills in a timely manner. Chief among these ratios are the current
ratio  and quick ratio , which compare certain current assets  to current liabilities .
Leverage and coverage ratios . These ratios are used to estimate the comparative amounts of debt,
equity, and assets of a business, as well as its ability to pay off its debts. The most common of
these ratios are the debt to equity ratio  and the times interest earned  ratio.
Activity ratios . These ratios are used to calculate the speed with which assets and liabilities
turnover, by comparing certain balance sheet and income statement line items. Rapid asset
turnover implies a high level of operational excellence. The most common of these ratios
are days sales outstanding , inventory turnover , and payables turnover .
Financial ratio analysis is only possible when a company constructs its financial statements in a
consistent manner, so that the underlying general ledger  accounts are always aggregated into the
same line items in the financial statements. Otherwise, the provided information will vary from
one period to the next, rendering long-term trend analysis  useless.
Meaning:
Ratio analysis is the process of determining and interpreting numerical relationships based on
financial statements. A ratio is a statistical yardstick that provides a measure of the relationship
between two variables or figures.
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This relationship can be expressed as a percent or as a quotient. Ratios are simple to calculate and
easy to understand. The persons interested in the analysis of financial statements can be grouped
under three heads,
i) owners or investors
ii) creditors and
iii) financial executives.
Although all these three groups are interested in the financial conditions and operating results, of an
enterprise, the primary information that each seeks to obtain from these statements differs materially,
reflecting the purpose that the statement is to serve.
Investors desire primarily a basis for estimating earning capacity. Creditors are concerned primarily
with liquidity and ability to pay interest and redeem loan within a specified period. Management is
interested in evolving analytical tools that will measure costs, efficiency, liquidity and profitability
with a view to make intelligent decisions.
Classification of Ratios:
Financial ratios can be classified under the following five groups:
1) Structural
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2) Liquidity
3) Profitability
4) Turnover
5) Miscellaneous.
1. Structural group:
The following are the ratios in structural group:
i) Funded debt to total capitalisation:
The term ‘total’ capitalisation comprises loan term debt, capital stock and reserves and surplus. The
ratio of funded debt to total capitalisation is computed by dividing funded debt by total capitalisation.
It can also be expressed as percentage of the funded debt to total capitalisation. Long term loans
Total capitalisation (Share capital + Reserves and surplus + long term loans)
ii) Debt to equity:
Due care must be given to the; computation and interpretation of this ratio. The definition of debt
takes two foremost. One includes the current liabilities while the other excludes them. Hence the ratio
may be calculated under the following two methods:
Long term loans + short term credit + Total debt to equity = Current liabilities and provisions Equity
share capital + reserves and surplus (or)
Long-term debt to equity =
Long – term debt / Equity share capital + Reserves and surplus
iii) Net fixed assets to funded debt:
This ratio acts as a supplementary measure to determine security for the lenders. A ratio of 2:1 would
mean that for every rupee of long-term indebtedness, there is a book value of two rupees of net fixed
assets:
Net Fixed assets funded debt
iv) Funded (long-term) debt to net working capital:
The ratio is calculated by dividing the long-term debt by the amount of the net working capital. It
helps in examining creditors’ contribution to the liquid assets of the firm.
Long term loans Net working capital
2. Liquidity group:
It contains current ratio and Acid test ratio.
i) Current ratio:
It is computed by dividing current assets by current liabilities. This ratio is generally an acceptable
measure of short-term solvency as it indicates the extent to which he claims of short term creditors are
covered by assets that are likely to be converted into cash in a period corresponding to the maturity of
the claims. Current assets / Current liabilities and provisions + short-term credit against inventory
ii) Acid-test ratio:
It is also termed as quick ratio. It is determined by dividing “quick assets”, i.e., cash, marketable
investments and sundry debtors, by current liabilities. This ratio is a bitterest of financial strength than
the current ratio as it gives no consideration to inventory which may be very a low- moving.

3. Profitability Group:
It has five ratio, and they are calculated as follows:

4. Turnover group:
It has four ratios, and they are calculated as follows:
5. Miscellaneous group:
It contains four ratio and they are as follows:

Standards for comparison:

For making a proper use of ratios, it is essential to have fixed standards for comparison. A ratio by
itself has very little meaning unless it is compared to some appropriate standard. Selection of proper
standards of comparison is a most important element in ratio analysis. The four most common
standards used in ratio analysis are; absolute, historical, horizontal and budgeted.
Absolute standards are those which become generally recognised as being desirable regardless of the
company, the time, the stage of business cycle, or the objectives of the analyst. Historical standards
involve comparing a company’s own’ past performance as a standard for the present or future.
In Horizontal standards, one company is compared with another or with the average of other
companies of the same nature.
The budgeted standards are arrived at after preparing the budget for a period Ratios developed from
actual performance are compared to the planned ratios in the budget in order to examine the degree of
accomplishment of the anticipated targets of the firm.
Limitations:
The following are the limitations of ratio analysis:
1. It is always a challenging job to find an adequate standard. The conclusions drawn from the ratios
can be no better than the standards against which they are compared.
2. When the two companies are of substantially different size, age and diversified products,,
comparison between them will be more difficult.
3. A change in price level can seriously affect the validity of comparisons of ratios computed for
different time periods and particularly in case of ratios whose numerator and denominator are
expressed in different kinds of rupees.
4. Comparisons are also made difficult due to differences of the terms like gross profit, operating
profit, net profit etc.
5. If companies resort to ‘window dressing’, outsiders cannot look into the facts and affect the validity
of comparison.
6. Financial statements are based upon part performance and part events which can only be guides to
the extent they can reasonably be considered as dues to the future.
7. Ratios do not provide a definite answer to financial problems. There is always the question of
judgment as to what significance should be given to the figures. Thus, one must rely upon one’s own
good sense in selecting and evaluating the ratios.
Meaning of Ratio Analysis
Now, we have previously learned what ratios are. They are a comparison of two numbers with respect to
each other. Similarly, in finance, ratios are a correlation between two numbers, or rather two accounts. So
two numbers derived from the financial statement are compared to give us a more clear understanding of
them. This is an accounting ratio.
Let us take an example. The income for the year from operations is let us say 1,00,000/- for a given year.
The Purchases and other direct expenses cost around 75,000/-. So the Gross Profit of the year is 25,000/-.
Now it can be said that the Gross Profit is 25% of the Operations Revenue. We calculate this as
G.P. Ratio = GPSales/Revenue ×100
G.P.Ratio = 25,0001,00,000 ×100
G.P. Ratio = 25%
One factor to be kept in mind is that ratio analysis is used only to compare numbers that make sense and
give us a better understanding of the financial statement. Comparing random financial accounts should be
avoided.

Ratio Analysis Definition

Ratio analysis is the comparison of line items in the financial statements of a business.
Objectives of Ratio Analysis
Interpreting the financial statements and other financial data is essential for all stakeholders of an entity.
Ratio Analysis hence becomes a vital tool for financial analysis and financial management. Let us take a
look at some objectives that ratio analysis fulfils.
Browse more Topics under Accounting Ratios
Types of Ratios
Liquidity Ratios
Activity (or turnover) Ratios
Solvency Ratios
Profitability Ratios
1] Measure of Profitability
Profit is the ultimate aim of every organization. So if I say that ABC firm earned a profit of 5 lakhs last
year, how will you determine if that is a good or bad figure? Context is required to measure profitability,
which is provided by ratio analysis. Gross Profit Ratios, Net Profit Ratio, Expense ratio etc provide a
measure of the profitability of a firm. The management can use such ratios to find out problem areas and
improve upon them.
2] Evaluation of Operational Efficiency
Certain ratios highlight the degree of efficiency of a company in the management of its assets and other
resources. It is important that assets and financial resources be allocated and used efficiently to avoid
unnecessary expenses. Turnover Ratios and Efficiency Ratios will point out any mismanagement of assets.
3] Ensure Suitable Liquidity
Every firm has to ensure that some of its assets are liquid, in case it requires cash immediately. So
the liquidity of a firm is measured by ratios such as Current ratio and Quick Ratio. These help a firm
maintain the required level of short-term solvency.
4] Overall Financial Strength
There are some ratios that help determine the firm’s long-term solvency. They help determine if there is a
strain on the assets of a firm or if the firm is over-leveraged. The management will need to quickly rectify
the situation to avoid liquidation in the future. Examples of such ratios are Debt-Equity Ratio, Leverage
ratios etc.
5] Comparison
The organizations’ ratios must be compared to the industry standards to get a better understanding of its
financial health and fiscal position. The management can take corrective action if the standards of the
market are not met by the company. The ratios can also be compared to the previous years’ ratio’s to see
the progress of the company. This is known as trend analysis.
Advantages of Ratio Analysis
When employed correctly, ratio analysis can be useful for overcoming many problems of the firm and
also to highlight some positives. Ratios are essentially whistleblowers, they draw the managements
attention towards issues needing attention. Let us take a look at some advantages of ratio analysis.
Ratio analysis will help validate or disprove the financing, investment and operating decisions of the firm.
They summarize the financial statement into comparative figures, thus helping the management to
compare and evaluate the financial position of the firm and the results of their decisions.
It simplifies complex accounting statements and financial data into simple ratios of operating efficiency,
financial efficiency, solvency, long-term positions etc.
Ratio analysis help identify problem areas and bring the attention of the management to such areas.
Some of the information is lost in the complex accounting statements, and ratios will help pinpoint such
problems.
Allows the company to conduct comparisons with other firms, industry standards, intra-firm comparisons etc.
This will help the organization better understand its fiscal position in the economy.
Ratio Analysis Limitations
While financial ratios are very important tools of financial analysis, they d have some limitations, such as
The firm can make some year-end changes to their financial statements, to improve their ratios. Then
the ratios end up being nothing but window dressing.
Ratios ignore the price level changes due to inflation. Many ratios are calculated using historical costs, and
they overlook the changes in price level between the periods. This does not reflect the correct financial
situation.
Accounting ratios completely ignore the qualitative aspects of the firm. They only take into consideration
the monetary aspects (quantitative)
There are no standard definitions of the ratios. So firms may be using different formulas for the ratios.
One such example is Current Ratio, where some firms take into consideration all current liabilities but
others ignore bank overdrafts from current liabilities while calculating current ratio
And finally, accounting ratios do not resolve any financial problems of the company. They are a means to
the end, not the actual solution.
Types of Ratios
Traditional Classification:
Profit and Loss Ratios
Balance Sheet Ratios
Composite Ratios
Modern Classification:
Liquidity Ratio
Leverage Ratios
Activity Ratios [turnover ratio(s)]
Profitability Ratios
Coverage Ratios