CHAPTER 7 Introduction -...
Transcript of CHAPTER 7 Introduction -...
CHAPTER 7
A SUMMARY OF FINDINGS, CONCLUSIONS AND SUGGESTIONS
Introduction
Financial management is primarily concerned with the optimal use
of finance - the most notable scarce resource in modern societies. Financial
management decisions can be grouped into four broad categories namely,
investment decision, capital structure decision, working capital decision
and dividend policy decision. All these decisions aim at maximizing the
return and minimizing the risk. To ensure this, each of the above decisions
is related to the objectives of financial management, viz., maximization
of the wealth of the owners in private sector corporate enterprises.
A cooperative society is a unique form of business organization.
It fundamentally differs from a private corporate enterprise. The latter 's
wealth maximization objective is not relevant to a cooperative society.
A cooperative is a service-oriented organization. Its primary objective is
to render service to its members at the minimum cost. This can be achieved
by minimizing the cost of administration which includes cost of capital.
The objective of financial management in cooperatives, therefore, is to bring
down the cost of capital.
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Financial management decision in cooperatives should aim at reducing
the cost of capital. Capital structure decision is thus a significant decision.
In a private enterprise, increasing the proportion of debt - otherwise known
as financial leverage - helps in bringing down the overall cost of capital
because debt is the cheapest source of finance. Various theories on capital
structure decision support this fct. But in a cooperative, equity is considered
as the cheaper source of finance because equity in cooperatives command
only a limited interest and they are not traded in stock exchanges and further
they are not considered as a form of investment. Leverage or increase
in the proportion of debt in the capital structure would increase the cost
of capital and thus leverage is detrimental to cooperatives. The present
study principally aims at testing the nature of relationship between capital
structure and cost of capital and the factors which influence this relationship.
The study is confined to all the cooperative sugar and spinning mills
in Tamil Nadu, which commenced production prior to 1983-'8f.
A Review of Working of Sample Cooperative
Sugar and Spinning Mills
Findings
Tamil Nadu ranks third in the country in terms of sugar output as
well as sugarcane production. There are 25 sugar mills in Tamil Nadu of
which 12 are in cooperative sector, 9 in private sector and the rest in public
sector.
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The cooperative spinning mills were organised in early 50's. Tamil Nadu
was the first to start spinning mills in cooperative sector and each district
has a cooperative spinning mill.
Objective : The objective of the cooperative sugar mills is to
manufacture sugar and its by-products to the best advantage of members,
whereas the objective of cooperative spinning mills is to promote the interests
of weavers and growers of cotton and to industrialise the backward regions.
Age of the Mill : Around 70 percent of the cooperative sugar mills
are of long standing ones. Around two-third of cooperative spinning mills
fall under the age group of 15-20 years. The average age was around 20.
Membership : The membership of the cooperative sugar mills is
composed of sugrcane growers, cooperative institutions and government.
The membership registered a spectacular growth recording eighteen-fold
increase over a period of 23 years. The average rate of annual growth for
the industry as a whole was 58.18 percent. Such a sharp increase in member
ship was maianly due to the establishment of new sugar mills in the co
operative sector, expansion of the exisitng mills, membership drive to meet
the increasing demand for sugarcane and the growers' desire to find a better
market for their cane.
The membership of the cooperative spinning mills which primarily
consists of primary weavers cooperative societies, cotton growers, handloom
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weavers and cooperative institutions had registered a six-fold increase over
the study period. But the ra te of growth was slow especially between 1963-'64
and 1968-'69.
Funds : The major sources of long-term funds for both the types
of mills are term lending institutions, State Cooperative Bank and National
Cooperative Development Corporation and the State Government. The working
capital is raised through cash credit accommodation from Central Cooperative
Banks and Commercial Banks and 'ways and means' advance from the State
Government.
Management : The bye-laws of the cooperative sugar mills provide
for the constitution of board of management consisting of 15 members.
Sixty percent of them are nominated representatives of external organizations.
Elected representatives constitute only 40 percent in the board of management.
Even this has not been given a proper trial. The committees of management
of the mills were superseded in 1976. Since then they were managed by
special officiers.
The cooperative spinning mills were managed by the democratically
elected board of management till August, 1975. Since then the boards were
reconstituted thrice and they consist of officials only.
Organizational Structure : The organizational structure is almost
the same in all the cooperative sugar and spinning mills. It remains without
much change over a period despite their growth and development. There
was no finance department in both the types of mills. The accounts
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department looks after routine finance functions and the mills have not
given due attention to finance management proper. The authority is highly
centralised in cooperative spinning mills than in sugar mills.
Production : The growth of the sugar mills largely depends upon
the price of the input and output. This can neither be manipulated nor
controlled as it is fully influenced by the government policy. However factors
like installed capacity, capacity utilization, manufacturing cost, and recovery
can easily be manipulated to the best advantage of the mills.
All the sugar mills are now operating with a crushing capacity of
1250 TCD or above, the average being 1695 TCD.
The average capacity utilization of the mills widely fluctuates. It
was as high as 110 percent in 1964-'65 and as low as 58.15 percent in 1980-'81.
The average capacity utilization was lower than All-India average.
On an average each sugar mill has to crush cane for 172 days in a
season to achieve 100 percent utilization. The average number of cane-crushed
days was 214 in 1964-'65. This has steadily declined over a period and stood
at 120 days in 1983-'84. Many of the mills, especially in the latter part
of the period under review, could not crush cane even for the minimum
number of days. The major reasons for the fall in the number of days
cane crushed are fall in sugarcane production and diversion of registered
cane to the manufacture of gur and khandasari.
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Recovery is a measure of technical performance of the sugar industry.
A sugar recovery of 8.5 percent is considered satisfactory. All the mills
have exceeded the minimum of 8.5 percent. The average recovery has risen
from 8.42 percent to 9.64 percent over a period of time. The rise in recovery
is attributed to cane development activities undertaken by the mills. Another
measure of technical efficiency is the rate of extraction of sucrose from
the cane. The extraction rate has consistently exceeded the norm of 84.32
percent and was; higher than the All India average.
The total production of sugar by the mills has increased from 2.74
lakh quintals in 1961-'62 to 17.63 lakh quintals in 1983-'84 ; whereas tine
average production per mill recorded fluctuations.
In the case of cooperative spinning mills, a minimum installed capacity
of 25,000 spindles is essential for a mill to operate as an economically viable
unit. Most of the mills at the time of their establishment did not have
this minimum capacity. Subsequently the capacity of the mills was expanded
and now all the mills have the capacity to operate as economically viable
units.
Majority of the cooperative spinning mills recorded poor utilization
of the capacity with less than 85 percent of the installed capacity upto
1977. In the subsequent years the situation improved a lot and many mills
were found to have achieved the norm of 95 percent. This was mainly due to
revised standards of working hours and days. The major reasons for the
under-unitization of the capacity were power shortage and shortage of skilled
labourers.
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The average production of yarn per spinning m i l h has increased from
6.56 lakh kgs of yarn in 1961-'62 to 20.83 lakh kgs of yarn in 198*. The
expansion of the capacity, higher capacity ut i l izat ion especially in the lat ter
part of the period under review and modernization of plant were responsible
for the increase in production.
Cost of Production : The average cost of production in the cooperative
sugar mil ls has increased f rom Rs.73.52 to 352.72 per quintal - nearly f ive- fo ld
increase over a period of 20 years. The rise in cost of production is witnessed
in al l the mills under study. An analysis of the cost of production of sugar
shows that the cost of raw material consituted 60 to 70 percent and interest
on borrowings 3 to 10 percent of the total cost of production.
In the case of cooperative spinning mil ls, count-wise costing provides
a base for deciding appropriate product mix. Unfortunately, mills in co
operative sector have not given due at tent ion to this. The conversion of
production figures to yarn of 40's shows that the cost of production per
kg of yarn has increased from Rs.7.42 in 1968-'69 to Rs.28.26 in 1984 -
registering more than four- fold increase. The break-up of the cost of
production reveals that raw material alone accounted on an average for
about 62 percent of the yarn selling price. The proportion of salary and
wages ranged between 13.28 percent and 17.61 percent.
Sales : The sale of sugar is influenced by government's policy and
control over sugar. The Government has adopted a dual pricing policy under-
which 65 percent of the output is acquired at a f ixed low price by the
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government for the public distribution system and the remaining output
is allowed to be sold in the open market. The average selling price of sugar
has increased from Rs.l 10.32 per quintal in 1961-'62 to Rs.392.58 in 1980-'81 -
recording a three-fold increase. This is lower than the average cost of
production. In some mills the cost of production has exceeded the selling
price. This has resulted in losses.
The price of yarn in cooperative spinning mills is fixed by the yarn
price sub committee constituted by the government. Yarn is mainly sold
to the weavers' cooperative societies. Surplus, if any, is sold in the open
market through brokers. Selling prices were invariably fixed below the cost.
The periodical revision in selling rates was not commensurate with the
increase in the various items of overhead. The value of yarn marketed
by the mills recorded an impressive growth. The average annual growth
ranged between Rs.0.67 crores to Rs.2 crores.
Financial Performance : The profitability of an enterprise depends
among other things on the effective utilization of resources. The utilization
of resources was measured through total assets turnover, fixed assets turnover,
inventory turnover and net working capital turnover ratios. The first three
turnover ratios in the case of cooperative sugar mills were below the standard
norms, which indicate ineffective utilization of total assets, fixed assets
and inventory. The net working capital turnover of the sugar mills was
more than the standard norm and thus it could be said that the mills were
efficient in utilizing the short-term funds.
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The average total assets turnover for the cooperative spinning mills
had increased from 0.52 to 1.19 over the years. The average fixed assets
turnover had increased from 1.24 in 1964-'65 to k.\7 in 1984, but it was
well below the norm throughout the period under review. The inventory
and the working capital turnovers of the spinning mills were on the higher
side.
The gross profit of the cooperative sugar mills registered an upward
trend. The net profit was low except in 1980-'81 and 1983-'84. Gross
operating margin was less than the norm of 30. Net operating margin was
fairly good in many of the years under review. Sales margin and return
on investment were poor except in 1980-'81 and 1983-'8'f. By and large
the rate of profitability of the mills was found to be unsatisfactory.
The average gross profit of the cooperative spinning mills ranged
from 3.07 lakhs to Rs.17.87 lakhs. Since 1964-'65 many mills suffered losses.
The ra te of profitability of the spinning mills in terms of gross operating
margin, net operating margin, sales margin and return on investment was
far from satisfactory.
The liquidity of the mills was measured through current and quick
ratios. The current ratio of the cooperative sugar mills came down from
W5 percent in 1961-'62 to 109 in 1980-'81. The quick ratio was less than
50 percent in many years indicating poor liquidity of the cooperative sugar
mills.
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The current ratio of the cooperative spinning mills was found to be
good whereas the quick ratio of 75 percent of the mills was less than 100
percent which indicates their poor liquidity position.
Sickness in Cooperative Spinning Mills : The South India Textile
Research Association's norm for measuring the sickness in spinning industry
was applied in the study. The results show that the mills had vast scope
for improving their profit and profitability. There is no chance for any
mill to become sick.
Financial Management : Analysis of financial management practices
is not the objective of this study. Yet, the researcher could identify certain
lacunae in the financial management practices of the mills. Personal
observation also helped him to understand certain pitfalls. They are stated
below.
Capital budgeting system is in vogue in both the categories of mills.
But investment proposals are evaluated only on the basis of traditional
methods like pay-back period. Modern methods of evaluation - 1RR and
NPV - were not adopted. Thus the mills were not taking financing decisions
in a scientific way. Budgetary control was not practiced. This had led
to delay in completion of the projects on time and thereby led to escalation
in the cost of project.
It was also observed that the mills followed some crude methods
of estimating working capital requirements. Cash flow estimates were not
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systematically prepared well in advance to find out the sources from which
the working capital was anticipated to flow. This has seriously impaird
the working capital position of many of the mills, which in turn has forced
the mills very often to go in for 'ways and means' advances from the
government to meet and make up the deficit in working capital.
Both the sugar and spinning mills did not have proper organizational
set-up for financial management functions such as financial planing and
control. Budgets were prepared in a traditional way. No scientific system
was introduced. Cost standard and budgetary control systems will be of
much use for exercising proper financial control. But unfortunately, mills
seemed to have paid very little attention to these systems.
Conclusion
The overall performance of the sugar mills was not satisfactory, in
spite of their better technical performance in terms of recovery and reduced
overall extraction of sugar. This was mainly due to under-utilization of
production capacity, unsound pricing policy and inefficient financial
management of the mills.
Majority of the cooperative spinning mills were running at loss. The
major reasons for loss are under-utilization of the capacity, increase in cost
of production, inefficient financial management, lack of sound management
and want of democratic participation.
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Suggestions
The findings and conclusions on the performance of the cooperative
sugar and spinning mills emphasize the need for better capacity utilization,
bringing down the cost of production, improving the financial management
practices and financial performance, redesigning the organizational structure
and revival of democratic management. In cooperative sugar mills, besides
the above aspects, there is an urgent need to review the policy relating
to pricing of sugarcane and sugar.
Better Capacity Utilization : The estimation of cane production
should be realistically made at the time of selection of site for the installation
of factory as well as at the time of expansion. The cooperative sugar mills
should develop meaningful relationship with the members. Only then would
they be able to have a legitimate claim on their loyalty. This in turn.wonl.d
help in the flow of sugarcane to the factory on a regular and continuous
basis. Agricultural development measures like liberal credit facitlity and
effective agricultural extension service to the cane growers are necessary
to improve the productivity and production of sugarcane. This in turn would
assure regular supply of sugarcane to the cooperative sugar mills. The
plant should also be kept in a state of efficiency in order to achieve fuller
utilization of the capacity.
Full capacity utilization in cooperative spinning mills is a formidable
task. Various steps need to be taken for achieving full capacity utilization.
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Some of them are : i) Data regarding capacity installed and utilized in
respect of each production cost centre should be periodically checked to
locate the degree of under-utilization and the reasons therefor, ii) To solve
the problems of power shortage and power cut, generators should be installed.
All the mills should make stand-by arrangements for generating electricity
and thereby avoid adverse effects of power cuts that the State may impose
from time to time. The State may also think of exempting cooperative
spinning mills from power cut. iii) Many of the cooperative spinning mills
are situated in rural areas at isolated places and do not have adequate
residential facilities both for technical personnel and the workers. Unless
this deficiency is removed, many mills may not, perhaps, be in a position
to attract talented personnel. The mills may therefore take up housing
programme with the financial assistance from HUDCO. iv) Frequent strikes
and lockouts have also caused idleness in spindles. The strained relation
between employer and employees could be reduced to a greater extent by
associating the workers in vital areas of management such as production
programmes, utilization of capacity, quality improvement and productivity
improvement. They need to be educated on the imperative of regular
attendance, reduction in waste, increase in spinning efficiency and so on.
The spinning mills should also concentrate on the provision of welfare measures
like better canteen facilities, recreational facilities, medical. ; care etc.
This would go a long way in promoting labour efficiency.
Bringing down the Cost of Production : The sugar mills may have no
control over cost of sugarcane, an important component in cost of production
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61 sugar, as sugarcane price is fixed by the government. Hence the areas
where the cooperative sugar mills need to bestow their attention are better
capacity utilization, recovery, improving the productivity of workers and
administrative personnel, reduction in the cost of maintenance and repair
and modernization of machinery.
The economy of the cooperative spinning mills depends on the
availability of cotton in the required quality and quantity at reasonable
price. Eventhough the centralised procurement of cotton facilitates the
purchase of quality cotton at a reasonable price, still there is vast scope
for reducing the proportion of raw material cost in total turnover by
appropriate mixing of cotton. Generally for production of any yarn no one
single variety of cotton is used. The properties of different types of cotton
vary in respect of staple length, fineness, maturity, strength and thrash
content. An optimum blending of different varieties of cotton has to be
determined taking into consideration the price of cotton, vis-a-vis its different
properties. Hence in a way it is the optimum combination of economics
and technology which helps to determine the right type of mixing for the
particular count of yarn or group of counts of yarn to be manufactured.
The quantum of waste that takes place during conversion process from cotton
to yarn in the case of different varieties is also a material factor to be
considered in the selection of cotton for the purpose of mixing, as it ultimately
determines the expensiveness or inexpensiveness of the clean cotton cost
in yarn. Thus avoiding of wastage, increasing the recovery of yarn and
appropriate mixing of cotton may help in reducing the proportion of raw
material cost in the total cost.
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Another area which deserves attention is labour cost. The cooperative
spinning mills in addition to the permanent strength of workers engage a
few temporary workers in each department depending on the fluctuation
in work load. In order to exercise proper control on the productive utilization
of labour force, records should be maintained showing the number of persons
engaged per 1000 spindles shifts.
Improving Financial Management : Flexible budgets for various levels
of capacity utilization should be prepared in a more scientific way and the
actual performance should be reviewed against the estimates at periodic
intervals to set right the deviation, if any. This requires the installation
of budgetary control system in each mill. The techniques of ratio ; analysis
and performance budgeting may be used by the department of finance to
monitor the financial performance of the mills.
A pragmatic financing policy for the mills would be to finance their
ongoing operations with funds generated internally. This calls for strategic
and operational measures to increase the internally generated cash surpluses.
Adoption of' scientific planning and control of inventories, receivables, cash
and continuous evaluation of mill's product-line by such techniques like
contribution margin could go a long way to improve the cashflow situation
on a lasting basis. Cashflow forecasts have to be prepared regularly and
methodically and cashflow budgets drawn up on the basis of cashflor forecasts.
All these presuppose the availability of correct and reliable data and
a systematic feedback. It is, therefore, necessary that the cooperative sugar
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and spinning mills should take steps to develop financial information system
that can generate the required financial information for the purpose of
financial planning and control. This also presupposes that the orientation
of the accounts department must change from one of conventional accounting
to that of financial management. All these necessitate the instalation of
computers for processing management information.
Revival of Democratic Control : The principle of democratic control
which is the cardinal principle of cooperation should be restored in Tamil Nadu
without any further delay. The special officers should be replaced by elected
boards of directors in the cooperative sugar and spinning mills. The number
of nominated directors in the Boards should not exceed 25 percent of the
total directors. Nominated members should have no voting rights. Member
education programmes should be launched in order to create awareness
and enlightenment among the members.
Reorganising Organization structure : The organizational set-up should
be reorganized with reference to the requirements of effective professional
management with a separate department for finance. This department should
be manned by persons with professional qualifications and expertise in financial
management. A costing section may be an integral part of the finance in
each mill.
Blending Democratic Control with Professional Management : The
bye-laws may suitably be amended so as to redefine the powers and functions
of the elected board and the chief executive. While the board should
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concentrate on policy making and evaluation of performance of the effective
management, the chief executive should be vested with adequate authority
to discharge his managerial, operational and technical responsibilities.
Pricing of Sugarcane : The unsound price policy should be replaced
by a rational policy based on a proper balance between the interests of
the growers and the consumers. An initial minimum price based on the
minimum price fixed by the Central Government adjusted to local cost of
cultivation may be paid to the growers at the time of delivery. Later,
patronage dividend on supply may be paid out of the profits in proportion
to the value of sugarcane supplied by the members. The payment of price
according to the weight of sugarcane supplied is not a very sound strategy.
The quality of cane in terms of sugar recovery should also be considered
in fixing prices. It is desirable to promote the cultivation of high recovery
varieties of sugarcane.
Pricing of Sugar : The price of levy sugar should be related to the
cost of production in different sugar zones.
Capital Structure
Findings
The major sources of capital for cooperative sugar and spinning mills
are share capital from members and government and borrowings from term-
lending institutions, the State Cooperative Bank and the State Government.
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The shares in cooperative sugar mills are issued to members and the
government. The ceiling on the contribution of share capital by the government
is around 50 percent of the total paid-up share capital. Every producer
member has to take at least one share for every one acre under sugarcane
cultivation. The value of a share ranges from Rs.200 to Rs.250. The co
operative sugar mills augment the share capital by converting the non
refundable deposits of members into share capital. The non-refundable
deposits from the members are collected at the rate of Rs.7.50 per tonne
of sugarcane supplied by the producer-members to the mills. Dividend
payable to members is also converted into shares.
Cooperative spinning mills issue shares to apex and primary weavers
cooperative societies, other cooperative institutions and the government.
The value of share is Rs.100.
Both the categories of mills raise, long-term loans to meet the capital
expenditure. Both the types of mills were not permitted to issue bonds
or debentures.
The cooperative sugar and spinning mills involve huge capital outlay.
But their equity base is thin because they are organizations of economically
weaker sections. Hence they have to rely heavily on long-term loans. The
proportion of debt has been found to be as high as 75 percent in the capital
structure of some of the mills especially during the initial years and periods
of expansion. When the term loans were repaid in instalments by these
mills, the proportion of debt declined and the proportion of equity in the
capital structure increased. The average proportion of debt in the capital
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structure of the cooperative sugar mills was 56.06 percent in 1961-'62 which
came down to 23.73 percent in 1983-'84. The proportion of equity has
increased from 43.97 to 76.27 percent during the same period. Similar trend
was observed in cooperative spinning mills. But the cooperative sugar mills
were able to bring down the proportion of debt to the lowest possible level
by repaying the instalments of loans regularly, whereas the cooperative
spinning mills could not do so because of their poor financial performance.
The reserves are weak in both the types of mills. Most of the mills
had no reserves especially during the period from 196i-'62 to 1972-73.
The situation has improved in the subsequent period. But the proportion
of reserves in equity was less than 10 percent in many of the mills. The
position of reserves in cooperative spinning mills was much worse.
The average proportion of Government's contribution in the paid-up
share capital of cooperative sugar and spinning mills ranged from 25 to 45
percent and between 75 to 95 percent respectively. Thus the cooperative
spinning mills have heavily relied upon State Government for their share
capital.
Conclusion
The analysis of the capital structure of the selected cooperatives
revealed that there was no set capital structure for the mills. The norm
for debt-equity in early 60's and 70's was 2 : 1 . It was revised to 1 : 1
in the beginning of the current decade. But this norm was not maintained in
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many of the mills. There were variations within the industry and between
the industries. Some mills had zero level of debt at some point of time
whereas some have a debt proportion of more than 75 percent. Some had
found it difficult to bring down the proportion of debt and therefore the
debt was hovering at a high level.
Suggestions
The norms of debt equity ratio laid down for cooperative sugar and
spinning mills should be strictly adhered to. Each mill should calculate its
debt-equity ratio periodically keeping in mind the norms. All possible steps
should be taken to strengthen the equity base. (For details, see the section
on "Factors influencing and relationship between capital structure and cost
of capital")
Cost of Capital
Findings
The estimation of cost of capital in cooperative is different from
that in a private enterprise. The shares of cooperatives have unique features.
They are not transferable and are not traded in stock exchanges. They carry
only a fixed nominal rate of interest depending on the amount of surplus
available for distribution. Therefore the procedure for equating the market
value with the present value of the expected benefits by a discount rate
as followed in corporate sector cannot be adopted in cooperatives. Similarly,
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the formula to calculate the cost of debt capital cannot be applied to co
operative because cooperatives borrow from several sources, at different
rates and on different terms and conditions. Keeping these special aspects,
a different appropriate approach was developed in this study for computing
the cost of equity and debt.
The cost of share capital in cooperatives is the average rate of dividend
paid over the study period. The cost of debt is the weighted average cost
of debt. The cost of retained earnings is calculated on the basis of opportunity
cost, that is, the average rate of dividend that has been paid to the share
holders. The weighted average cost of capital is the summation of all the
costs associated with acquiring cooperative capital.
The cost of debt is costlier than the cost of share capital in both
the categories of mills. The cost of debt ranged from 8 to 12 percent in
both the mills. The average cost of debt for the cooperative sugar mills
as a whole was 10.40 percent and for spinning mills it was 10.44 percent.
The average specific cost of share capital for cooperative sugar mills was
6.U percent and that for cooperative spinning mills was 6.39 percent. Thus
the average specific cost of debt was higher than that of share capital.
The overall cost of capital was hovering around 6 to 10 percent in
cooperative sugar mills and 4 to 8 percent in cooperative spinning mills
at the initial stage. This has subsequently declined due to repayment of
debt in instalments. Similarly the overall cost of capital was on the higher
side in both the types of mills at the time of expansion and modernization,
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but it declined later. It was also observed that many of the sugar mills
were able to bring down the cost of capital at a quicker pace than the spinning
mills.
Conclusion
The cost of debt was costlier than the cost of share capital and retained
earnings. The overall cost of capital was found to be high at the initial
stage and at the time of the expansion of capacity and modernization of
plant. The behaviour of the cost of capital is influenced by financial leverage.
Suggestions
Suggestions for reducing the cost of capital are discussed in the section
on "Factors influencing the relationship between capital structure and the
cost of capital",
Relationship Between Capital Structure
and the Cost of Capital
Findings
Capital structure decision is concerned with the composition of
capitalization, the relative proportions of various long-term sources of capital
and the financial leverage. Financial leverage refers to the use' of fixed
charge sources of funds such as debt and preference share capital in the
capital structure. The basic logic behind financial leverage is that the owners
of the firm will have the benefit of a higher rate of return on their capital
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than that earned by the firm on its total capital through the use of fixed
sources of funds, provided the rate of fixed charges is less than overall
rate of return on the firm's total capital. Thus, financial leverage has a
significant bearing on the composition of capital structure and the cost
of capital. A firm can bring about a change in the cost of capital through
changes in debt equity proportion in the total capital.
The analysis of relationship between the capital structure and the
cost of capital in sample cooperatives shows that there is a direct positive
association between these variables. In the mills under study, the overall
cost of capital tended to increase with a rise in the proportion of debt
in the total capital ; and it recorded a declining trend with a fall in the
proportion of debt, because in cooperatives debt is the costliest source of
fund. The cost of debt is higher than the cost of share capital and retained
earnings. Further the cost of debt is constant whereas the cost of share
capital and retained earnings tend to reach zero level whenever the co
operatives pay no dividends. A rise in the proportion of debt, therefore,
tends to increase the overall cost of capital.
Conclusion
Cost of capital in cooperative is a function of financial leverage.
Cost of capital tends to rise with a rise in proportion of debt and it falls
with a fall in proportion of debt in the capital structure.
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Factors Influencing the Relationship Between the
Capital Structure and the Cost of Capital
Findings
The cooperatives need to bring down the cost of capital in order
to fulfill their objectives of extending services to their members at a
reasonable cost. The cost of capital is greatly influenced by financial
leverage, which in turn, is determined by several direct and indirect factors.
The two direct factors which determine leverage are 'need for funds' and
'internal financing'.
The Influence of 'Need for Funds' on Leverage : The need for funds
arise when a firm is promoted ; when it is expanded/modernized ; and when
it incurs social expenditure.
The investment made during the establishment of a firm is called
initial investment. The initial investment depends upon the capital intensive-
ness of the firm. The cooperative sugar and spinning mills are capital
intensive in nature, requiring a huge capital outlay. The establishment of
a cooperative sugar mill with a crushing capacity of 1250 TCD involved
an outlay of Rs.256.26 lakhs in 1971-72. The cost has increased steadily
over a period of time and it stood at Rs.1020 lakhs in 1983-'84. Similarly
the cost of establishing a cooperative spinning mill with a capacity of 12,000
spindles has increased from Rs.61 lakhs in 196<f-'65 to Rs.265 lakhs in
1984-'85. Thus the establishment of cooperative sugar/spinning mill requires
huge amount of capital outlay which could not be met out of owned funds.
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Hence the mills had to rely upon debt capital. Naturally the leverage was
higher in the initial stages varying from 60 to 75 percent in the case of
cooperative sugar mills and 60 to 67 percent in cooperative spinning mills.
The remaining portion represents share capital only due to the absence of
any reserves. An examination of composition of share capital revealed that
a major chunk of share capital had been contributed by the government.
Moreover, there was cost overrun in some mills to the extent of
Rs.6 to 10 lakhs because of delay in completing the project. Thus, delay
in commencing the production operations of the mills did have some, though
not dramatic, effect on leverage.
The additional investment depends upon the growth rate. The growth
rate is influenced by expansion and modernization. Expansion/modernization
also involves a considerable amount of capital expenditure. Higher growth
rate would mean high amount of capital and greater proportion of capital
has to be derived from debt sources. Thus, there is a positive association
between growth rate and leverage. The results of the correlation also run
in the expected direction, but the association is rather weak. The reason
is that the selected mills have been able to finance their expansion/
modernization partly through internally generated funds during latter stages.
The need for debt capital at the time of expansion/modernization is less
when compared to the initial period.
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Cooperative sugar mills were found to have launched various social
welfare programmes like promotion of education, health and medical care
within the area of operation of the mills. Spinning mills have not undertaken
such activities. The expenditure incurred on social welfare by the cooperative
sugar mills was financed mainly out of earnings before depreciation and
also the Area Development Fund. As such the expenditure on social welfare
does not affect leverage.
The Influence of Internal Financing on Leverage : Internal financing
is negatively correlated to leverage in the mills under study and this means
the mills with retained earnings have been able to bring down the level
of leverage and the mills which do not have retained earnings are operating
at a higher level of leverage.
Retained earnings or internal financing depends upon the profitability
of the mills. Mills earning profits are able to generate internal funds. Thus
profitability indirectly influences the level of leverage. Profitability itself,
in turn, is influenced by a set of factors.
Factors Affecting Profitability : The five variables considered
for the indepth analysis are : i) capacity utilization ; ii) degree of operating
leverage ; iii) total assets turnover , iv) fixed assets turnover and v) inventory
turnover.
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fixed assets turnover and inventory turnover. This association is not quite
unexpected. Whereas, in the case of cooperative spinning mills capacity
utilization and fixed assets turnover are the only two factors associated
with profitability.
Multiple Correlation and Regression Analysis : The five variables
namely capacity utilization, degree of operating leverage, total assets turnover,
fixed assets turnover and inventory turnover, to which correlation analysis
was applied, are also subjected to multiple correlation and regression analysis.
The results show that the contribution of above factors to profitability was
21.30 percent in cooperative suga'r mills. They also show that individually
when other variables are kept constant only two variables namely fixed
assets turnover and inventory turnover significantly influence profitability
and these factors together account for 20.50 percent of variations in
profitability. Also, the standard regression coefficient indicates that fixed
asset turnover is the most important followed by inventory turnover in the
case of cooperative sugar mills. But in the case of cooperative spinning
mills, the results of multiple correlation and regression analysis reveal that
the percentage contribution of the five factors was only 7.3. Further-more
the test of controlled association shows the fixed assets turnover only
significantly influences profitability.
Factors Influencing Gross Operating Margin : It was found that
there was a close positive association between gross operating margin and
profitability. Gross operating margin in turn is influenced by a set of variables,
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namely, recovery, rate of change in cost of productio, rate of change in
selling price and variability in sales in the case of cooperative sugar mills.
The analysis shows that recovery is positively associated with gross operating
margin as expected. The rate of change in cost of production is negatively
correlated, as expected. The correlation between variability in sales and
gross operating margin is negative and significant ; but it runs against the
expectation. The rate of change in selling price had a weak association
with gross operating margin.
Multiple Correlation and Regression : All the four variables were
also subjected to multiple correlation and regression analysis. The total
contribution of four variables to gross operating margin was around 25 percent.
The analysis also indicated that individually when other variables are kept
constant, only three factors namely recovery, rate of change in cost of
production and variability in sales significantly influenced gross operating
margin and these factors together account for 23.6 percent of the variation
in gross operating margin. The standard regression coefficient indicated
that recovery is the most important factor followed by rate of change in
cost of production and variability in sales.
In cooperative spinning mills, only two variables namely rate of change
in cost of production and variability in sales were analysed in the above
fashion. The rate of change in cost of production did not correlate well
with gross operating margin, whereas variability in sales had a positive and
significant association with gross operating margin. When these two variables
were put into multiple correlation and regression analysis, the total
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contribution of these two variables to gross operating margin was only 7.H
percent.
Age and Leverage :
Age is also determinant of leverage. A younger cooperative may
require more amount of debt capital because of high cost of setting up a
business coupled with low equity. On the other hand an older firm may
be operating at a lower level of leverage because of successful operation
and solvency. Age and leverage are negatively correlated in cooperative
sugar mills indicating that younger firms have high debt level and the older
firms have low debt level. But in cooperative spinning mills age and leverage
are positively correlated. This was mainly because of the fact that many
of them had unsuccessful operation and they were not successful in bringing
down the level of debt over the years.
Leverage in a Successful Cooperative
A firm successful in its operation may retire its debt early thus bring
down leverage level. The relation between successful operation and leverage
revealed that a successful cooperative has attained lower leverage in lesser
number of years than an unsuccessful cooperatives. Success was measured
by profitability. This corroborates the fact that profitability and leverage
are negatively correlated.
Conclusion
The findings of the study demonstrate that the cost of capital increases
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as the leverage increases*. , Many cooperatives were found to be operating
at a higher level of leverage, hence the high cost of capital. High cost
of capital coupled with poor profitability has rendered many of the mills
under study financially weak. A financially weak cooperative cannot fulfill
its objective of providing effective service at a reasonable cost. Thus there
is an urgent need for bringing down the cost of capital. This can be done
only by bringing down the level of debt in the capital structure. The level
of debt or leverage is primarily influenced by the need for funds and the
internal financing. Behind each of these variables as we have seen a host
of other variables indirectly affect leverage. The mills need to bestow
adequate attention to these variables in order to bring down the leverage.
Presented below are some suggestions for bringing down the leverage and
hence the cost of capital.
Suggestions
1. Before launching a cooperative sugar/spinning mill or before expanding
its capacity or before modernizing plant, the debt capacity of the
mill has to be carefully studied by cashflow analysis. If the expected
net cashflow is large enough to meet the estimated debt servicing
cost it may resort to debt ; otherwise it may try to reduce the debt
level as much as possible. This exercise was not carried out by many
of the mills studied.
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On completion of the projects, the mills never bothered to find out
the deviations from the original cost estimate. Escalation of cost
is bound to affect the leverage. Hence the mills need to conduct
a post-project audit to analyse the cause of deviations and their
effects ion future cashflow, debt servicing cost and the cost of capital.
Such an analysis would help the management to know where exactly
things have gone wrong and what remedial actions should be made.
The Directorate of Sugar and the Directorate of Handloom and Textiles
which have trained technical personnel may be entrusted with the
responsibility of such a post-project audit.
The mills relied heavily on debt at the time of their promotion.
Such a high level of debt adversely affected their cost of capital
and profitability. Hence it is suggested that the borrowings for fixed
assets at the initial stages should not exceed 60 percent of the value
of such fixed assets. The cost of capital at this debt level would
be around 6 percent. The expansion and modernization may be financed
by internally generated funds to the extent possible and borrowings
for these purposes should not exceed 50 percent of the estimated
outlay. The approximate cost of capital at this debt level would
be around 5 percent.
As any project overrun in cost and time adversely affects the earnings
and the cost of capital, there should be an effective monitoring of
project implementation.
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Long-term loans raised for financing capital expenditures should be
repaid as early as possible so as to reduce the level of leverage and
the overall cost of capital.
Some mills have resorted to 'ways and means' advance from the
government in order to meet debt servicing cost. Such a practice
has not only added to the debt burdens of the mills but also seriously
affected their liquidity and working capital position. Hence it is
absolutely necessary that the mills should meet fixed charges only
out of their earnings.
The ability of the mills to tolerate leverage depends on the stability
of the net operating income. Mills with unstable income should try
to avoid debt as much as possible.
As low gearing i.e. a lower proportion of debt in the capital structure
is a means for minimizing the cost of capital in cooperatives, they
should aim at low gearing at least over a period of time. This could
be achieved by collecting additional share capital from members in
proportion to the value of their patronage (cane supplied/yarn purchased
as the case may be), conversion of dividend on share capital and
patronage into share capital with members' consent, and allocation
of higher percentage of profits to reserves. Recurring and fixed
deposits from the public may . also be accepted, as cost of this source
is lower than that of borrowings.
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9 Ownership and control should always be vested with members. Excessive
state support in the form of share capital contribution to cooperative
sugar and spinning mills has led to a dependency syndrome, affecting
the democratic character and autonomy of the mills. Therefore mills
should try to redeem the share capital subscribed by the government.
A Share Capital Redemption Fund may be created in each mill to
redeem the share capital contributed by the government.
10. The location of the mills especially sugar mills should be carefully
considered. Their success largely depends on regular availability of
adequate quantity of sugarcane throughout the season. The inadequate
availability of raw material results in under-utilization of production
capacity and this inturn affects the financial viability of the mills.
Hence careful selection of site assumes greater significance.
11. Each mill should calculate the overall cost of capital in financing
a project and compare it with the expected rate of return. But,
no mill under study has given serious attention to this important aspect.
The promoters of the new mills should get this exercise done through
consultants. The viability of expansion/modernization should be
scientifically evaluated by the finance department of the mill, if
necessary, with the help of financial consultants.
12. The mills should take inflationary conditions into account and create
Replacement Fund in addition to normal depreciation, in order to
provide for adequate funds for replacing fixed assets when they go
out of use.
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13. The mills should try to improve their profitability by adopting effective
methods of management and cost control techniques in order to bring
down the cost per unit and increase profit margin. An improvement
in financial performance would facilitate early redemption of debt
and strengthening owned capital.
14. Mill should have sufficient working capital to operate the plant. Lack
of sufficient working capital may lead to ineffective utilization of
fixed assets, which, in turn, would affect profitability and thus leverage.
Similarly mills should not seriously deplete its working capital at
the time of expansion/modernization.
Suggestions for Further Research
Research studies in financial management in cooperatives are rare.
There is vast scope for conducting research in financial management in
cooperative organizations. Some of the areas for research in financial
management in cooperatives are :
1. The status of financial management in various types of cooperatives
and their financial management practices may be studied with a view
to suggesting better approaches and methods.
2. In order to evaluate the financial performance of different types
of cooperatives, norms for liquidity, operational efficiency etc. have
to be established. Such norms are required for intra-firm and inter-firm
comparisons.
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3. Intensive studies of cashflow pattern in different types of societies
may be made in order to develop models for determining cash balances
to be maintained.
*f. Liquidity management is important in large sized cooperatives. Research
studies to determine the optimal structure of current assets and to
plan the investment of excess cash balance may be undertaken.
Similarly studies for determining the optimal financing mix for financing
current assets may be made.
5. Another area of research is financing of replacement and modernization.
What should be the mode of financing replacement/modernization ?
How tax and other incentives available for capital expenditure influence
financing decision relating to replacement/modernization ? These
issues call for an indepth study. The findings of such studies may
be of great help in setting guidlines for future action on replacements
in older cooperatives.
6. Government plays a major role in promoting, developing and controlling
cooperative organizations. The policies of the government particularly
licensing, taxation, fiscal, control of prices of input and output have
an important bearing on financial decision in cooperatives. What
is the impact of such policies on the financial decisions ? How do
they promote or retard cooperative growth ? These issues invite
an indepth analysis.