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FINANCE FOR STRATEGIC MANAGERS


FINANCE FOR STRATEGIC MANAGERS

CONTENTS

S No Description Page No I UNDERSTAND THE ROLE OF FINANCIAL INFORMATION IN BUSINESS STRATEGY 6

1. Need for Financial Information 7 1.1 Major Financial Activities of the Enterprise 7

1.1.1 Mobilisation of Funds Required by the Enterprise 7 1.1.2 Effective Use of Funds of the Enterprise 7

1.2 Strategic Managers Need Financial Information for Decision-Making 8 1.3 Assessing Finance Requirements 8 1.4 Obtaining Finance 8 1.5 Investment Decisions 9 1.6 Dividend Decisions 9 1.7 Setting and Meeting Targets 10 1.8 Appraising New Projects (Capital Budgeting) 10 1.9 Sources of Long-Term Finance 10 1.10 Managing Risks 11 1.11 Reporting to Shareholders and the Stock Exchange 11

2. Time Value of Money 13 2.1 Concept of Time Value of Money 13 2.2 Value of Money Received at Different Time 13 2.3 Compounding Technique 14

2.4 Technique of Discounting 14

3. Financial Information 15 3.1 Cash Flows 15 3.2 Profitability 16 3.3 Business Value 16 3.4 Financial Stability 17 3.5 Cost Projections 17

4. Business Risks 19 4.1 Concept of Risk 19 4.2 Systematic & Unsystematic Risks 19

4.2.1 Systematic Risks 19 4.2.2 Unsystematic Risks 20

4.3 Managing Risk: Trade-Off between Risk & Return 20 4.4 Risk-Modelling 20

II. BE ABLE TO ANALYSE PUBLISHED FINANCIAL STATEMENTS FOR STRATEGIC DECISION MAKING PURPOSES 21

5. Published Accounts 22


5.1 Purpose of Published Accounts or Financial Statements 22 5.2 Users of Published Information 22 5.3 Annual Report of the Company 23 5.4 Internal Management Accounts versus Published Financial Accounts 24 5.5 Weakness of Published Accounts 24

6. Structure of Financial Statements 25 6.1 Main Financial Statements 25 6.2 Balance Sheet 25

6.2.1 Equity & Liabilities 26 6.2.2 Assets 27

6.3 Statement of Profit and Loss 27 6.3.1 Revenue 28 6.3.2 Expenses 28

6.4 Cash Flow Statement 29 6.5 Notes to Accounts 31

7. Analysis & Interpretation of Financial Statements 32

7.1 Analysis of Financial Statements 32 7.1.1 Comparative Statement 32 7.1.2 Common-Size Statement 32 7.1.3 Ratio Analysis 32 7.1.4 Cash Flow Statement 33

7.2 Types of Financial Statements Analysis 33 7.3 Purpose of Financial Analysis 33 7.4 Comparison between Years 34

7.4.1 “Comparison between Years” based on ‘Comparative Balance Sheet’ 34 7.4.2 Format of Comparative Statement of Profit & Loss 35 7.4.3 Comparative Financial Statements Using Common Size Statement 36 7.4.4 Common Size Statement for Profit & Loss 36 7.4.5 Common Size Statement for Balance Sheet 37

7.5 Company/Industry Comparisons & Benchmarking 38 7.6 Difference between Capital and Revenue Expenditure 38

8. Accounting Ratios 39 8.1 Accounting Ratios 39 8.2 Reasons for using Ratios 39 8.3 Types of Accounting Ratios 39 8.4 Liquidity Ratio (Short-Term Solvency Ratios) 39 8.5 Capital Structure or Solvency Ratios (Long Term Solvency Ratios) 40 8.6 Activity / Efficiency Ratios 42 8.7 Profitability Ratios 43 8.8 Investor Ratios 44 8.9 Limitations of Ratio Analysis 46

III. UNDERSTAND HOW BUSINESSES ASSESS AND FINANCE THE NON-CURRENT ASSETS,

INVESTMENTS AND WORKING CAPITAL 47 9. Short and Long-Term Finance 48


9.1 Finance for Business 48 9.2 Meaning of Short Term and Long Term 48 9.3 Short-Term Finance 48 9.4 Long-Term Finance 49 9.5 Differences between Short & Long-Term Finance 49 9.6 Matching Finance-Issues with the Specific Business Requirement 49

10. Sources of Finance 50

10.1 Range of Sources 50 10.2 Internal and External Sources 50

10.2.1 Internal Source of Finance 50 10.2.2 External Sources of Finance 51

10.3 Sources of Short-Term Finance 51 10.3.1 Purpose of Short-term Finance 51 10.3.2 Sources of Short-term Finance 51 10.3.3 Merits and Demerits of Various Short-Term Finance Systems 52

10.4 Sources of Long -Term Finance 53 10.4.1 Purpose of Long-term Finance 53 10.4.2 Factors Determining Requirements of Long-term Finance 53 10.4.3 Sources of Long-term Finance 53 10.4.4 Merits / Demerits of Popular Sources of Long-Term Finance 54

10.5 Role of Markets and Government 54 11. Cash Flow Management 56

11.1 Objectives of Cash Management 56 11.2 Strategy for Cash Management 56 11.3 Cash Flow Forecast 56 11.4 Budgetary Control Process 57

11.4.1 Budgetary Controls 57 11.4.2 Cash Budget 57

11.5 Managing Inventory 58 11.5.1 Necessity of Holding Inventory 58 11.5.2 Managing the Inventory 58 11.5.3 Inventory Control 59

11.6 Managing Trade Payables 60 11.7 Managing Trade Receivables 60

12. Investment Appraisal Techniques (Capital Budgeting) 61 12.1 Capital Budgeting 61 12.2 Capital Budgeting Decisions 61 12.3 Use of Cash-Flow Analysis in Capital Budgeting Process 61 12.4 Types of Cash-Flows Associated with Capital Budgeting 62 12.5 Payback Method for Analysing Investment Project 62 12.6 Accounting Rate of Return (ARR) Method 63 12.7 Discounted Value (Present Value) Method 63 12.8 Net Present Value (NPV) Method 63 12.9 Internal Rate of Return (IRR) Method 64 12.10 Profitability Index (PI) or Benefits-Cost Ratio Method 65


IV. UNDERSTAND DIFFERENT OWNERSHIP STRUCTURES AND HOW THEY INFLUENCE AND

MEASURE FINANCIAL PERFPRMANCE 66 13. Ownership Structure 67

13.1 Sole Trader or Sole Proprietorship 67 13.2 Partnership 68 13.3 Types of Partnership 68 13.4 Private Corporation 69 13.5 Other Types of Corporations 69

13.5.1 ‘S’ Corporation 69 13.5.2 Limited Liability Company (LLC) 70 13.5.3 Private Limited Company 70 13.5.4 Public Limited Company 70 13.5.5 Non-Profit Corporations 71 13.5.6 Cooperatives 71 13.5.7 ‘Limited by Guarantee’ Companies 71

13.6 Public Sector Organisation 71 13.7 Accounting Standards 72 13.8 Tax Laws 72 13.9 Commercial Laws 72

14. Accountability and Roles 74 14.1 Accountability Concept 74 14.2 Accountability towards Stakeholder Interests 74

14.2.1 Control Issues 75 14.3 Shareholder vesus Sole Trader 76 14.4 Manager and Owner 76 14.5 Decision-Making Interests 77 14.6 Organisation Strategy 77 14.7 Corporate Social Responsibility (CSR) 77


I. UNDERSTAND THE ROLE OF FINANCIAL INFORMATION

IN BUSINESS STRATEGY


UNIT 1. NEED FOR FINANCIAL INFORMATION

1.1 Major Financial Activities of the Enterprise 1.2 Strategic Managers Need Financial Information for Decision-Making 1.3 Assessing Finance Requirements 1.4 Obtaining Finance 1.5 Investment Decisions 1.6 Dividend Decisions 1.7 Setting and Meeting Targets 1.8 Appraising New Projects (Capital Budgeting) 1.9 Sources of Long-Term Finance 1.10 Managing Risks 1.11 Reporting to Shareholders and the Stock Exchange

1.1 Major Financial Activities of the Enterprise All business activities have certain financial implications. The objectives of a business organisation is mostly expressed in finance-related terms like business share or market leadership, cost leadership, profitability, wealth maximisation etc. Financial management at corporate level is concerned with taking decisions regarding planning, organising, and controlling of financial activities of the organisation. There are two major areas of financial management relating to: (i) arranging the required funds for the organisation; and (ii) effective-utilisation of these funds for achieving the objectives of the organisation. 1.1.1 Mobilisation of Funds Required by the Enterprise Funds for a business enterprise can be obtained from different sources which have different degree of cost, risk and control factors for the organisation. Finance managers have an important responsibility to ensure that funds are procured at minimum cost, at relatively low risk and control factors. Different sources of funds namely equity shares, bank-loans, other credits, debts, foreign direct investments (FDI) etc carry different level of annual pay-backs, and pose different levels of financial risks. Therefore, senior managers of the enterprise need appropriate financial information for taking various strategic decisions, such as:

Options for raising funds from various sources;

Determining the optimal finance-mix (financial packages from various sources) for the organisation;

Action-plan for raising the funds at minimum possible cost(s); and

Allocation of profits into (i) dividends for shareholders and (ii) retention within the organisation.

1.1.2 Effective Use of Funds of the Enterprise An important responsibility of a Senior Financial Manager is ensuring optimum allocation and utilisation of funds to various activities. He has dual responsibility: funds should not be kept idle; and funds must be used optimally to get best possible returns to the organisation. A fundamental requirement is that “the funds must generate more income for the enterprise than the cost of the (procurement of) the


funds”. The Finance Managers require proper financial information and knowledge regarding capital-budgeting techniques and also for working capital management techniques.

1.2 Strategic Managers Need Financial Information for Decision-Making Various types of decisions taken by strategic managers of an enterprise require extensive information, knowledge and skills of financial nature so that they may carry out proper quantitative analysis of all related issues to arrive at optimal decisions. As discussed above, managers need variety of financial information for:

assessing the finance-requirements of the enterprise; and

procuring ‘finance’ at minimum possible cost and manageable risks. Many financial decisions are inter-related; and such issues are considered simultaneously to arrive at proper decisions in the short-term and long-term interests of the enterprise. Various important corporate decisions needing detailed and accurate financial information include:

Assessing the ‘requirements of funds’ for the enterprise;

Understanding short-term & long-term requirement of funds;

Deciding proper capital structure for meeting the fund-requirement;

Working-capital management;

Cash management;

Financial negotiations;

Investment decisions; and

Dividend decisions etc. Some of these important examples of financial information required by the corporate decision-makers are described briefly in subsequent sections of this Unit. These are also the important roles of Senior Finance Manager in a business enterprise.

1.3 Assessing Finance Requirements A business company needs finance for its short-term and long term needs. As a practice, these are carefully forecasted or assessed. For this, the business managers need extensive information regarding various activities needing allocation of funds. Major activities needing fund allocations include the following:

Investments for fixed long-term assets;

Working capital requirements;

Estimation of funds blocked in current assets; and

Other liabilities needing payments in the period under consideration. Techniques namely ‘budgetary-control’ and ‘long-range planning’ are used for forecasting the requirement for finance. Based on such forecasting regarding all business activities, a proper estimate is prepared for fund-requirements.

1.4 Obtaining Finance Adequate financial information is required for understanding of fundamental issues & activities for which funds are required to be raised. These activities include:


Identifying the possible sources of finance;

Analysing the ‘cost of finance’ from each possible source;

Carrying out cost-benefits analysis for raising funds from different sources; and

Taking decisions regarding the fund/source-mix or the capital structure. After deciding on requirement of finance, a decision is taken regarding the sources from where funds are to be raised and also a proper source-mix has to be decided as various sources of funds have different risks and control issues. The management has to decide on the proper ‘capital structure’ by evolving balance between long-term funds and short-term funds. Due care has to be taken to ensure that sufficient funds are available for use as the ‘working-capital’. Both ‘profitability’ and ‘liquidity’ issues have to be considered simultaneously by the Financial Managers. The main objective in arranging for corporate finance is to procure funds at minimum cost.

1.5 Investment Decisions The funds raised have to be properly utilised for generation of revenue and profits. This activity is aiming at effective use of funds raised for the organisation. The Finance Managers have to:

analyse the investment proposals received from various groups of the organisation;

analyse various investment-proposals using the established techniques;

rank the investment-proposals on the basis of the evaluation criterion; and

decide on ‘most-attractive’ investment proposal for the organisation. Taking investment decisions about the long-term assets involves use of a financial technique called ‘Capital Budgeting’. Deciding on short-term assets involves use of technique called ‘Working Capital Management’. The investment proposals are analysed to calculate cost of funds and also the benefits and financial-returns from the investment. The timing and magnitude of the cash-flows likely to be generated are also assessed and analysed. Working capital management is also called short-term financial management. It takes care of cash requirements for day-to-day dealings involving current assets. It is important as meeting the ‘short-terms requirements’ is crucial for ensuring success of the business in the long-term. Sufficient availability of cash with various units of the organisation is essential for ensuring “liquidity” for the organisation. But on the other side, keeping large amount of ‘cash money’ in the organisation means that such money is not being used for revenue generation; and it has adverse affect on the “profitability” of the organisation. Therefore, a judicious balance has to be achieved between ‘liquidity’ and ‘revenue generation for profitability’.

1.6 Dividend Decisions Senior managers have important responsibility in taking dividend related decisions for the enterprise. The company earns certain ‘net profit’ after providing for ‘depreciation’ and making payment of ‘taxes’ as applicable. This ‘net profit’ can be partly distributed as ‘dividend’ among the shareholders of the company, and the balance called “retained profit” remains with the company as the “reserve” over the existing equity capital. Retained profit can be used as ‘internal finance’ for business investment. It thus helps in further generation of revenue and helps the organisation in earning further profit for the shareholders. Though the above mentioned dividend related decision-making looks very simple, it can affect the market price of company’s shares and also the sentiments of the shareholders. It can have an important


impact on shareholders’ interest in investing for further equity capital, if such an offer is made by the company. However, the accumulated retained profit can also be used as the basis of a “right-issue offer” for new equity capital for the existing shareholders. Such right issues are generally made at a price lesser than the net worth value of existing share (to make the offer attractive for the shareholders).

1.7 Setting and Meeting Targets The senior managers set goals and targets for achievement of progress for the company for meeting its objectives. Such targets may be in terms of sales-targets, production-quality targets, employee productivity targets, ‘accident-free days’ targets, cost-reduction target, market-share targets, or customer satisfaction target. These business-related targets have certain financial implications. For example, ‘sales targets’ are related to production quality, product pricing, and more importantly providing customers’ satisfaction. Each of these issues has cost implications which need to be resolved through a “balanced approach”. The production may be organised to produce better quality products; which have higher customer-value, result in higher level of satisfaction for the customers at relatively lesser price. Such a combination provides a winning strategy for the company leading to higher sales, cost-reduction for the product, and higher profitability for the company.

1.8 Appraising New Projects (Capital Budgeting) Any new project has three common characteristics:

It needs funds for investment (which may be for long-term);

It has potential for providing good ‘financial returns’ for the organisation in terms of revenue generation and good profitability, and

Every investment proposal has inherent financial-risks which require careful analysis before taking any final decision.

The new projects need large capital outlays and have to undergo careful appraisal from technical and financial aspects. The financial appraisal of new long-term project proposals is carried out using the Capital Budgeting technique. Some commonly used methods/techniques to arrive at capital budgeting decisions (for project appraisal) are mentioned below:

Traditional Capital Budgeting Techniques;

Average Rate of Return;

Pay Back Method;

Discounted Cash Flow (DCF)/Time-Adjusted Techniques;

Cash Flow Analysis Method;

Net Present Value Method;

Profitability Index Method; and

Internal Rate of Return. These are described in a subsequent unit on long-term financing. Various capital budgeting techniques are used to either (i) to assess the profitability of an investment proposal, or (ii) to rank various proposals on the basis of financial returns or payback.


1.9 Sources of Long-Term Finance A business enterprise needs funds to purchase (and to build) fixed assets namely land, buildings, office furniture, equipment, plant and machinery. Such funds are called “fixed capital”. A part of working capital is also of permanent nature. Long-term finance is required for following purposes:

To finance ‘fixed assets’ of the enterprise;

To finance permanent part of the ‘working capital’; and

To finance growth and expansion of business. Numbers of sources are available to meet the requirements of long-term finance. Broadly these sources are of two types: (i) share capital, and (ii) debt financing. Various sources of long-term finance are as under:

Ordinary Equity Capital;

Preference Share Capital;

Debentures and Bonds;

Loans from Banks & Other Financial Institutions;

Retained Earnings; and

Bridge Finance.

1.10 Managing Risks All financial actions namely investments, loans, or any other activity have uncertainty regarding future outcome; and therefore have inherent financial risk. Such a risk arises as the financial outcome cannot be estimated or forecasted with accuracy. It is not practically possible to accurately forecast the possibility of occurrence of an event. In real-life situation, there may be three possibilities:

Certainty: The risk associated is NIL.

Risk: The outcome is not known, and the uncertainty poses a finite amount of risk.

Uncertainty: The likely event, or the outcome is ‘not known’. Thus, there is total risk; as no idea is possible regarding the future state.

In business activities, there can be various types of risks:

Market Risk: Its examples may include sudden change in equity price, or change in foreign currency rates, or sudden fluctuations in commodity prices.

Interest Rate Risk: There may be change in the interest-bearing assets namely loan, bond due to change in the interest rates.

Purchasing Power Risk: There may be impact of inflation or deflation on an investment. Prices of goods or services may change due to changes in demand-supply conditions.

In any business, changes in the business-risk conditions influence the financial “returns”. Generally a high-risk investment may lead to higher financial returns, though not always true. It is said that the ‘risk’ and ‘return’ go together. Therefore, business managers attempt to make some kind of “trade-off” between the risk and the returns.

1.11 Reporting to Shareholders and the Stock Exchange The Board of Directors of a company have a legalistic responsibility to make a “summary reporting” about the company’s performance and the financial results to the shareholders during their Annual


General Meeting (AGM). An ‘Annual Report’ is an essential requirement as per company laws of the country, and comprises of following documents authenticated by the Board of Directors:

A Report prepared by the Board of Directors, presenting: Report in terms of the Companies Act; Directors’ Statement regarding their responsibilities; Corporate Governance Report;

Board’s analysis of the prevailing business environment and the business-progress made by the company.

Report of the Company’s Auditors prepared as per the laid down Accounting Standards;

“Financial Statements” prepared as per the Accounting Standards, giving summary of financial activities and achievements of the Company for the year under consideration, presenting:

‘Balance Sheet’ as on the end of last financial year; ‘Profit & Loss Statement’ for the last financial year; ‘Cash-Flow Statement’. ‘Notes to the Accounts’ of the last Year.

A copy of the Annual Report is required to be provided to the respective Stock Exchange where company’s equity shares (and other financial instruments) are listed for the purpose of trading. The Annual Report can thus be accessed by anybody in the general public through the Stock Exchange. Thus, the annual report and its constituent financial statements meet the ‘external need(s)’ for the financial information about the company. External investors, lenders, suppliers, general public and even the competitors use this information for assessing the financial state of the company. Other companies interesting to form joint ventures also need such financial information. Further, decisions regarding acquisitions and mergers are also taken by external agencies/companies on the basis of such financial information provided by the company in the open public-domain.


UNIT 2. TIME VALUE OF MONEY

2.1 Concept of ‘Time-Value’ of Money 2.2 Value of Money Received at Different Time 2.3 Compounding Technique 2.4 Technique of Discounting

2.1 Concept of ‘Time-Value of Money’ In business environment, money is not kept idle as it does not earn further money when idling. The basic concept in business operations is that rather than keeping the money idle, it should be invested to generate more revenue. Therefore, if $ 1000 is earned and is available in a business organisation, it is to be invested further and is not kept idle. If the interest rate is 4%, than in one year, it can earn interest of $ 40, and thus then the total amount becomes $ 1040. In financial terms, we may state that at interest rate of 4%, the present value of money available is $1000, but its future value after 12 months is $ 1040. Stated in other way, if $ 1040 is likely to be received after 12 months, then its present value in $ 1000. In yet another manner, we may say that the discounted value today (at interest rate pf 4%) of $ 1040 receivable after 12 months, is $ 1000. It may be noted that interest rate is the yardstick for computation of ‘value of money’ at different time.

2.2 Value of Money Received at Different Time Money received in future is less valuable than the money received today. The time value of money helps in converting the different ‘money amounts’ arising at different points of time into ‘equivalent values’ of a particular point of time. These equivalent values can be expressed as future values or as present values. By compounding techniques, the present value can be converted into a future value and by discounting method, a ‘future value’ can be converted into ‘present value’. For this purpose, we use ‘rate of interest’ as the discounting factor. Time Value of Money is an important concept in financial management. It is one of the important tools used in ‘project appraisal’ to compare various investment alternatives. ‘Time Value of Money’ is based on the concept that money invested today is worth more than the same amount expected to be received in future. For example, $ 1000 on hand now is more valuable than $ 1000 receivable after a year. A key concept behind ‘Time Value of Money’ is that a single sum of money or a series of equal, evenly spaced payments or receipts promised in the future can be converted to an ‘equivalent value’ today. Conversely, there may be some ‘cash flows’ of a single sum or a series of payments at some future times, then these future payments may be converted into their present money-values. The former is called the Future Value of Cash Flows. And the later is called the Present Value of (future) Cash Flows. Present Value is an amount that is equivalent to a future payment or a series of payments, that has been discounted by an appropriate interest rate.


Discounting of future value is the process of determining the present value of future cash flows. It is an important concept, which is used in project appraisals. The opportunity cost rate is the rate available on the ‘next best alternative’ with same equal risk as the current investment. Future Value is the amount of money that an investment with a fixed, compound interest rate will grow to, at a future date.

2.3 Compounding Technique The process of putting the money and any accumulated interest on an investment for more than a year’s period, thereby reinvesting the interest is called compounding. Future Value of a Single Cash Flow:- Suppose that an infant-baby wins a Baby-Show, and wins $ 5000 gift receivable when the child attains the age of 18 years. This money can be invested at 10% per annum until the baby-child attains age of 18 years. Future-value concept helps in determining how much the child will receive will be in the account 18 years from now. The Future Value of a single sum is given by the formula:

FV = PV (1+r)n

Here, r = Rate of Interest, And n = Nos of years for which compounding is done.

In this case, we have FV = $ 5000 (1.10)18 = $ 27,800

2.4 Technique of Discounting Discounting the future value is the process of figuring out what that the ‘future value’ is in terms of present day money. By compounding technique, the present value can be converted into a future value and by discounting method future value can be converted into present value. Present Value of a Single Future Amount:- Present value = Future Amount X ( 1/(1+r)n ) here r = Interest rate; n = number of periods, and ‘X’ is the sign of multiplication. Present Value of an Ordinary Annuity:- Present value = Annuity Amount X (1/r) X [ 1 – 1/(1+r)n] Here, r = interest rate, and n = number of periods.


UNIT 3. FINANCIAL INFORMATION USEFUL

IN DECISION MAKING

3.1 Cash Flow 3.2 Profitability 3.3 Business Valuation 3.4 Financial Stability 3.5 Cost Projections

3.1 Cash Flow The movement of ‘cash’ in a business enterprise is seen as the ‘flow of cash’ in and out of the enterprise. Such a movement of cash is referred as the ‘cash-flow’ in the business organisation. The ‘cash flow’ related information regarding a business enterprise forms the basis for preparing financial statements for the enterprise. It thus provides a basis to assess: (i) the ability of the enterprise to generate cash and cash equivalents and (ii) the needs of the enterprise to utilise these cash flows. The term ‘cash’ broadly covers both, the currency and other generally accepted equivalents of cash, such as cheques, drafts, and demand deposits in banks. The broad term of cash also includes near-cash assets such as marketable securities and time deposits in banks. These are included in the term ‘cash’ as these can be converted into cash. Thus, these support the liquidity of the organisation by providing cash in short time, when needed. Thus, the excess cash available can be kept as a short-term investment instrument which may be encashed when need arises. There are four primary motives of maintain cash balances: transaction motive; precautionary motive, speculative motive, and compensating motive. There are inflows and outflows of cash and cash equivalents. When cash is paid out to receive/procure some asset, it is called outflow of cash. On the other hand, when cash is received on selling some asset or on maturity of other asset, or on sale of goods & services, it is called inflow of cash. A cash flow information when used with financial statements, provides information that helps in evaluating the changes in net assets of an enterprise. Cash flow information is useful in assessing the ability of the enterprise to generate cash and cash equivalents; and enables users to develop models for assessing and comparing the present value of the future cash-flows of different enterprise. In financial term, cost and benefits are measured through cash-flows. The costs are denoted as cash outflows and benefits are denoted as cash inflows. Thus, all estimates of receipts and payments are also based in terms of likely/expected cash flows in financial analysis. Cash inflows are shown with positive sign and cash outflows are shown with negative sign for the purpose of quantitative analysis. At the end of the operating cycle (generally the year-end) the annual report submitted to shareholders is accompanied by the Cash Flow Statement (CFS). Here the cash flows from different types of activities are reported under four major-heads as under:

Cash Flow from Operating Activities;


Cash Flow from Investing Activities;

Cash Flows from Financing Activities; and

Net Increase in Cash and Cash-equivalents

3.2 Profitability All types of capital raised for the business have certain cost (like the interest payable) which may be called as the ‘pay-out’. The funds available with the company are invested for generating revenue (income) for the enterprise. The difference between such ‘revenue earned’ and the ‘cost paid’ on the capital is called ‘profit’, and this process is called as the ‘profitability process’. Basic aim of business is profit generation through positive difference between income and expenditure. The business process is based on the principle of revenue generation through sales generated by meeting customers’ requirements and providing satisfaction to the customers. Thus, production and marketing are the basic workhorses for profit generation. External business environmental factors have strong influence of profitability of the firm. Therefore, different types of business strategies are adopted to ensure optimum degree of profitability for the enterprise. In trade and business: Profit = Price – {Costs of production (and all allied expenditures)}

– (Depreciation) – (Taxes as payable) Therefore, ‘cost reduction’ and ‘competitive advantage’ are the two very important strategies for enhancing profitability for the enterprise. Profitability is closely linked with effective utilisation of funds, particularly the cash funds of the enterprise. Thus cash management has an influence on profitability. Companies generally face the risk of ‘running out of cash’ when the need arises to make payment through cash money. All companies want to ensure liquidity and avoid risk of becoming technical bankruptcy. Therefore, all business enterprise try to keep certain additional cash then what is necessary. But, keeping excess cash money means idle money which is not earning revenue. This has adverse effect of profitability of the company. Therefore there is a need for trade-off between liquidity and profitability.

3.3 Business Valuation The term ‘valuation’ implies estimation of value of the asset, security-instrument, or a business. The purchasing decision regarding an asset is based on such a valuation. But there is no specific method of valuation of any asset; it is only based on estimation. Two different buyers may have different understanding regarding the worth/value of an asset. Business valuation is required to be done both for tangible as well as for intangible assets. Similarly the business liabilities may be both recorded liabilities and also unrecorded liabilities. Thus, the valuation process is affected by subjective considerations. Book Value: The assets are shown in the ‘Balance Sheet’ and certain value is mentioned there. This value is called the ‘book value’ of the asset. Generally, this amount is the ‘initial acquisition cost’ of the


asset less the accumulated depreciation. This method of valuation is as per the principles of accounting. This ‘book value’ of an asset may differ with its sale value. The sum of book values of all assets of a business firm less the total of its ‘external liabilities’ including preference shares gives the book value or net worth of a business entity. Market Value: The value at which the asset can be sold in the market, is called its market value. This valuation can be applied only to the tangible assets of a business entity. The intangible assets cannot be sold or purchased in the market. Therefore, they do not have market value. Market value of a company, listed in stock exchange, refers to the total price of all shares of the company as per the quotation in a stock exchange. Intrinsic Value: The intrinsic value of an asset is given by the discounted values of future cash-inflows likely to occur due to the particular asset. When an asset is acquired and put to use, it is likely to earn certain cash flows in coming time. These cash-inflows are discounted at the appropriate ‘rate of return’ to get the intrinsic or economic value of the asset. It is also an indication of maximum price a buyer may be willing to pay. This method of valuation using ‘discounted values’ of future cash flow is similar to the methodology used for ‘Capital Budgeting Decision-Making’. (For ‘present value’ and ‘discounted value’, see the previous Unit on ‘Time-Value of Money’.) Value of Goodwill: It has been noticed that business entities enjoying market ‘goodwill’, earn higher rate of return (ROR) on invested funds than by a similar firms without goodwill. As per this concept of goodwill, the value of goodwill is equivalent to the ‘discounted present value’ of such “additional profits due to goodwill”, likely to accrue in future. Fair Value: The ‘fair value’ of an asset or a business is in fact the hybrid of the book value, intrinsic value, and market value. It is most often is the average of these three values.

3.4 Financial Stability A firm acquires its assets using two types of funds: its equity funds or the borrowed capital (liabilities). The “liability” includes the borrowed capital and also value of goods provided by the creditors as per the general business practice. ‘Owners equity’ (paid by owners/promoters and general public) is the internal or owner's fund. If the liabilities are greater than the owner's equity, than the firm can face a financial problem; as the creditors can demand their money, which the firm may not be able to pay at that particular time. This is a risk, which the business must avoid. In such a circumstance, if the creditors demand payment, ‘owner’ may not be able to meet that obligation and the firm may fail. Therefore, the business should be able to demonstrate that:

It can pay the creditors when payment is due.

The profitability of the business is increasing.

It has enough profits to cover the interests on liabilities.

Its net cash flow is positive.

3.5 Cost Projections


Before starting any venture or project, a proper estimate is needed for the total cost involved in different kinds of expenditures. At a preliminary stage, when exact cost figures are not available, a broad ‘projection of costs involved’ is made to prepare the first estimate of the total cost involved. Compilation of “cost projections” for proposed task/investment/project involves following steps:

Identification of broad heads of expenditures;

Further, identification of “minor heads of expenditure” involved for each broad major-heads of expenditure for the proposed tasks/activities;

Making best possible financial estimates of costs for each expenditure-head so identified;

Summing up the estimated expenditures for all work-packages identified under above steps;

Adding any further cost due to any other activities required to be undertaken to complete the procedural requirements or other necessities.

Thus “cost projection” is carried out during the project planning stage for a project needing financial investments. ‘Cost-projection statement’ and its analysis are the essential steps for estimating the future investments. The cost projections for a business project cover the cost of procurement of all assets, lease-based procurement costs, and also the amounts for all payable taxes. Further, there is a need for adding the capital required for purchasing the hardware-equipment required for business and the associated software; and also cost of training of employees.


UNIT 4. BUSINESS RISKS

4.1 Concept of Risk 4.2 Systematic & Unsystematic Risks 4.3 Managing Risk: Trade-Off between Risk & Return 4.4 Risk-Modelling

4.1 Concept of Risk Exact guess regarding the ‘future returns on investment’ can be made only in case of investments carrying a fixed rate of return. For other type of investments, it is not possible to guess the future rate of return. The situation where rate of return can be guessed, poses financial ‘risk’. Risk is defined as the “variability that is likely to occur in future cash flows from an investment”. Larger the ‘variability of likely return’, higher is the financial risks. Uncertain outcomes mean financial risks. A ‘state of certainty’ means zero level of risk. Risk is a situation between ‘certainty’ and ‘uncertainty’. Higher the degree of uncertainty, higher is the degree of risk.

4.2 Systematic & Unsystematic Risks 4.2.1 Systematic Risks Systematic risks refer to situations, where the cause of risk can be understood and explained. Such factors affect all business in a similar way. Its systematic nature makes it explainable. For example, market related risk factors affect all business organisations operating in the market. Such market-related factors include changes in interest rates, and taxation policies etc. These types of risks are not manageable by individual investor or business entity. Systematic risks can be divided into following categories: market risks, interest rate risk, and purchasing power risk.

(a) Market Risk: This risk refers to the situation when changes in market related factors reduce the profitability of business. This may be due to change in cost of finance or relating to cost of commodities required for business. Four factors may contribute to such risks:

Equity Risk arising out of changes (generally big fall) in equity share prices making it difficult to raise market finance;

Loan-Interest Rate Risk arising from variation (increase) in Loan-Interest rate etc, Currency Risk arising from variation in foreign exchange rate, and Commodity Risk arising due to change (increase) in commodity prices due to changes in

demand-supply conditions and or due to inflation.

(b) Interest Rate Risk: Change in the interest-rate affects the ‘net cost of assets’ which are acquired using such loans. This may increase the cost of future investment, and introduce uncertainties in the likely income from such assets.

(c) Purchasing Power Risk: Changes in inflation or deflation bring a change in the prices of goods and services, needed for running the business operations. Further, there may be changes in market demand-supply position.


4.2.2 Unsystematic Risks Unsystematic risks refer to the factors which do not affect all business units in the same manner, but differently. For example, such factors may relate to changes in import/export policies, price rise in certain raw materials, and labour unrest etc. These are specific to certain types of businesses, and not the market as a whole. Unsystematic risks may have variety of reasons. One example is increase in cost of raw material and other inputs for some types of business. Such risks are specific only to few types of businesses for some period of time. These risks are commonly called “Business Risks”. Financial Risks refer to “the situations where the revenue generated from the business are insufficient to cover the fixed charges like interest payments on debt payable. Management Risk refers to the situation when the managers of a business firm lack the required managerial knowledge and expertise manage the business operations and the competition, thereby not able to ensure profitably of business in a particular situation arising due to external business environment.

4.3 Managing Risk: Trade-Off between Risk & Return It is generally said that “risks are inevitable and have to be faced”. Business practices show that greater the risk, greater the gain. As stated earlier, ‘return’ is defined as the variability of expected returns from an investment. “Return is the gain or loss expected over a period of time”. Business managers attempt to maximise/optimise the returns from their investments by adopting a “trade-off” between risk and return. In business operations, returns and risks go together. Business decisions are based on finding optimal “risk-return trade-off”. If risk can be assessed properly, a comparison of return and risk is meaningful; and trade-off can be attempted. Risk arises when ‘expected return’ is not known precisely. As the risk arises due to variability in the expectations, risk can be assessed through measurement of variability using statistical techniques, namely (i) standard deviation, (ii) variance, (iii) co-efficient of variation, (iv) skewness, and (v) probability distribution.

4.4 Risk-Modelling Capital Asset Pricing Model (CAPM): The standard deviation of the returns on the portfolio is used as an indicator of increase or decrease of risk. Thus, if adding a stock to a particular portfolio increases its standard deviation, then it means that the new stock adds to the risk of the portfolio. A variable ‘Beta’ is used to assess the systematic risks. Beta is defined as under. Risk of the Market Portfolio when New Asset is added it

Beta = Risk of the Market Portfolio


Thus, ‘Beta’ is a measure of the systematic risk of an asset relative to that of the market portfolio. Beta value of 1, indicates an asset of average risk. Beta value > 1, indicates that the selected investment is riskier than the average level of market-risk. Beta value < 1, indicates that new investment is less riskier than the market level.

II. BE ABLE TO ANALYSE PUBLISHED FINANCIAL

STATEMENTS FOR STRATEGIC DECISION MAKING

PURPOSES


UNIT 5. PUBLISHED ACCOUNTS

5.1 Purpose of Published Accounts or Financial Statements 5.2 Users of Published Information 5.3 Annual Report of the Company 5.4 Internal Management Accounts versus Published Financial Accounts 5.5 Weakness of Published Accounts

5.1 Purpose of Published Accounts or Financial Statements As per companies Act, business companies are required to disclose and publish their financial accounts or financial statements every year. The Financial Statements are summarised statements of ‘accounting data’ prepared at the end of an accounting year. “As required by the law, these serve as a medium of disclosing accounting information for use by the internal and external users”. Following documents form part of the Yearly Financial Statements of a company:

Balance Sheet: It is a statement of ‘assets’ and ‘liabilities, and their constituents, of the company at a particular date, generally the end of the accounting year.

Statement of Profit and Loss: It is a statement showing the result of business operations in terms of the income and expenditure made during the accounting year.

Notes to Accounts: It provides the details of items mentioned in the ‘Balance Sheet’ and the ‘Statement of Profits and Loss’.

Cash Flow Statement: it shows the flow of cash into the company (called Cash In-Flows or the Receipts) and the cash flowing out of the company (called Cash Out-Flows or the Payments).

The objectives of financial statements are to disclose:

Financial data on assets and the liabilities of the company at the end of the accounting year.

Implications of financial profits on the financial-performance of the company.

Summarised financial information about the company for use by various interested parties.

Fair and correct picture of the “financial position of the company” as required under the Laws.

It also serves as the basis of further reporting on the business operations of the company.

5.2 Users of Published Information

(a) Internal Users The internal users of financial statements of a company may be classified in three categories as under:

Shareholders: They have invested in the “equity of the company” and have a right to know the ‘true picture’ regarding the financial position of the company, particularly its profitability, assets, liability, and cash position.

Company’s Management: They are responsible to manage the operations and profitability of the company. For this purpose, they need summarised financial position for taking appropriate decisions.


Company’s Employees: The employees have interest in the growth and profitability of the company, as their bonus is liked with the profits and the reserves of the company.

(b) External Users

The external users of financial statements of a company may be categorised as under:

Investors: They need authenticated statement of financial position of the company so as to decide about continuing with their investments.

Creditors: As per business practice, materials and semi-finished goods are supplied to the company on credit basis. The terms and conditions of credit vary with the financial position of a company. Therefore, the suppliers (as creditors) need to know authentic statements of financial position of a company.

Banks and Other Lenders: As providers of loans, they are interested to know the true financial positions of the company so as to safeguard their loans and to ensure timely recovery of their loans. Cash Flow Statements provide useful information to assess the cash position of the company.

Industry Bodies and Government Agencies: Government agencies make assessment of business related factors and to make assessment about various industry segments so as to make appropriate policies for industrial development and growth.

5.3 Annual Report of the Company A company is required, as per the law, to publish its Annual Report and provide prescribed information to help the users in making appropriate financial judgements and decisions about the company. The information is required to be disclosed in the Financial Statements, Board Report, and by a separate statement being part of the annual report. The Annual Report of a company comprises of following documents:

A Report submitted by the Board of Directors having: A report prepared according to the Company’s Act and summarising the business

environment, company’s performance, and the results in brief; Director’s Responsibility Statement’; Report on Corporate Governance’; and Discussion/Comments by the Management.

Auditor’s Report, as per the provisions of the Company’s Act.

Financial Statements including: Balance Sheet as on the last day of the accounting year; Statement of Profits & Loss for the year ended; and Cash Flow Statement. Notes to the Accounts, providing:

o Accounting Policy followed by the Company; o Notes to the Accounts giving details of the Items mentioned in the ‘Balance

Sheet’ and the ‘Statement of Profit & Loss’; and Other additional information required to be disclosed in terms of the Company’s Act.

As per the company’s Act, a company is required to hold a meeting of all shareholders once a year, called the Annual General Meeting (AGM). This meeting is convened to adopt, consider and approve the Board’s Report, Balance Sheet, Statement of Profit and Loss, and the Cash Flow Statement. The meeting also considers the report of the Auditors appointed for the company in the last AGM.


The Auditors are required to examine the Books of Accounts of the company, make a considered professional opinion on the financial figures provided in the ‘Balance Sheet’ and the ‘Statement of Profit and Loss’. The Auditors record their expert-views, which are included in the Auditor’s Report. The Annual Report is submitted to the shareholders for consideration in the Annual General Meeting.

5.4 Internal Management Accounts versus Published Financial Accounts Financial accounting is prepared to meet the requirements of the Companies Act for providing information regarding ‘financial performance in the last accounting year’ to the shareholders, bankers, creditors, and others who are outside the organisation. Management Accounting is defined as the “process of identification, measurement, analysis, interpretation, and communication of information for use by the management in planning, evaluating, and controlling the business operations within the organisation.” Management accounting refers to (i) analysing the financial performance of a company and (ii) generating financial inputs for the management of the organisation, for use in financial planning (for the future) and for appropriate decision-making (for the present). Management accounting is prepared to meet the specific requirement(s) of the business-managers. Managerial accounting generates financial data for running the business activities of the organisation. Financial accounting provides the summarised authenticated “financial results” useful for evaluating the company’s past performance. Major differences between financial accounting and managerial accounting are as under:-

Financial accounting covers business results of the entire organisation, but management accounting may be prepared for a part of the organisation.

Financial accounting discloses the financial results of the business for its stakeholders as per the requirement stipulated in the Company’s Act. But management accounting information is prepared to provide to generate certain information required by the management of the organisation for planning and goal-setting.

Financial accounting provides “reports on the past performance” whereas the management accounting aims at supporting the activities of the future.

Financial accounting reports are prepared as per a specified format, but management accounting reports may be prepared in any format.

5.5 Weakness of Published Accounts The financial statements provide summarised financial information about a company, for a particular accounting period. While making a summary, specific details are not mentioned and are lost in the process. Their limitations are described as under:

Use of different accounting practices may present all together different picture.

Presents only the historic summarised statements, but not full year’s picture.

These are based on accounting practices.

Financial statements present company’s position in monetary terms. Only quantitative picture is presented, and qualitative explaination is not provided.

Only a summarised picture is presented; details of various transactions of business activities are not presented.


UNIT 6. STRUCTURE OF FINANCIAL STATEMENTS

6.1 Main Financial Statements 6.2 Balance Sheet 6.3 Statement of Profit and Loss 6.4 Cash Flow Statement 6.5 Notes to Accounts

6.1 Main Financial Statements

As mentioned in the last unit, financial statements are the ‘summarised statements’ of ‘accounting data’ as on the last day of the ‘accounting period’. These comprise of:

Balance Sheet,

Statement of Profit and Loss,

Cash Flow Statement; and

Notes to Accounts

6.2 Balance Sheet Format of the Balance Sheet

Name of the Company: ..............................; Balance Sheet as on ......................................

Particulars Note Figures as at the Figures as at the No end of the current end of the Previous Reporting Period Reporting Period I EQUITY & LIABILITIES

Shareholders’ Funds: o Share Capital o Reserves & Surplus o Money Received against Share Warrants

Share Application Money Pending Allotment

Non-Current Liabilities: o Long-Term Borrowings o Deferred Tax Liabilities (Net) o Other Long-Term Liabilities o Long-Term Provisions

Current Liabilities: o Short-Term Borrowings o Trade Payables o Other Current Liabilities o Short-Term Provisions

TOTAL =

II ASSETS

Non-Current Assets: o Fixed Assets o Non-Current Investments o Deferred Tax Assets (Net) o Long-Term Loans and Advances o Other / Non-Currents Assets


Current Assets: o Current Investments o Inventories o Trade Receivables o Cash and Cash-Equivalents o Short-Term Loans & Advances o Other Current Assets

TOTAL =.

Balance Sheet provides a summarised statement of company’s equity, assets and liabilities, as on the last day of the accounting year. It is presented in two segments: (i) equity & liabilities; and the (ii) assets. 6.2.1 Equity & Liabilities Equity is treated as a liability as it is a sum provided by shareholders; and the company is liable to earn profit on the equity capital. It includes the followings:

Ordinary Share Capital

Preference Share Capital

Reserves and Surplus (accumulated amount of ‘retained profit’ over earlier years), and

Money Received against Share Warrants (awaiting allotment of shares at a later date). Liabilities:

Liabilities of a company refer to the amounts/loans/debts payable by the company. These are presented in two sets: (i) Current Liabilities and the (ii) Non-Current Liabilities.

(a) Current Liabilities are those which are payable within 12 months; and include liabilities which

are likely to be settled:

Within 12 months from the ‘reporting date’;

Within the Operating Cycle of the Company;

Current Liabilities include:

Short-Term Borrowings;

Short-Term Provisions for other payments likely to become due in 12 months;

Debts of long term nature payable within 12 months;

Amount payable in Trade Circle for goods obtained on credit basis;

Interests not yet payable but will become due later;

Income received in advance; and

Dividends not yet collected by shareholders.

(b) Non-Current Liabilities As per the Companies Act, non-current liabilities are those which are payable in time of more than 12 months, and include the followings:

Long Term Borrowings: Repayable after 12 months of date of balance sheet. These may include bonds, debentures, term loans, and deposits received from public.

Deferred Tax Liabilities (Net): These relate to the taxes on income, which will become payable on a later date as fixed by tax authorities.


Other Long Term Liabilities: These include (i) ‘trade payables’ for goods & services procured, and the payments becoming due after 12 months from the date of balance sheet, and (ii) other amounts payables after 12 months of balance sheet.

Long Term Provisions: These are amounts kept aside to meet the future liabilities. 6.2.2 Assets As per Companies Act, assets are of two types: (i) current assets and the (ii) non-current assets. Non-current assets are defined in a negative manner; meaning the “non-current assets are those assets which are not the current assets”.

Current Assets: Current assets are defined in the Companies Act, as the assets which are:

Expected to be encashed or sold within the normal operating cycle;

Acquired and held for short-term for sole purpose of trading;

Cash and cash-equivalent, encashable within 12 months of the date of balance sheet. These are classified under following headings:

Current Investments: These investments are expected to be converted into cash within 12 months of date of purchase.

Inventories: These include raw material, work-in-progress, finished goods, stock-in-trade, stores, spares and tools etc used as part of the manufacturing process.

Trade Receivables: These relate to cash to be received within 12 months of balance sheet, for the goods sold on credit-terms.

Cash and Cash Equivalents: This includes cash in hand, cash held in banks, cheques and drafts yet to be encashed, and bank deposits with maturity date within 12 months of balance sheet.

Short Term Loans and Advances: These are expected to be realised within 12 months of balance sheet.

Other current Assets.

Non-Current Asset: These are classified as under:

Fixed Assets: These assets support revenue-generation process of the company and are generally not intended for sale. These include both the tangible and intangible assets.

Non-Current Investments: These assets are intended to be held for long time.

Deferred Tax Assets (Net): If the accounting income is less than the taxable income, it results in Deferred Tax Asset (Net).

Long Term Loans & Advances to other parties, expected to be received back after 12 months of balance sheet.

Other Non Current Assets, like the long-term trade receivables to be received after 12 months of balance sheet.


6.3 Statement of Profit and Loss The format of Statement of Profit and Loss is given on the next page.

This statement shows the financial performance of the company in terms of the ‘profit earned’ or ‘loss incurred’ during the particular accounting period. The difference between ‘revenue’ and the ‘expenses’ shows the profit or the loss for the accounting year. The column for “Note No” is provided for the purpose of creating a ‘cross-reference number’ which also appears in the “Notes for Accounts” where the details about this entry can be seen against this particular “Note No”. Various terms used in ‘Statement of Profit and Loss’ are described below in succeeding paragraphs.

Format of Statement of Profit & Loss Name of the Company: ................. , Statement of Profit and Loss for the Year ended on ......................

Particulars Note Figures as at the Figures as at the No end of the Current end of the Previous Reporting Period Reporting Period I Revenue from Operations II Other Income III Total Revenue (I + II)

IV Expenses: o Cost of Materials Consumed o Purchase of Stock-in-Trade o Change in Inventories of Finished Goods o Work-in-Progress and Stock-in-Trade o Employees Benefit Expenses o Finance Costs o Depreciation and Amortisation Expenses o Other Expenses Total Expenses

V Profit before Tax (III – IV) VI Less Tax VII Profit or Loss for the Period (V – VI)

6.3.1 Revenue

(a) Revenue from the Operations: ‘Revenue from operations’ means ‘income’ earned by the company from its business operations.

(b) Other Income: A company, besides earning revenue from its main operations, may also earn income from sources other than its main activities. Such incomes are shown as ‘Other Income’ in the statement of profit and loss.

6.3.2 Expenses:


(a) Cost of Material Consumed: The term ‘material’ means raw material and other materials used in manufacturing of goods. ‘Cost of material used’ means cost of raw materials and other materials consumed in manufacturing the goods.

(b) Purchase of Stock-in-Trade: Purchase of Stock-in-Trade means goods purchased for trading or resale purposes. For example, if a company buys steel for making steel-components as part of manufacturing process, then this expenditure will be shown under “cost of material used”. However, if steel if bought for trading purposes to be resold on profit, than it will be shown under “Purchase of Stock-in-Trade.”.

(c) Change in Inventories of Finished Goods, Work-in-Progress and Stock-in-Trade: It means difference between the Opening and Closing Inventories (Stock) of Finished Goods, Work-in-Progress and Stock-in-Trade.

(d) Employees Benefit Expanses: It means payments made towards expenditure relating to the Employees of the business. This may include payment for wages, salaries, bonus, and employee welfare activities.

(e) Financial Costs: Financial costs means expenditure incurred by the company on the financial activities, like the interests paid on its borrowings from banks and other sources (like debentures and bonds etc).

(f) Other Expanses: The expanses that are not shown under the above headings are shown under ‘Other Expanses’.

6.4 Cash Flow Statement

The Format of Cash Flow Statement is as given below.

Name of Company: ............., Cash Flow Statement for the Year ended : ..................

Particulars Amount Total for the for this Item Main Head I Cash Flow from Operating Activities A. Net Profit before Tax and Extraordinary Item (as per Working Note) --- Adjustment for Non-Cash and Non Operating Items B Add: Items to be added

Depreciation --- Goodwill, Patents and Trademarks and Amortised --- Interest on Bank Overdraft/Cash Credits --- Interest on Borrowings (Short-term and Long Term) and Debentures --- Loss on Sale of Fixed Assets --- Increase in Provision for Doubtful Debts --- ---

C Less: Items to be Deducted Interest Income --- Dividend Income --- Rental Income --- Gain (Profit) on Sale of Fixed Assets --- Decrease in Provision for Doubtful Debts --- ---

D Operating Profit before Working capital Changes (A + B – C) --- E Add: Decrease in Current Asset and

Increase in Current Liabilities Decrease in Inventories (Stock) --- Decrease in Trade Receivables (Debtors / Bills Receivable) --- Decrease in Accrued Income --- Decrease in Pre-Paid Expenses --- Increase in Trade Payables (Creditors/Bills Payables) --- Increase in Outstanding Expenses --- Increase in Advance Income --- ---


F Less: Increase in Current Assets and Decrease in Current Liabilities Increase in Inventories (Stock) --- Increase in Trade Receivables (Debtors / Bills Receivables) --- Increase in Accrued Incomes --- Increase in Pre-Paid Expenses --- Decrease in Trade Payables (Creditors / Bills Payables) --- Decrease in Outstanding Expenses --- Decrease in Advance Incomes --- ---

G Cash Generated from Operations (D + E – F) --- H Less: Income Tax Paid (Net of Tax Refund received) --- I Cash Flow before Extraordinary Items ---

Extraordinary Items (+/-) --- J Cash Flow from (or Used in) Operating Activities --- II Cash Flow from Investing Activities

Proceed from Sale of Fixed Assets --- Proceeds from Sale of Investments (Other than Current Investments

(to be included in Cash and cash equivalents) and Marketable Securities) --- Proceeds from Sale of Intangible Assets --- Interests and Dividend Received (For Non-financial Companies only) --- Rent Received --- Payment for Purchase of Fixed Assets (---) Payments for Purchase of Investments ( Other than Marketable Securities) (---) Payments for Purchase of Intangible Assets like Goodwill (---) Extraordinary Items (e.g. Insurance Claims on Machinery against fire) (+/-) ---

Cash Flow from (or Used in) Investing Activities --- III Cash Flow from Financing Activities

Proceeds from Issue of Shares and Debentures --- Proceeds from Other Long Term Borrowings --- Increase/Decrease in Bank Overdraft and Cash Credit --- Payment of Final Dividend --- Payment of Interim Dividend (---) Payment of Interest on Debentures and Loans (Short Term and Long Term) (---) Repayment of Loans (---) Redemption of Debentures/Preference Shares (---) Payment of Share Issue Expanses (---) Payments for Buy-back of Shares as Extra-Ordinary Activity (---)

Cash Flow from (or Used in) Financing Activities --- IV Net Increase/Decrease in Cash and Cash Equivalents (1 + 2 + 3) --- V Add: Cash and Cash Equivalents in the beginning of the Year

Cash-in-Hand --- Cash at Bank --- Short-term Deposits --- Current Investments --- Marketable Securities --- ---

--- VI Cash and Cash Equivalent at the end of the Year

Cash-in-Hand --- Cash at Bank --- Short-term Deposits --- Current Investments --- Marketable Securities --- ---

Working Note: Net Profit before Tax and Extraordinary Items Net Profit as per Statement of Profit and Loss or Difference between Closing Balance and Opening Balance of Surplus, i.e. Balance in Statement of Profit and Loss. ---


Add: Transfer to Reserves --- Proposed Dividend for Current Year --- Interim Dividend paid during the Year --- Provision for Tax for the Current Year --- Extra-Ordinary Items, if any, debited to the Statement of Profit and Loss ---

--- Less: Extra-Ordinary Items, if any, credited to the Statement of Profit and Loss ---

Refund of Tax credited to the Statement of profit and Loss --- --- Net Profit before Tax and Extra-Ordinary Items ---

Cash Flow Statement is a statement that shows the flow of ‘Cash and Cash Equivalents’ during the accounting period. Receipt of cash money is shown as “Cash-inflows” and the cash payments are shown as the “Cash-outflows”. The ‘Accounting Standards’ require Cash Flow Statements to be prepared showing cash flows under three heads:

Cash Flow from Operating Activities,

Cash flow from Investing Activities, and

Cash flow from Financing Activities. The “Cash Flow Statement” is prepared by computing cash-flows from each of the above activities. Following steps are followed:

For each of above three activities, ‘cash inflows’ and ‘cash outflows’ for various transactions are computed. Summing up such individual cases of cash flows, net sum of cash flows of these three activities is obtained. This gives the net change in cash flow, which may be a positive or negative number or even be zero.

‘Cash and cash equivalent’ balance in the beginning of the year is added to the net change in cash flow. This provides the net ‘cash and cash equivalents’ at the year end.

6.5 Notes to Accounts ‘Notes to Accounts’ is the statement attached to the Financial Statements. It has the details of items/entries covered under ‘Balance Sheet’ and the ‘Statement of Profit and Loss’. In addition, it also mentions the Accounting Policies adopted and additional information required to be disclosed as per the requirements of the Company Act.


UNIT 7. ANALYSIS & INTERPRETATION OF FINANCIAL

STATEMENTS

7.1 Analysis of Financial Statements 7.2 Types of Financial Statements Analysis 7.3 Purpose of Financial Analysis 7.4 Comparison between Years 7.5 Company/Industry Comparisons & Benchmarking 7.6 Difference between Capital and Revenue Expenditure

7.1 Analysis of Financial Statements Financial Statements of business companies provide information about ‘assets’, ‘liabilities’, ‘equity’, ‘revenues’, ‘expenses’, and ‘profit or loss’ of an enterprise in absolute amounts as on the last day of a particular accounting year. These are analysed with the financial statements of (i) the same enterprise for earlier years, or (ii) with that of another similar enterprise operating in similar business environment. Methods used for analysis of Financial Statements, and are briefly described in this Unit. 7.1.1 Comparative Statement ‘Comparative Statement’ is also called the ‘Comparative Financial Statement’. It is used for making comparative study of various items covered in the Financial Statements, namely ‘Balance Sheet’ and ‘Statement of Profit & Loss’ of two or more years of a company. In Comparative Statement, amounts of two or more years, for each item, are placed side by side. Then in the next two columns, the ‘change in amount’ is written in absolute amount and in percentage terms. Thus, comparison of yearly figures can be made and difference can be seen in absolute value and also in terms of percentage change. This method can be used both for ‘Balance Sheet’ and for ‘Statement of Profit & Loss’. 7.1.2 Common-Size Statement ‘Common Size Statements’ are also called ‘Common Size Financial Statements’. In this method, various items of the Financial Statements of two or more years are placed side by side; and then in the next column, these are converted into percentage taking a ‘common base’. The ‘common base’ normally taken is (i) “Total of Assets” or “Total of Equity & Liabilities”, for Common Size Balance Sheet; and (ii) “Revenue from Operations” for Common Size Statement of Profit & Loss. In the Balance Sheet, the total of ‘Assets’ or ‘Equity & Liabilities’ is take as 100; and all the figures are expressed as percentage of the total. Similarly in the Statement of Profit & Loss, ‘Revenue from Operations’ is taken as 100 and all amounts are converted as percentage of ‘Revenue from Operations’. 7.1.3 Ratio Analysis Ratio expresses arithmetic relationship between two items of Financial Statement, which related or inter-dependent in nature. This method can be used for both, the ‘Balance Sheet’ and ‘Statement of Profit & Loss’.


7.1.4 Cash Flow Statement Cash Flow Statement is a statement showing flow of ‘Cash and Cash Equivalents’ during the accounting period. It shows from where the flow started and where it was received. This is shown both for expenditure (Cash-outflows) and for income/receipts (cash-inflows). It also shows the changes in ‘net-cash positions’ from one accounting period to another.

7.2 Types of Financial Statement Analysis Generally, there are four types of Financial Statement Analysis, as described below. External Analysis: External analysis is conducted by people/agencies external to the business organisation, who do not have access to the financial records of a company and, therefore, have to depend on the published accounts, i.e. Statement of Profit and Loss, Balance Sheet, Directors’ & Auditors Report. Internal Analysis: Internal analysis is conducted by the management of the organisation to know the deeper insights of financial position and operational efficiency. As total financial records are available to the management, such analysis can be very elaborate. Horizontal (or Dynamic) Analysis: It refers to comparative analysis of specific items of financial statements for different years of operation of business. It presents comparison of figures for certain financial data for different years by taking ‘values of a particular year’ as the base value. It facilitates trend analysis and is useful for making forecasting and planning for the company. It generally uses comparative financial statement for making year-wise analysis. Vertical (or Static) Analysis: Such an analysis compares different figures of the same year statements by expressing the result as ratio or percentage. Ratio Analysis of the Financial Statement for one accounting year is also vertical analysis. This analysis is useful in comparing the performance of several companies of the same type or divisions or departments in one company.

7.3 Purpose of Financial Analysis Financial analysis serves the following purposes and brings out the significance of such analysis. Assessment of Earning Capacity or Profitability: Financial Statements provide information regarding yearly earnings and profitability of a company. Using ‘trend analysis’ and ‘extrapolation technique’, future earning in coming years may also be forecasted for purpose of planning and budgeting. Further, long-term creditors are generally interested in earning-capacity forecast. Assessing the Managerial Efficiency: ‘Financial-Statement Analysis’ is used to generate comparative information regarding various heads of business performance. It thus helps to identify the areas where the management have been efficient. Any variation can be identified and analysed to focus on various degrees of managerial efficiency. Assessing the Short-Term and the Long Term Solvency of the Company: Long-term and the short-term solvency of a company can be assessed on the basis of financial statement analysis. Both ‘cash flow


analysis’ and ‘ratio analysis’ provide information regarding liquidity and solvency position of the company. Forecasting and Budgeting: Using the method of ‘Comparative Financial Statements’, it is possible to carry out trend analysis for various financial parameters. Using extrapolation technique, the financial trends can be extended or extrapolated to make forecast regarding the next year or future years. Such information is very useful for budgeting exercises.

7.4 Comparison between Years Use of Comparative Statements or Comparative Financial Statements facilitates comparison between financial performances for two or more accounting years. Comparative Statements show the changes in each item with respect to the figures of the base year in ‘absolute amount’ and in ‘percentage’. 7.4.1 “Comparison between Years” based on ‘Comparative Balance Sheet’ The format of Comparative Balance Sheet is as given below:

Name of the Company: ..............................; Balance Sheet as on ......................................

Particulars Note Figures for Figures for Absolute Change Percentage Change No Previous Year Current Year Increase/Decrease Increase / Decrease

(1) (2) (3) (4) (5) (6)

(A) (B) (B – A) 1/A {(B – A) x 100} I EQUITY & LIABILITIES 1 Shareholders’ Funds

Share Capital Reserves & Surplus Money against Share Warrants

2 Money Pending Share Allotment 3 Non-Current Liabilities

Long-Term Borrowings Deferred Tax Liabilities (Net) Other Long-Term Liabilities Long-Term Provisions

4 Current Liabilities Short-Term Borrowings Trade Payables Other Current Liabilities Short-Term Provisions

TOTAL =

II ASSETS 1 Non-Current Assets

Fixed Assets Non-Current Investments Deferred Tax Assets (Net) Long-Term Loans & Advances Other / Non-Currents Assets

2. Current Assets Current Investments Inventories Trade Receivables Cash and Cash-Equivalents Short-Term Loans & Advances


Other Current Assets TOTAL =

Two additional columns are added to the standard format of Balance Sheet. The first ‘additional column’ is used to compute ‘difference in values’ for current year and previous year. The other additional column is used to convert the ‘difference in values’ to the percentage of value (using the value for the previous year as the basis). This indicates the change in value between the two years as the percentage value with respect to value for previous year. As shown in format given above, the “Comparative Balance Sheet” has six columns which are constructed as mentioned below:

Column 1: This Column is same as that of the Balance Sheet for the current year.

Column 2: in this column, the “Note No” given against each line in the Balance Sheet is repeated here.

Column 3: Here the amounts for the previous year (Amount ‘A’) are written, for each item.

Column 4: Here the amounts for the current year (Amount ‘B’) are written for each item

Column 5: Here “difference” in value for current year and for previous year (Amount B –A) is written against each item.

Column 6: Here, the “difference” computed above, is expressed as percentage of the ‘amount for the previous year’ (as the base for the calculations).

As seen for the format, a comparison is made with the data for the base year, and it generates following data/information for other (desired) year in following ways:

The values in absolute amounts;

Increase or decrease in absolute amounts;

Increase or decrease in terms of percentages; 7.4.2 Format of Comparative Statement of Profit & Loss The format for comparative statement of profit & Loss is as given under: Name of the Company: ................. , Statement of Profit and Loss for the Year ended on ......................

Particulars Note Figures for Figures for Absolute Change Percentage

No Previous Year Current Year Increase/ Increase / Decrease Decrease

(1) (2) (3) (4) (5) (6)

(A) (B) (B – A) 1/A {(B – A) x 100}

I Revenue from Operations II Other Income III Total Revenue (I + II)

IV Expenses Cost of Materials Consumed Purchase of Stock-in-Trade Change in Inventories of Finished Goods Work-in-Progress and Stock-in-Trade Employees Benefit Expenses Finance Costs Depreciation and Amortisation Expenses Other Expenses Total Expenses


V Profit before Tax (III – IV) VI Income Tax Payable VII Profit or Loss for the Period (V – VI)

7.4.3 Comparative Financial Statements Using Common Size Statement In the ‘Common-Size Financial Statement’, the amounts of various items of Balance Sheet or Statement of Profit & Loss, for the previous and current years are written in their respective columns (as in comparative statement). In next two columns, these are converted into percentages to a ‘common base’. This common base for Statement of Profit and Loss is ‘Revenue from Operations’. The common base for Balance Sheet is taken as the ‘total of Balance Sheet’. The percentage so calculated can be compared with the corresponding percentages in other periods of time. For example, in case of Common Size Statement for Profit & Loss, the value of ‘revenue from operations’ is taken as 100 (i.e. 100%). All other items are expressed as percentage of ‘absolute value of revenue from operations’. Common Size Statement of Profit and Loss may be prepared for different period of time for the company or for the same period for two companies. 7.4.4 Common Size Statement for Profit & Loss The format of ‘Common Size Statement of Profit & Loss’ is given below:- Name of the Company: ................. , Statement of Profit and Loss for the Year ended on ...................... Absolute Amounts Percents of Revenue from

Operations (Net Sales)

Particulars Note Figures for Figures for Previous Year Current Year No Previous Year Current Year Percentage Percentage

(1) (2) (3) (4) (5) (6) I Revenue from Operations --- --- --- 100% 100% II Other Income --- --- --- --- --- III Total Revenue (I + II) --- --- --- --- ---

IV Expenses Cost of Materials Consumed --- --- --- --- --- Purchase of Stock-in-Trade --- --- --- --- --- Change in Inventories of Finished Goods --- --- --- --- --- Work-in-Progress and Stock-in-Trade --- --- --- --- --- Employees Benefit Expenses --- --- --- --- --- Finance Costs --- --- --- --- --- Depreciation and Amortisation Expenses --- --- --- --- --- Other Expenses --- --- --- --- --- Total Expenses --- --- --- --- --- V Profit before Tax (III - IV) --- --- --- --- --- VI Less Income Tax --- --- --- --- --- VII Profit or Loss for the Period (V – VI) --- --- --- --- ---


Preparation of Common Size Statement of Profit & Loss is done with six columns (as for the Comparative Statement):

First Column: In this column, the usual items of Statement of Profit & Loss i.e. ‘revenue’ and ‘expenses’ are written.

Second Column: In this column, “Note No” given against the Item(s) in the Statement of Profit & Loss is written.

Third Column: In this column, amounts of previous year are written as the Statement is prepared for different period of time for the same company.

Fourth Column: The amounts of current year are written in this column.

Fifth Column: Here, percentages of different Items of Statement of Profit & Loss of the previous Year, calculated with respect to the ‘Revenue from Operations’ are written.

Sixth Column: Here, percentages of different Items of Statement of Profit & Loss of the Current Year calculated with respect to ‘Revenue from Operation’ are written.

7.4.5 Common Size Statement for Balance Sheet The format of the Common Size Balance Sheet is as given under:- Name of the Company: ................. , Common Size Statement of Balance Sheet for the Year ended on ......................

Absolute Amounts Percents of

Balance Sheet Total

Particulars Note Figures for Figures for Previous Year Current Year No Previous Year Current Year Percentage Percentage

(1) (2) (3) (4) (5) (6) I EQUITY & LIABILITIES 1 Shareholders’ Funds

Share Capital --- --- --- --- --- Reserves & Surplus --- --- --- --- --- Money against Share Warrants --- --- --- --- ---

2 Money Pending Share Allotment --- --- --- --- --- 3 Non-Current Liabilities

Long-Term Borrowings --- --- --- --- --- Deferred Tax Liabilities (Net) --- --- --- --- --- Other Long-Term Liabilities --- --- --- --- --- Long-Term Provisions --- --- --- --- ---

4 Current Liabilities Short-Term Borrowings --- --- --- --- --- Trade Payables --- --- --- --- --- Other Current Liabilities --- --- --- --- --- Short-Term Provisions --- --- --- --- ---

TOTAL = --- --- --- 100% 100%

II ASSETS 1 Non-Current Assets

Fixed Assets --- --- --- --- --- Non-Current Investments --- --- --- --- --- Deferred Tax Assets (Net) --- --- --- --- --- Long-Term Loans & Advances --- --- --- --- --- Other /non-Currents Assets --- --- --- ---- ---

2. Current Assets (a) Current Investments --- --- --- --- --- (b) Inventories --- --- --- --- --- (c) Trade Receivables --- --- --- --- ---


(d) Cash and Cash-Equivalents --- --- --- --- --- (e) Short-Term Loans & Advances --- --- --- --- --- (f) Other Current Assets --- --- --- ---- --- TOTAL = --- --- --- 100% 100%

Common Size Balance Sheet shows the percentage relation of each asset/liability to the total asset/liabilities including capital. In Common Size Balance Sheet, total assets or total liabilities are taken as 100% and all other figures are expressed as percentage of the total. Common Size Balance Sheet for different periods/years helps to highlight the trends in different items. If it is prepared for different companies in an industry, it facilitates to assess financial soundness and helps in understanding their financial strategy. Its six columns are complied in similar manner as for Statement of Profit & Loss. Here the total assets are taken as 100% and figures for other items are expressed as percentage of the amount of total asset. Similar treatment is given to the liability figures, by taking total liability to be 100%.

7.5 Company/Industry Comparisons & Benchmarking As mentioned earlier in section 7.4 above, “Comparative Statements: and the “Common Size Statements” can be prepared for:

Comparison of financial performance of same company for two or more different years;

Comparison of financial performances of two or more companies in a particular year;

Compiling Industry Comparison regarding financial performance.

Benchmarking the financial performance of a company with the “Industry-Best Company” to bring out the “strengths” and “weaknesses” in performance-results.

Thus, the methodology of ‘comparison for two different companies’ or for ‘industry comparison’ is just the same as for comparing different year’s performance for the same company.

7.6 Difference between Capital and Revenue Expenditure Revenue Expenditure:

It brings benefits for the current accounting year.

Its benefits are not carried forward to the next year or years.

It is incurred in the normal course of business to run the business and to maintain the fixed assets of business.

It is incurred to purchase goods meant for resale or to purchase materials which will be used in converting it into final product.

The revenue expenditure is a recurring expenditure made continuous operation of the business. The amount spent is generally small and the benefit is for a short period, not more than one year. Capital Expenditure: Its benefit is not fully consumed in one year but is spread over several years. Such expenditure is incurred for purchase or acquisition of asset or property. It is also incurred to upgrade an old asset, and also for repair or improvement of existing asset .


Capital expenditure benefits the business for many years in future. The expenditure is generally non-recurring and the amount spent will be normally large. However, all large expenditures need not be capital expenditure. Capital expenditures are shown in Balance Sheet.


UNIT 8. ACCOUNTING RATIOS

8.1 Accounting Ratios 8.2 Reasons for using Ratios 8.3 Types of Accounting Ratios 8.4 Liquidity Ratio (Short-Term Solvency Ratios) 8.5 Capital Structure or Solvency Ratios (Long Term Solvency Ratios) 8.6 Activity / Efficiency Ratios 8.7 Profitability Ratios 8.8 Investor Ratios 8.9 Limitations of Ratio Analysis

8.1 Accounting Ratio “Ratio” is an arithmetical expression of relationship between two interdependent or related items. Ratios, when calculated on the basis of accounting information, are called Accounting Ratios. Ratio analysis is a study of relationship among various financial factors in a business. Ratio analysis is a process of determining and interpreting relationship between the items of Financial Statements (‘Balance sheet’ and/or ‘Statement of Profit & Loss’) to provide a deeper understanding of the financial performance of a company.

8.2 Reasons for using Ratios The ‘ratio analysis’ is useful in understanding financial performance of the company, as stated below:

Useful in understanding the overall financial position of a company in a simple and easy-to-understand manner.

Accounting Ratios are useful for assessing liquidity, solvency, and profitability of a company.

It is helpful in business planning and forecasting.

Accounting Ratios assist in locating the weak areas of the business.

Ratio analysis facilitates Inter-Firm Comparison.

8.3 Types of Accounting Ratios Accounting Ratios may be classified into following categories:

Liquidity Ratios (Short Term Solvency);

Capital Structure or Solvency Ratios (Long Term Solvency);

Activity or Efficiency Ratios;

Profitability Ratios; and

Profitability Ratios related in Investments (Investors’ Ratios)

These ratios are described in subsequent sections of this Unit.

8.4 Liquidity Ratios (Short-Term Solvency) Liquidity ratios are computed to evaluate the capability of the company to meet its short term liabilities. Commonly used liquidity ratios are: Current Ratios, and Liquid or Quick Ratios.


(a) Current Ratio: It is a relationship of current asset and current liabilities. This ratio measures ability of the company to pay its short term financial obligations, that is, liabilities. Thus, current ratio is a measurement of financial health of the company. This ratio is computed as:

Current Assets Current Ratio =

Current Liabilities Acceptable value of Current Ratio varies from industry to industry. Generally acceptable value in most industries of Current Ratio is 2 : 1. Generally, the current assets are twice of current liabilities. When value of Current Ratio falls below 1, it implies that the company may not be able to meet its short term financial obligations if they become due on that date. It means the company does not enjoy good financial health. However, value of Current Ratio above 1 indicates that the current liabilities of the company are lower than its current assets. High Current Ratio means better liquidity position. But a very high Current Ratio means large investments in assets which may not be getting utilised properly or generating poor revenue. (b) Liquid Ratio or Quick Ratio or Acid-Test Ratio: Liquid Ratio or Quick Ratio or Acid-Test Ratio is the liquidity ratio which provides a relationship of liquid assets with current liabilities. This ratio is calculated as under:

Liquid Assets of Quick Assets

Liquid/Quick Ratio = Current Liabilities Liquid or quick assets are either in the form of ‘Cash and Cash Equivalents’ or can be converted into cash within a very short period. Thus, these assets are the most liquid assets. Quick/Liquid Ratio of 1 : 1 is an accepted standard. The value of Quick/Liquid ratio of less than 1, indicates that current liabilities are more than liquid/quick assets, and consequently the company may not be able to meet its current liabilities or the short term financial obligations.

8.5 Capital Structure or Solvency Ratios (Long Term Solvency) ‘Capital Ratios’ or ‘Solvency Ratios’ show whether the company will be able to meet its long term obligations or its long term liabilities. Important Capital/Solvency Ratios include: (i) debt : equity ratio; (ii) total assets : debt ratios; (iii) proprietary ratio, and (iv) interest coverage ratio. (a) Debt : Equity Ratio: This ratio helps in assessing the long term financial health of the company. It expresses the relationship between long term external debts and the internal equity or the shareholders’ funds of the company. Liabilities like external debts payable to outsiders include ‘long-term borrowings’ and ‘long-term provisions’. These are shown as Non Current Liabilities in the ‘Equity & Liabilities’ part of the Balance Sheet. This ratio is computed as under:


Debt Debt : Equity Ratio =

Equity (Shareholders Fund) A high ‘Debt : Equity Ratio’ means that the company is depending more on the external debts than on the Shareholders Fund. Therefore, it means that the agencies providing loans are taking high risk. Low value of this ratio means that the company is depending more on Shareholders Fund than on the external debts. Therefore, the agencies providing loans are not facing high risk. ‘Debt : Equity Ratio’ of 2 : 1 is considered a satisfactory level. (b) Debt to Total Capital Ratio The ‘debt to total capital ratio’ establishes relationship of external liabilities or debts with the total capitalisation of the company. This is a variant of the Debt to Equity Ratio (D/E Ratio). It can be expressed and calculated in different ways, as mentioned under:

Debt to Total Capital Ratio: It relates the ‘long term debt’ to the ‘permanent capital’ of the company. Permanent Capital includes both shareholders’ equity and also the long term debts. This ratio provides relationship between Creditor’s Fund and Owner’s Capital.

Long Term Debt

Thus, Debt :Total Capital Ratio = Permanent Capital

Debts : Total Assets Ratios : This ratio calculates ‘debt to capital ratio’, and relates total debt to the total assets. The total debt of the company comprises of long-term debts plus current liabilities. The total assets comprise of permanent capital plus current liabilities.

Total Debt (Long Term Debt) Debt to total Assets/Capital Ratio =

Total Assets

This ratio reflects the ‘safety margin’ available to the lenders of long term debt. Higher this ratio, higher is the safety margin for the lenders.

Proprietary Ratios: It is another variant of D/E Ratio and relates the Owners’/Proprietors’ fund with total assets. It is computed as under:

Proprietors’ Fund Proprietary Ratio =

Total Assets (c) Interest Coverage Ratios This ratio establishes the relationship between ‘Net Profit before Interest & Tax’ and ‘Interest on Long-term Debts’. This ratio assesses the amount of profit available to cover interest on long term debt. The result is expressed in number of ‘times’. Profit before Interest & Tax


Interest Coverage Ratio = = ...... Times Interest on Long Term Debt

8.6 Activity / Efficiency Ratios Activity Ratios also called ‘Performance Efficiency Ratios’ or ‘Turn-Over Ratios’, measure how well the resources have been used by the company. In other words, these ratios measure the effectiveness with which the company uses its available resources. The result is expressed in number of ‘times’. The activity ratios include: (i) inventory turnover ratio; (ii) trade receivable turnover ratio; (iii) trade payable turnover ratio; and (iv) working capital turnover ratio. (a) Inventory Turnover Ratio Inventory Turnover Ratio expresses relation between ‘cost of revenue from operations’ and ‘average inventory’ carried. It is an activity as well as efficiency ratio and measures the number of times a company sells and replaces its inventory in an accounting year. The ratio is computed as follows: Cost of Revenue from Operations (Cost of Goods Sold) Inventory Turnover Ratio = = ..... Times Average Inventory This ratio attempts to ascertain whether investment in inventory has been well utilised or not. Thus, this ratio measures the efficiency of carrying and managing inventory. (b) Trade Receivable Turnover Ratio Trade Receivable is the amount receivable against goods sold or services rendered (on credit) in the normal course of business by the company. It is the amount remaining outstanding against the sale of goods or services rendered. It includes debts and bills receivables. This ratio is computed as follows: Trade Receivable Ratio = Trade Revenue from Operations i.e. Net Credit Sales = = ...... Times Average Trade Receivables It shows how quickly the amount of ‘trade receivables’ is recovered or collected and thus shows the efficiency in collection of amounts due. (c) Trade Payable Turnover Ratio Trade payable means ‘amount payable for purchase of goods or services taken by the company’ in the normal course of business. This ratio expresses the relationship between the ‘net credit purchases’ and ‘average payables’. It is calculated as under: Net Credit Purchases Trade Payable Turnover Ratio = = ...... Times


Average Trade Payable High ‘trade payable turn-over ratio’ or shorter payment period shows the availability of less credit or early payments. However, a high ratio also indicates that the company is not availing full credit period. A low ratio or longer payment period indicates that creditors are not being paid in time or credit period has increased. This may affect the creditworthiness of the company. (d) Working Capital Turnover Ratio Working capital turnover ratio shows the relationship between ‘working capital’ and ‘revenue from operations’. The objective of computing this ratio is to ascertain whether or not the working capital has been effectively used in generating revenue. This ratio is computed as follows: Revenue from Operations Working Capital Turnover Ratio = = ..... Times Working Capital Cost of Revenue from Operations (Cost of Goods Sold) = Working Capital Higher the ratio, better it is for the business. This ratio is considered to be a better measure than the Inventory Turnover Ratio.

8.7 Profitability Ratios These ratios measure profitability of business operations. Important profitability ratios are: (i) gross profit ratios; (ii) operating ratios; (iii) operating profit ratios; (iv) net profit ratios; and (v) return on investment (ROI) or return on capital employed ratios. (a) Gross Profit Ratio It establishes the relationship of ‘gross profit’ and ‘revenue from operations’, i.e., net sales of a company. The ratio is calculated and is shown in percentage. This ratio is computed as follows: Gross Profit

Gross Profit Ratio = x 100 Revenue from Operations Gross profit is the difference between ‘Revenue from Operations’ (i.e., Net Sales) and the ‘Cost of Revenue from Operations’ (Cost of Goods Sold). (b) Operating Ratio Operating ratio establishes the relationship between ‘operating cost’ and ‘revenue from operation’. Operating costs are the costs incurred from ‘operating activities’ of the business. It does not include non-operating income and expenses which are not incurred for operating activity of the business. This ratio is computed as follows:


Cost of Revenue from Operations + Operating Expenses Operating Ratio = x 100 Revenue from Operations Operating Cost

OR = x 100 Revenue from Operations Operating Profit Ratio and Operating Ratio are complementary to each other, and thus, if one of the two ratios is deducted from 100, another ratio is obtained. The objective is to assess the operational efficiency of the business. Lower Operating Ratio is better for business. (c) Operating Profit Ratio Operating Profit Ratio measures relationship between ‘Operating Profit’ and ‘Revenue from Operations’, i.e. Net Sales. Operating Profit Ratio is computed by dividing ‘Operating Profit’ by ‘Revenue from Operations (Net Sales)’ and is expressed as percentage. Operating Profit

Operating Profit Ratio = x 100 Revenue from Operations (Net sales) The objective of computing this ratio is to determine ‘operational efficiency’ of the business. Higher value of this ratio over the last accounting period means that there has been improvement in the operational efficiency of the business. (d) Net Profit Ratio Net Profit Ratio establishes the relationship between ‘net profit after tax’ and ‘revenue from operations (i.e., net sales)’. It shows the percentage of ‘net profit’ earned on ‘revenue from operations’. This ratio is computed as follows: Net Profit after Tax

Net Profit Ratio = x 100 Revenue from Operations, i.e. Net Sales Net Profit Ratio is an indicator of overall efficiency of the business. Higher the Net Profit Ratio, better is the business. This ratio helps in assessing the operational efficiency of the business.

8.8 Investor Ratios These ratios are described under:

Return on Investment (ROI) or Return on Capital Employed Ratio


‘Return on Investment’ or ‘Return on Capital Employed’ ratio shows the relationship of ‘profit’ (profit before interest and tax) with ‘capital employed’. This ratio is computed by dividing ‘profit before interest and tax & dividend’ by ‘capital employed’. This ratio is expressed as:

Net Profit before Interest, Tax and Dividend ROI = X 100 Capital Employed

This ratio is expressed as a percentage. ‘Return on capital employed’ or ‘return on investments’ assesses overall performance of the company. It assesses how efficiently the resources of the business are used.

Return on Total Shareholders’ Equity

According to this ratio, profitability is measured by dividing the ‘net profit after taxes’ (but before preference dividend) by the ‘average total shareholders’ equity. Thus,

Net Profit after Taxes Return on Total Shareholders’ Equity = X 100 Average Total Shareholders’ Equity The ratio reveals how profitably the owners’ funds have been utilised by the company.

Return on Ordinary Shareholders’ Equity (Net Worth)

The ordinary shareholders own all equity of the company. They bear risks and are therefore entitled to all earning i.e. profits after meeting all liabilities. From owners’ point of view, profitability of the company should be accessed through the return on ordinary shareholders’ equity. This ratio is calculated as under:

Net Profit after Taxes – Preference Dividend

Return on Ordinary Shareholders’ Equity = x 100 Average Ordinary Shareholders’ Equity (Net Worth)

Earning per Share (EPS)

This ratio measures the profit available to the equity shareholders on a ‘per share basis’, that is, the amount that they can get on every share held. It is calculated as under:

Net Profit available to Equity Holders

Earning per Share (EPS) = Total Number of Ordinary Equity Shares

Cash Earning Per Share

This ratio is computed using cash flows from business operations as the numerator. This value is determined by adding non-cash expenses, such as depreciation and amortisation to ‘net profit’ available to equity owners. Thus,


( Net Profit available to Equity-Owners + Depreciation + + Amortisation + Non Cash Expanses)

Cash Earning Per Share = Total Number of Equity Shares

Dividend per Share (DPS)

This denotes the dividend paid to the equity shareholders on a per share basis. In other words, DPS is the net distributed profit belonging to the ordinary shareholders divided by the number of ordinary shares outstanding.

Dividend Paid to Ordinary Shareholders

DPS = Number of Ordinary Shares Outstanding

Price / Earnings (P/E) Ratio

This ratio is computed as under: Market Price of the Share

Price / Earning Ratio = EPS

Here, EPS is the net earning per share. The P/E ratio reflects the price currently being paid by the market for the currently reported EPS.

8.9 Limitations of Ratio Analysis

The financial ratios or the accounting ratios are based on the ‘figures’ presented in the Financial Statements of a company. They suffer from a limitation that these are not based on full financial data for business performance during the accounting year.

Accuracy of ratio analysis is limited to the accuracy with which the Financial Statements are prepared.

Ratio analysis is based on certain numbers presented in Financial Statements. Therefore, the analysis provides only quantitative results without presenting any qualitative explaination.

Each ratio presents only one aspect of the business performance. No single ratio explains the financial performance of the company.

Price level changes are not reflected in the accounting ratios.

Interpretation of accounting ratios is subject to personal judgement of persons interpreting the ratio analysis.


III. UNDERSTAND HOW BUSINESSES ASSESS AND

FINANCE THE NON-CURRENT ASSETS, INVESTMENTS AND

WORKING CAPITAL


UNIT 9. SHORT AND LONG-TERM FINANCE

9.1 Finance for Business 9.2 Meaning of Short Term and Long Term 9.3 Short-Term Finance 9.4 Long-term Finance 9.5 Differences between Short & Long-Term Finance 9.6 Matching Finance-Issues with the Specific Business Requirement

9.1 Finance for Business Business activities of all types need financial investments. The finance may be arranged from internal or external sources. Further, need for finance for different requirements may of different time durations, and of different levels of capital. Some requirements may need finance for short-term and others may need finance for long term. Long-term financing is required mostly for procuring assets or for setting up project facilities. On the other side, normal types of business operations for business activities need funds for shorter duration of time. Business organisations have needs for both, short-term finance as well as for long-term finance. This combination of twin needs should be met by a judicious mix of sources of finance keeping in view the required cash flows at company level. 9.2 Meaning of Short-Term and Long-Term In terms of business accounting, “short term” refers to holding an asset for a period “less than a year”. The term “current” is often mentioned regarding ‘assets’ or ‘liabilities’ having less than one year time for ‘being converted into cash’ or for ‘being paid out’. Terms like “current assets” and “current liabilities” are used where time schedule is less than one year. “Long term” in business accounting means associated ‘time period’ is more than the operating cycle or say one year. Long term financing refers to seeking finance for long-term duration i.e. more than one year, and is generally used for financing procurements of capital assets. In such cases, the assets are established over long period of time and need large amount of capital. The time is more than one year; and time frames of 3 to 25 years are also common. 9.3 Short Term Finance Short term finance generally has time span of less than one year. But in some cases, the time period can be about 3 years in view of certain special requirements. Mortgage is one such example where requirements may span from few years to 15-20 years, which is considered long term finance. There can be a case of short term financing when time period is of 3 years or less; and there can be case of long term financing when time period is much long i.e. 10-15 years.


Short-term financing is generally used for period up to one year. Its examples may be the cases of inventory-ordering, payments of wages, and payments of fast-moving supplies for operations-related requirements. Short term financing is also used for current assets and working capital requirements. As short term financing involves shorter time periods for payments, the interests charged are also comparatively lower, and the risk involved is also much lesser. Therefore, it is easy to arrange for short term financing. Short-term loans, bank over draft facility, trade-payables, and short term leases are examples of short-term financing. 9.4 Long Term Finance Long term financing generally has time periods of 3 to 20 years, depending on the type and nature of asset being financed. Purchase of costly capital equipment, setting up of new projects, research and development tasks, all have long gestation periods and therefore are financed through long term financing. As such financing is for long term, the associated uncertainties are also more and the risk involved is also of higher order. Further, the amounts required are also of higher order. Financing agencies generally hesitate giving loans for high amounts for longer periods which also involve high risks. As a practice, financial institutions like banks demand certain collateral against which the loan is provided. The arrangement of collateral covers the risk for the bank and motivates the borrower for not defaulting on repayments. Capital assets established in project-mode are financed through long term financing. 9.5 Differences between Short & Long Term Finance

Short-term Financing Long-term Finance 1. Generally needed for ‘operations’ requirements. 1. Needed for capital assets and projects

2. Needed for periods about one year. 2. Generally needed for 3-20 years. 3. Generally need smaller amount. 3. Need large amounts of capital. 4. Involve lesser risk. 4. Involve large risks. 5. Comparatively easier to obtain. 5. Difficult to obtain, collateral required.

9.6 Matching Finance-Issues with the Specific Business Requirement Finances needed for business are for different amounts and for different periods of repayments. Therefore, they carry different rates of interest, as the risks involved are also different. High interest rates can have adverse impact on the profitability. Therefore, attempt should be to reduce the overall interest liability of the company. This is achieved by matching the finance requirements with time periods and interest payable. Even some part of long term requirements may be financed through short-term financing, if the repayment can be done in shorter timeframe. Therefore, there is a standard practice to plan for a proper finance-mix. For short term financing, finance-mix is limited to selection of source of finance and their associated interests and other terms & conditions.

https://www.boundless.com/finance/definition/period/


The capital assets need long term finance as such projects need large amounts and involve longer period of time for completion and consequent repayment. However, certain flexibility may be adopted in case of current assets. Two options may be used for short term financing: (i) short term sources (current liabilities) and (ii) from long term sources such as share capital, long term borrowings etc. Management should decide regarding what percentage of current assets should be financed through current liabilities and how much through long term sources.


UNIT 10. SOURCES OF FINANCE

10.1 Range of Sources 10.2 Internal and External Sources 10.3 Sources of Short-Term Finance 10.4 Sources of Long -Term Finance 10.5 Role of Markets and Government

10.1 Range of Sources As discussed in last Unit, the financial sources are two general types: source for short-term finance and source for long-term finance. The funds required for short period of time, say for about one operating cycle (or one year) are called short term finance. The funds required for longer time, say 3 to 30 years are called long term finance. As short term finance is needed for lesser time, the associate risk is much lesser as compared to long term finance. The source of finance may be from within the business organisation (internal source) or may be outside the organisation, like a bank. The source of finance can therefore be classified into two types: internal sources and external sources of finance.

10.2 Internal and External Sources All businesses require funds to finance their day-to-day operations; and also for their business expansion and growth. One option for finding a source of finance is to use the retained earnings or profits; and it is called internal source of finance. Another option can be to raise loan from banks and other creditors; and this is called external source of finance. 10.2.1 Internal Source of Finance ‘Retained earnings’ is an easy and readily available source of finance as these are liquid assets. These are part of ‘net earnings’ of previous years which have been retained by the company after paying dividends to the shareholders. ‘Current assets’ can also be used for short term finance as these consist of cash or other-thing which can easily be disposed to get the cash money to finance important urgent requirements. A company may be holding shares in other company. These can be sold to get money for using as internal source of finance. ‘Fixed assets’ are used as basic facilities to support business operations for generating revenue. These are basically established for long time use; and are not supposed to be converted into cash. Such assets include land, building, equipment and machinery. These assets cannot be converted into cash in short period of time and are therefore not used as source of short term finance. There are two sources of internal finance:

Retained earnings, and

Increasing ‘working-capital management efficiency’.


Retained Earnings Retained earnings is surplus cash from earning of previous years, which had not been needed for operating costs, interest payments, tax liabilities, asset replacement or cash dividends. Retained earnings basically belong to the shareholders. Advantages of using Retained Earnings:

Retained earnings are available within the company, and, if used, are not required to be paid back.

Using retained earnings does not dilute management-control.

Retained earnings have no ‘issue-costs’. Disadvantages of using Retained Earnings:

As it basically belongs to the shareholders, they will like it to be spent on dividend payouts.

Using this fund means that a opportunity of issuing further equity as “right-issue” may be lost. Another way of funding short term requirements of finance can be through saving in working capital requirements by increasing Working Capital efficiency. Efforts can be made to generate savings through efficient management of trade receivables, inventory, cash and trade payables. Better management of working capital can facilitate reduction in use of bank overdraft and interest charges. It can also help in faster collection of cash-receivables. 10.2.2 External Sources of Finance It refers to raising finance from sources external to the company. Such sources may include:

Banks and other financial institutions may be approached for seeking loans or ‘line of credit’.

Capital Market may be approached for issue of shares, debentures and bonds.

Creditors like suppliers may be requested to supply raw materials and semi-finished goods on credit (for certain specified period of time)

10.3 Sources of Short-Term Finance 10.3.1 Purpose of Short-term Finance Short-term finance is usually needed by businesses to run their day-to-day operations like payment of employee wages and inventory. Businesses need funds to make payments on day-to-day basis. Thus, there is a continuous requirement of liquid cash for meeting such requirements, otherwise the organisation may face situation of technical insolvency. Short-term finance supports following activities of the business organisation:-

Meeting day to day financial requirements.

Holding stock of raw materials and finished product.

Selling of goods on credit-basis, for increasing the business-sales.

Increasing the volume of production at a short notice.

Supporting the cash-flows during the operating cycle. 10.3.2 Sources of Short-term Finance


There are a number of sources of short-term finance which are listed below:

Trade credit, i.e. getting supplies on credit basis,

Bank credit,

Customers’ advances,

Instalment credit,

Commercial Paper, and

Promissory Note Trade Credit: Trade credit refers to credit granted to manufactures and traders by the suppliers of raw material, finished goods, components, etc. Usually suppliers give goods and services to business organisations on a credit of 30 to 90 days. Payments are collected towards the end of this period. This type of credit facilitates purchases without making immediate payment. Bank Credit: Commercial banks grant short-term finance to business firms. This is known as bank credit. The borrower may draw the amount of credit at one time or in any number of instalments, subject to the terms and conditions specified in the credit-document. Such credit may be granted by way of (i) loan, (ii) cash credit, (iii) overdraft and (iv) discounted bills. Customers’ Advances: Sometimes, businessmen insist on their customers to make some advance payment. It is generally demanded when the ‘value of order’ is quite large. Customers’ advance represents a part of the payment towards price on the product(s) which will be delivered at a later date. Customers generally agree to make advances when such goods are not easily available in the market or there is an urgent need of goods. A firm can meet its short-term requirements with the help of customers’ advances. Instalment Credit: Instalment credit is popular source of finance for purchase of consumer goods like television, refrigerators as well as for industrial goods. Small amount of money is paid at the time of purchase and the balance is paid in a number of instalments. The supplier charges certain interest for providing credit. The amount of interest is included while deciding on the amount of instalment. Another similar system is the hire purchase system under which the purchaser becomes owner of the goods after the payment of last instalment. Commercial Paper: This instrument facilitates raising short-term loans through money market. It is an unsecured promissory note issued by big reputed companies, with a fixed maturity of 1 to 364 days in the global money market. It is backed by an issuing bank or promise by the business company to pay the amount on the maturity date. Promissory Note: This is a negotiable instrument, wherein one party (the maker or issuer) makes an unconditional promise in writing to pay a determinate sum of money to the other (the payee), either at a fixed or determinable future time or on demand of the payee, under specific terms. 10.3.3 Merits and Demerits of Various Short-Term Finance Systems Merits and demerits of commonly used sources of short-term finance are discussed below:-

(a) Overdraft: Overdrafts are deficits financed by the bank. Overdrafts can be arranged relatively quickly, and are flexible with regard to the amount borrowed at any time, and interest is only paid when the account is overdrawn.


(b) Short-term Loans: It is drawn in full at beginning of the loan period and repaid at a specified time or in defined instalments. A term loan is not repayable on demand by the bank.

(c) Advantages of a Terms Loan: Both customer and bank know exactly (i) what the repayments of the loan will be, and (ii) how much interest is payable; and (iii) when interest are payable. The customer does not have to worry about the bank deciding to reduce or withdraw an overdraft facility. Loans normally carry a letter setting out the precise terms of the agreement.

10.4 Sources of Long-Term Finance Major operational facilities, land, buildings, machinery and major equipment need large outlay of capital. Further, these have long gestation period. The repayment of finance is therefore done in longer time frame of the order of 3-20 years. The capital required for these assets is called fixed capital. A part of working capital is also of a permanent nature, as this does not rotate in the accounting period. 10.4.1 Purpose of Long-term Finance Long-term finance is required for the following important purposes:

To finance procurement/setting-up of fixed assets;

To finance the permanent part of working capital; and

To finance growth and expansion of business. 10.4.2 Factors Determining Requirements of Long-term Finance The amount required to meet the ‘long term capital needs’ of a company depends upon many factors. These are:

Nature of Business: A manufacturing company requires land, buildings, machinery etc. So it has to invest a large amount of capital for a long period. But a trading company dealing in, say, microwave ovens etc requires smaller amount funds as long term finance.

Nature of Goods Produced: A business engaged in manufacture of simple items will need smaller amount of fixed capital as compared to a company manufacturing heavy machines or heavy consumer items like cars, refrigerators etc, which will require more amount of capital.

Technology Used: Industries like steel, cars, aeroplanes etc use high technology and require much large level of capital.

10.4.3 Sources of Long-term Finance There are different sources of funds available to meet long-term financial needs of business. The sources generally are of two broad categories: (i) share capital (including owners’ equity, preference share capital, retained earnings, and Bonds) and (ii) debt (including debentures, bank loans and other long-term borrowing instruments). Commonly used sources of long-term finance are described below. Equity Financing: This includes preferred stocks and common stocks. It is less risky as no repayment of equity is required. However, increased number of shares in the hands of public and outsiders dilutes the strength of original owners and their control over business. Another disadvantage is that the cost of equity is higher than the cost of debt. But cost of raising equity is treated as expenses deductible from the gross earnings.


Corporate Bond: A corporate bond is issued by corporations to raise money from general public and interested agencies. It is a long-term debt instrument. Some corporate bonds have an option to apply for equity at a later data; and are called convertible bonds. Capital Notes: Capital notes are a form of convertible security which may be converted into equity shares. Capital notes are similar to warrants. Sometimes, capital notes are issued with provision of debt-for-equity exchange on a particular date. The holders of capital notes have option of not taking equity shares, but to get their amount with pre-specified rate of interest on a particular date. Asset-based Loan: Banks and financial institutions prefer to issue ‘high risk loans’, secured with the backing of company's assets. Such loans may be backed by assets namely land, buildings, plant & machinery etc. Letter of Credit: This ‘letter’ is issued by a bank or financial institution to a business organisation engaged in selling of goods or providing services to customers on credit basis. This letter provides a guarantee for payments of goods or services sold to third party. 10.4.4 Merits / Demerits of Popular Sources of Long-Term Finance

(a) Raising Equity Shares: The advantages of raising funds by issue of equity shares are as under:

It is permanent source of finance.

Possible to issue shares capital, at premium, by making a ‘right issue’.

No need of ‘re-payments’ (as for loans) to shareholders of equity shares. (b) Preference Share Capital: The advantages of raising finance through preference shares capital

are as follows:

There is no risk of take-over by hostile shareholders.

There is no dilution of managerial control.

It can be redeemed only after a specified period of time. (c) Raising Debentures or Bonds: There are advantages as well as certain disadvantages of issuing

debentures for raising finance, as described under:

Advantages: The Interest payable on Debenture is tax-deductible. Therefore, the net cost of

debentures is much less than the cost of equity. There is no dilution of control.

Disadvantages: There is liability of interest payment and capital repayment at specified date. It enhances the financial-risk for the company.

(d) Bank Loans:

Interest on bank loans is tax-deductible.

Tern-loans represent secured and reliable source of borrowings useful for new projects.

Bank loans are available at different rates of interest under different schemes of banks and financial institutions; and have to be paid back as per agreed repayment schedule.

10.5 Role of Markets and Government The ‘Financial Markets’ and the ‘Governmental Agencies’ act as facilitators for business financing. Capital markets and institutional investors are the sources of long-term finance. A capital market provides trading platform in financial securities for individuals, corporate and


interested institutions. It facilitates buying of securities for investment and also selling for booking profit or for raising capital in the time of need. Capital market is composed of both the primary and secondary markets. The primary market is where new issues are first offered, with any subsequent trading going on in the secondary market. In the primary market, prices are often set beforehand, whereas in the secondary market only basic market-forces like supply and demand determine the price of the security. Stock markets allow investors to buy and sell shares in publicly traded companies. The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities are traded. The money market is used by participants as a means for borrowing and lending in the short term. Financial institutions and financial markets help business firms to raise money in the time of need. Many governments have a long-term financial planning process to generate a long-range perspective for decision makers.


UNIT 11. CASH FLOW MANAGEMENT

11.1 Objectives of Cash Management 11.2 Strategy for Cash Management 11.3 Cash Flow Forecast 11.4 Budgetary Control Process 11.5 Managing Inventory 11.6 Managing Trade Payables 11.7 Managing Trade Receivables

11.1 Objectives of Cash Management The objectives of cash flow management are:

to reduce the liquidity risks;

to make cash available for day-to-day purposes;

to minimise the needs of cash;

to invest the ‘balance cash’ in most optimal manner; and

to maintain optimal cash balance. Companies hold cash balance to meet the payment requirements. This becomes necessary as the timings and amount of cash inflows do not match the timings and amount of cash outflows. Followings are the requirements for which “optimal cash” is required to be kept:

Cash money is required to settle day-to-day payment requirements, namely payment of creditor’s bills, payment of wages of employees, and to pay for sundry purchases.

In business environment, it cannot be assumed that cash-inflows will occur as per the estimates. Further, the future cash needs are also uncertain. The company has to protect itself from such contingencies by holding additional cash.

The company may get some attractive opportunities for investments in future. Therefore, it has to keep some cash balance for this purpose.

11.2 Strategy for Cash Management The main component of strategy for effective cash management is to ensure uninterrupted supply of cash for the business operations during the operating cycle. The strategy has three important components:

Making Forecast of Cash-Flows: The cash-flow forecast for next year period is prepared by making closer estimates for likely transactions and resulting cash flows.

Reducing the Time in Collecting the Trade Receivables: The Company has to make effective strategy and action plan for making speedy collection of trade receivables.

Managing the Trade Payables in Longer Time: The Company should attempt to spread out the trade pay-outs as wide as possible.

11.3 Cash Flow Forecast Following points are useful in preparing cash-flow forecast for a business organisation:

A realistic forecast of likely cash flows should be prepared for the next accounting period.


The first part of forecast originates from the sales forecast for the year; while the second part originates from the capital budget.

A cushion is added to the forecasted figures to cater for the normal contingencies.

For realistic cash flow forecast, the sale projections and capital budget have to be drawn up after extensive deliberations with senior managers of the company along with other experts.

Involvement of operational level people, both from production and sales departments, is essential for realistic cash flow forecast.

11.4 Budgetary Control Process 11.4.1 Budgetary Controls A budget is prepared to make effective utilisation of resources and for the realisation of objectives, in an efficient manner. “A budget is a monetary and quantitative expression of business plans and policies, prepared in advance, to be pursued in the future period of time”. Budgeting is a method of financial planning for the future. Budgets are prepared for various areas of the business, namely (i) purchases, (ii) sales (revenue), (iii) production, (iv) labour payments, (v) trade receivables, and (vi) trade payables. Characteristics of a Budget: The budget is prepared in advance for a definite period, for meeting a comprehensive business plan for the organisation. It is expressed in quantitative form. Financial budgets are prepared using a proper system of accounting. Budgetary Control is a system which uses budgets as a means of planning and controlling. Three stages are relevant:

In the first stage, the budgets are prepared.

In second stage, the actual performance-results are recorded.

In the third stage, comparison is made between the planned progress and the actual progress; and the variances are identified and computed.

Once the discrepancies are known, remedial measures are taken for achieving the planned results. A budget is a means; and budgetary control leads to the desired results. 11.4.2 Cash Budget Cash budget is a ‘cash management’ tool to plan and control the use of cash. It reflects the estimated cash outflows and inflows for the accounting period. The cash budget is used to monitor and manage the cash flows of a business budget. Generally, cash budget are used to manage short term cash flows by creating an organised system of keeping-up with cash receipts and balancing them against the cash payments during the accounting period. The cash budget shows the cash-related effects of all plans made within the budgetary process. Its preparation can lead to a modification of budget if it shows that there are insufficient cash resources to finance the planned operations. Cash budget helps the management in the following ways:


Identification of the period and amount of ‘cash shortage’ so that appropriate plan may be made about arranging the fund at the required time.

Identification of period and amount of ‘cash surplus’ position so that plans may be made to invest the excess cash amount in an appropriate manner.

Proper coordination of timings of cash inflows and cash outflows, so that chances of shortages or surplus of cash may be avoided.

Preparation of Cash Budget:

First of all, budget-duration is finalised. It is generally one year; but may be divided into smaller periods say six months or three months period. Some time, smaller budget cycle can also be adopted to meet the special requirements.

Next step is to identify and estimate the ‘cash items’ covering the inflows and outflows. For this purpose, cash flows relating to Operations, Investing, and Financing activities are separately identified and listed.

Third step relates to preparation of cash budget wherein both inflows and outflows are plotted against the time horizon; and excess/shortage of cash at the end of each interval is identified.

Fourth, action-plans are prepared for meeting the situation of excess or shortage of cash.

11.5 Managing Inventory 11.5.1 Necessity of Holding Inventory In any business operation, certain items / goods are procured and stored in advance for use at a later stage, as getting the required items at time of actual requirement is generally not possible. Such items and goods are called the inventory of a business operation. There are three important objectives of holding sufficient level of inventory of a business firm. These are as follows:

The company must hold certain items and materials necessary to facilitate the smooth and uninterrupted production and sales operation. In real-life situation, it is not possible to procure the raw materials immediately when required. There may be a time-lag between the demand for the material and its receipt. Therefore, certain minimal stock of inventory is essential to continue with operations related activities in an uninterrupted manner.

The company should guard against risk of unpredictable changes in demand and supply. Hence, company should maintain sufficient level of inventory to take care of such situation.

If any attractive offer of incentive on bulk purchase is available, the company may like to purchase and stock the inventory in the quantity which is more than what is needed for production and sales purposes.

11.5.2 Managing the Inventory

The objective of inventory management is to ensure that: (i) optimal levels of inventory is maintained at all times, and simultaneously (ii) the cost of holding the inventory is also minimised or kept at lowest levels as feasible. To reduce the requirement of cash in business, inventory turnover should be maximised and management should avoid chances of loss of production and sales, if the stock of inventory is exhausted. The main objective of inventory management is to maintain inventory at appropriate level so that it is neither excessive nor short of requirement. Thus, management is faced with two conflicting objectives:


To keep inventory at sufficiently high level to perform production and sales activities smoothly.

To minimise investment in inventory at minimum level to maximise profitability.

The objectives of inventory management can be explained as under:

To ensure that uninterrupted supply of raw material and finished goods so that production process is not halted.

To minimise cost of carrying the inventory.

To keep investment in inventory at optimum level. 11.5.3 Inventory Control Inventory control refers to keeping inventories at an optimal level so that production is not interrupted and cost of carrying inventory is kept at lowest levels as may be feasible. Inventory management and inventory control must be designed to meet the changing market conditions and to also support the company’s strategic plan. Various models adopted for Quality Control are described under.

(a) Economic Order Quantity (EOQ) Model Inventory level can be managed by adopting a Economic Order Quantity (EOQ) Model. This model determines the ‘order size’ that will minimise the total inventory cost. According to this model, three parameters are fixed for each item of the inventory:

(a) Minimum level of each inventory item to be deciding based on its ‘rate of usage’, and ‘supply time’.

(b) The inventory-level at which next order for the item must be placed to avoid possibility of zero stock.

(c) The quantity for which the reorder should be placed.

(b) ABC Classification Model The ABC classification model is based on the analysis of inventory items into three categories:

Category ‘A’: Items of extremely high level of importance;

Category ‘B’: Items of average importance, and

Category ‘C’: Items which are relatively unimportant. The A, B, C classification system is based on grouping the inventory items according to ‘annual issue value’. Strict control is kept on ‘A’ and ‘B’ items, with preferably low safety stock level for ‘C’ items.

(c) Stock Level Model This model is based on three guiding parameters, as under: Reorder Level: The store keeper starts purchasing-process when the inventory in the Stores reaches this level. Minimal Level: Inventories are not allowed to fall below this level. Maximum Level: This is considered to be the highest level beyond which holding of inventories implies blocking of funds unnecessarily. Re-Order Point: This is the inventory level at which the procurement order must be placed.

(d) F-S-N Model (Fast-Moving, Slow-Moving, Non-Moving Model)


Inventory items are also classified and managed on the basis of fast-moving, slow-moving, and non-moving items (FSN Analysis). The non-moving items are critically examined for their needs; and the items that are not critical are disposed off in a suitable manner. The order levels and economic order quantity for slow moving items are reviewed to check, whether they can be further reduced without affecting the purchase process.

The above inventory control models are not used in exclusive manner. In fact, these are used in a combined manner to achieve the most optimal results.

11.6 Managing Trade Payables Most firms attempt to spread-out the payments on items ‘bought through trade’ for routine business. As a practice, the market-suppliers provide the raw materials and others items/goods needed for operation purposes, on credit basis, generally for periods of 1 to 3 months. Credit-worthy companies also spread out their ‘trade payable commitments’ to a date close to the credit limiting date. As a prevalent practice, if credit period is available in some cases, business companies utilise it fully. Bunching of payments is generally avoided.

11.7 Managing Trade Receivables Receivable management means collection of payments for the goods and services provided to customers on credit basis. These payments are referred as “receivables”. Goods and services are provided on credit as this practice is expected to increase the sales of the company. The purpose of making ‘credit sales’ is as under:

If the company sells goods on credit, it should result in higher level of ‘total sales’ than if goods are sold on ‘immediate cash’ payment.

It should lead to increase in profit.

To grant better credit facilities than those offered by its competitors, for achieving even higher levels of sales.

Receivable management involves the following aspects:

Formulation of credit policy;

Credit evaluation;

Adopt methods (like providing cash incentives) to facilitate faster collection of payments;

Monitoring receivables. Some companies adopt a novel method for collecting trade receivables. Such companies providing credit, sell their ‘accounts receivable’ to an agency called ‘factor’. A factor is a specialised financial intermediary who purchases ‘accounts receivables’ at a discount. Under a factoring agreement, a company sells or assigns its ‘accounts receivables’ to a ‘factor’ in exchange for a cash advance. The factor typically charges certain interest on the advance plus a commission. Factoring is a technique used by companies to manage their ‘accounts receivables’ and provide financing. Typically, companies that have excess to suitable ‘sources of financing’ that is less expensive than ‘factoring charges’, would not use source of factoring.


UNIT 12. INVESTMENT APPRAISAL TECHNIQUES

(CAPITAL BUDGETING)

12.1 Capital Budgeting 12.2 Capital Budgeting Decisions 12.3 Use of Cash-Flow Analysis in Capital Budgeting Process 12.4 Types of Cash-Flows Associated with Capital Budgeting 12.5 Payback Method for Analysing Investment Project 12.6 Accounting Rate of Return (ARR) Method 12.7 Discounted Value (Present Value) Method 12.8 Net Present Value (NPV) Method 12.9 Internal Rate of Return (IRR) Method 12.10 Profitability Index (PI) or Benefits-Cost Ratio Method

12.1 Capital Budgeting The term Capital Budgeting refers to long term planning for proposed capital outlays and their financing. It includes both deciding on the investment proposals and then raising of long term funds for the specified purpose. It is, thus, “firm’s formal process for acquisition and investment of capital”. Capital budgeting decision may be defined as “the firm’s decision to invest its current fund more efficiently in long term activities in anticipation of an expected flow of future benefits over a series of years”.

12.2 Capital Budgeting Decisions A capital investment decision involves a commitment of resources that is generally subject to high degree of financial risk. The capital investment decisions are important decisions for a business organisation, due to the following reasons:

Capital Budgeting decisions involve the investments of large amounts of fund;

A capital budgeting decision has its effect over a long period of time;

Most of such investment decisions are irreversible in nature.

Capital investment decisions involve issues which are spread over a long period of time, and are difficult to predict.

Types of Capital Investment Decisions

Decisions relating to replacement and/or modernisation of assets.

Decisions regarding setting up of new assets or projects.

Decisions regarding expansion of business.

Decisions regarding diversification of business.

12.3 Use of Cash Flow Analysis in Capital Budgeting Process In capital budgeting, the costs and benefits are measured in terms of cash flows. The term ‘cash flow’ is used to describe the cash oriented measures of ‘return’ generated by proposal. Using the accounting data, exact cash-effect measurement may not be possible; but useful approximations are possible for


drawing conclusions. The costs (payments) are termed as ‘cash outflows’; and benefits (receipts) are termed as ‘cash inflows’. Accrual principle is considered better for the purpose of accounting; but for a long term investment decision-making, cash principal is better. Payment of cash for all cases is termed as ‘outflow’, and all cash receipts are termed as ‘cash inflow’. Following principles should be followed for estimating cash flows for projects:

Calculations of cash flows are made on incremental (additional amount) basis; and not on aggregate/total basis.

Cash flows are taken on ‘after tax’ basis.

Cash needs for ‘working capital’ should be treated as a cash outflow at the time of commencement of a project. On closure of the project, cash amount of ‘working capital’ is released. Then, it is treated as inflow.

Increases or decreases of working capital should be treated as outflows and inflows.

12.4 Types of Cash-Flows Associated with Capital Budgeting Cash flows associated with proposals may be classified into:

Initial Cash Outflow: This represents the amount of money paid when the investment or project is started. Because the initial outlay is made at the start of the project (time zero), it is not discounted.

Subsequent Cash Flows: The original investment is expected to generate series of cash inflows contributed by the project. Sometimes, cash outflows are also incurred during subsequent years like repairs, renovation costs etc.

Terminal Cash Flows: Terminal cash flows refer to the cash flow, occurring when the project life comes to an end.

12.5 Payback Method for Analysing Investment Project This technique assesses a project on the basis of time required to recover (payback) the amount of investment. In this method, different projects are arranged as per the time required to recover (payback) the initial investment. The payback period for each investment proposal is compared with the maximum period acceptable to the management. The proposals with payback time more than the acceptable time are rejected. Other acceptable proposals are then ranked in order of payback time. The project having minimum payout-period is selected. Here, the cash benefits (receipts) or the cash inflows are calculated on “after tax basis” (Cash Flow After Tax). Thus, the payback period is used as a decision criterion to accept or reject a project. Merits:

It is easy to calculate and simple to understand.

The payback method is an improvement over the average rate of return approach. Demerits:

Ignores the time value of money. This weakness is eliminated with the Discounted Payback Method.

Does not reflect all dimensions of the profitability.


Ignores cash flows occurring after the payback period.

12.6 Accounting Rate of Return (ARR) Method This method covers one weakness of payback method i.e. it considers the relative profitability of different proposal for capital investment and uses this criterion as basis for ranking the projects. In this method, the ‘rate of return’ is calculated by dividing the earnings by the capital invested.

Average Profit After Tax (PAT) ARR =

Initial Investment Acceptance or rejection of proposal depends on value of ARR being more or less than the minimum rate of return expected by the management of the business organisation. Therefore, the firm accepts the proposal if the ARR is more than the minimum expected rate of return (cut-off rate). The firm rejects the project if the calculated ARR is less than the minimum expected rate of return (cut off rate). Advantages of ARR Method:

Earnings over the entire life of the project are considered.

This method is easy to understand, simple to follow.

It is based on the accounting concepts of profit, calculated from financial data. Disadvantages of ARR Method:

Ignores the time-value of funds.

The method ignores the shrinkage of original investment as this amount decreases due to depreciation chargeable before calculating the net earning.

12.7 Discounted Value (Present Value) Method The method of Discounted Cash Flow (DCF) takes into consideration the ‘time value of money’ while evaluating the cost and benefits of an investment project. The DCF based capital budgeting techniques take into account all benefits and costs occurring during the entire life of the project. In this method, all cash flows are expressed in terms of their present values. Various cash flows occurring at different times in the project, can be compared only when these are expressed in terms of a common denominator, that is, their Present Values. It, thus, takes into account the concept of ‘time value of money’ for determining Present Value of different cash flows occurring in the project. The ‘present values (PV) of cash inflows’ is compared with the ‘PV of cash outflows’. If the present values of sum of all cash inflows of the investment project are higher than the cash outflows of the investment-project, then the project proposal can be accepted.

12.8 Net Present Value (NPV) Method Net Present Value (NPV) Method is the best available method for evaluating the capital investment proposals. Under this method, the cash outflows and inflows associated with each project are


ascertained. Cash inflows are calculated by adding depreciation to profit after tax arising to each project. Since the cash outflows and inflows arise at different point of time and cannot be compared, so both are reduced to their Present Values at the rate of return acceptable to the management. The first step of the method is to discount each cash flow (both the cash-inflows and the cash-outflows) back to its present value (PV). The net Present Values of all cash-inflows are determined by summing these. The ‘net present value’ can be computed by subtracting the initial cash outflow from the sum of all cash-inflows. Net present value (NPV) is the difference between the sum total of present values (discounted) of all the future cash ‘inflows’ and ‘outflows’. If this value is positive, then the investment proposal may be accepted. Merits:

It explicitly recognises the time value of money.

It considers the total benefits arising out of proposal over its life time.

It is useful for selection of mutually exclusive projects. Demerits:

It is difficult to calculate as well as to understand and use, in comparison with Payback Method or ARR Method.

It involves calculation of the ‘required rate of return’ to discount the cash flows.

This method accepts the project which has higher present values. But, it is likely that this project may also involve a larger initial outlay.

12.9 Internal Rate of Return (IRR) Method The internal rate of return is defined as ‘the interest rate’ that equates the present value of the expected future cash flows, or receipts, to the initial outlay. Here the future cash flows are discounted to get their equivalent present values. The equation for calculating the ‘internal rate’ of return is: CF1 CF2 CF3 CFn

IRR = + + + ................. + - I0 (1 + IRR) (1 + IRR)2 (1 + IRR)3 (1 + IRR)n OR n CFt IRR = - I0

t = 1 (I + IRR)t Here we know the value of the initial investment I0 and also the values of future cash flows CF1, CF2, CF3, CF4, and ....... CFn, but we do not know the IRR, which is to be determined from this equation. Thus, we have an equation with one unknown, and we can solve for the value of IRR. Some value of IRR will cause the sum of the discounted receipts to equal the initial cost of the project, making the equation equal to zero, and that value of IRR is defined as the Internal Rate of Return.


Here, the Internal Rate of Return is found by trial and error. First, compute the present value of the cash flows from an investment using an arbitrarily selected interest rate (for example, 10%). The present value so obtained is compared with the investment cost. If the present value is higher than the cost figure, try a higher interest rate and go through the procedure again. Merits:

The IRR is easier to understand.

It provides a rate of return which is indicative of the profitability of proposal.

The acceptance or rejection of a project proposal is based on a comparison of IRR with required rate of return. The required rate of return is the minimum rate, which investors expect on their investment.

Demerits:

It involves tedious calculations.

In evaluating mutually exclusive proposals, the project with highest IRR would be picked up. But, it may not be the most profitable.

It is assumed that all intermediate cash flows are reinvested at the IRR. This is rather unrealistic.

12.10 Profitability Index (PI) or Benefits-Cost Ratio Method Profitability Index (PI) or Benefits-Cost Ratio is the ratio of ‘the present value of future expected cash flows subsequent to initial investment’ divided by the ‘amount of the initial investment’. It shows the relative profitability of an investment by showing the ratio of the benefit from an investment (the present value of cash inflows) to the cost (the present value of cash-outflows).

Present Values of Future Cash-Flows Profitability Index (PI) = Present Value of Initial Investment

The above ratio (PI) is an indicator of the profitability of the investment project. If value of PI is equal or greater than 1, then it shows that the project has an expected rate of return equal to or greater than the discount rate. If PI value is less than 1, the project has an expected rate of return less than the discount rate. Decision Rule:

If PI > 1, accept the project;

if PI = 1, management can be indifferent; and

if PI < 1, reject the project. Merits:

It considers ‘time value of money’.

It is a sound investment criterion.

It can be used to rank projects of varying cash and benefits in order of their profitability. Demerits:

It is rather difficult to compute.

It does not take into account the size of the investment.


IV. UNDERSTAND DIFFERENNT OWNERSHIP STRUCTURES

AND HOW THEY INFLUENCE AND MEASURE FINANCIAL

PERFPRMANCE


UNIT 13. OWNWERSHIP STRUCTURE

13.1 Sole Trader or Sole Proprietorship 13.2 Partnership 13.3 Types of Partnership 13.4 Private Corporation 13.5 Other Types of Corporations 13.6 Public Sector Organisation 13.7 Accounting Standards 13.8 Tax Laws 13.9 Commercial Laws

13.1 Sole Trader or Sole Proprietorship It is a business owned and operated by a single individual; and is the most common form of business structure for small businesses. Such firms are owned by one person, who also has day-to-day responsibility for running the business. Sole proprietorships own all the assets of the business and the profits generated by it. The proprietor has complete responsibility and liabilities for all aspects of the business. The sole proprietorship can be started with ease and needs low capital for its formation. One can start such business simply by filling few forms to provide necessary information and to request for licenses/permits as required by the local authorities. The owner has full claim over the profits. The owner has good degree of flexibility in decision making and running the business. Further, the business can be ended with ease. Major problem here is that such business has unlimited liability as all ‘business debts’ are considered personal debts, under the laws. The debts and other liabilities may be recovered from property and assets owned by the owner. There is limited scope of finding sources of finance, which can be availed only on the basis of credit worthiness of the owner. The owner has to play many roles for the business. He himself is his manager, market-staff, and accountant, etc. The business has to pay income tax as payable by an individual. The owner pays all taxes as personal taxes. Merits:

Easiest and least expensive to start business.

Sole proprietors are in complete control of their business and may make all decisions.

Owner has all rights over the ‘profits’.

The business is easy to dissolve, if desired. Demerits:

Sole proprietor has unlimited liability and is responsible for all debts.

Can raise finance only on the basis of owner’s credit-worthiness.

Some employee-benefits such as owner’s medical insurance premiums are not directly deductible from business income.


13.2 Partnership They are governed by the U.K. Partnership Act of 1890. Partnership based business is owned and operated by two or more persons, who share the ownership of a single business. Like proprietorships, the law does not distinguish between the business and its owners. It is most uncommon form of business in most of the developed nations. There are two basics forms of partnerships, general and limited. In a general partnership, all partners have unlimited liability. In a limited partnership, one or more partner(s) has/have limited liability, but at least one partner accepts full liability for all aspects of business. Most countries require a legal document inform of an agreement, generally called the “Articles (or terms & conditions) of Partnership”. This agreement of partnership defines detailed mode of business operation and liability of various partners; and also of the investment and role of each partner. It stipulates the ‘agreed framework’ defining:

How decisions will be made,

How the profits will be shared,

How the disputes will be resolved,

How future partners will be admitted to the partnership,

How partners can be bought out, and

If needed, what steps will be initiated/taken to dissolve the partnership. Merits:

Easy to establish; only an application to authorities along with a ‘partnership agreement’ is needed to start the business.

Very little Governmental regulations.

More partners mean better decision making.

With more than one owner, the ability to raise funds may be increased.

The business benefits from partners who bring complementary skills. Demerits:

Unlimited personal liability.

Profits shared among partners as per Articles of Partnership.

Partnership ends when a partner dies or leaves.

All partners are accountable for the decisions taken.

13.3 Types of Partnerships

(a) General Partnership

Partners divide responsibility for management and share the profit or loss according to their internal agreement. Equal shares are assumed unless there is a written agreement that states otherwise. Other aspects are as stated in the previous section.

(b) Limited Partnership and Partnership with Limited Liability


This type of partnership is governed by the ‘Limited Partnership Act 1908'. The word ‘limited’ means that most of the partners (accept at least one partner) have limited liability (to the extent of their investment) as well as limited role regarding day-to-day management decisions. (c) Joint Venture

This is an association of two or more parties for a specific purpose for a limited period of time till all parties agree to continue or as specified in their agreement. It is like a general partnership, but is for a limited period of time and for a single specified project. If the partners repeat the activity beyond the initially agreed period of time, they will be recognized as an ‘ongoing partnership’.

13.4 Private Corporation It is a legal business entity whose assets and liabilities are separate from its owners. Its stocks are not listed and not traded on stock exchange. Most small businesses are (or at least start as) private corporations. A private corporation is owned by a small group of people who also manage the business. A legal document, “Articles of Incorporation” is required to be submitted to the State in which the corporation wishes to operate. As per the law, it is considered to be a unique entity, separate and apart from those who own it. A corporation can be taxed, it can be sued, and it can enter into contractual agreements. The shareholders are the collective-owners of the corporation. They elect a Board of Directors to oversee the major policies and decisions. The corporation has a life of its own and does not dissolve when ownership changes. Merits:

Shareholders have limited liability for the corporation.

There is unlimited lifespan for such company.

Ease of transfer of ownership.

Corporations can raise funds through the sale of stock.

Employee benefits are tax-deductible.

Can elect S-corporation status if certain requirements are met.

Demerits:

Incorporation process requires more time and money than other forms of organization.

Incorporating may result in higher overall taxes.

The corporation pays taxes on its income, and then shareholders also pay taxes on any dividends received.

13.5 Other Types of Corporations Other types of ownership of business organizations are discussed in this section, as under. 13.5.1 ‘S’ Corporation

http://www.themoneyalert.com/incorporating.html


It provides the ‘best’ of two forms of ownerships: partnership structure and corporation structure. In this structure, the liability of the owners is limited like in a corporation. Further, owners i.e. the shareholders, have total claim over the profit. Tax is not paid be the corporation, but by the owners. The number and type of shareholders has to be kept in accordance with the guidelines of the local government. Thus, this corporation is taxed like sole proprietorships and partnerships. It has shareholders, directors, and employees. The shareholders have the benefit of limited liability. Regulatory Guidelines:

Maximum number of 75 shareholders, who may be the individuals or organisations.

Only one type of shares can be issued.

More than 75% of income should be from main declared business.

Less than 25% income may be the ‘income from other sources’. 13.5.2 Limited Liability Company (LLC) It is now popular in the U.S. as it provides limited liability and is taxed as a partnership or sole proprietorship. This type of company can be incorporated by submitting articles of organization to the Government. Such companies enjoy high degree of flexibility, and ease of getting incorporation. It has liability like a corporation, and taxation and flexibility advantages of a partnership. 13.5.3 Private Limited Company A Private Limited Company in Asian & other countries is similar to a C-Corporation in the USA. Like a conventional (C) corporation, such companies are state-chartered legal entity, and enjoy limited liability for the owners/shareholders. Private Limited Company has rights to select its shareholder-owners who pay the share capital amounts as decided by the company. It is a legal entity in terms of taxation and limited liability. A private limited company can be formed by registering the company name with the appropriate authority. “Memorandum of Association” and “Article of Association” are prepared and signed by the promoters (initial shareholders) of the company. These have to submitted to the concerned authorities at the time of registration. It can have limited number of shareholders (as specified by local authorities) with share capital paid by them as per local rules. The shareholders appoint Directors (minimum of 02 in number) of the company, who look after the operations and management of the company. The company maintains its account in proper style as per the requirements of Company’s Act and the taxation requirements. The company pays tax on its profit, and the ‘balance profit’ is passed to the owner shareholders, who also pay tax on their personal income. 13.5.4 Public Limited Company Public Limited Company is similar to Private Limited Company with the difference being that number of shareholders of a Public Limited Company can be unlimited with a minimum seven members. A Public Limited Company can be either listed in a stock exchange or remain unlisted.


The shares of a listed Public Limited Company are traded on stock exchange where it is listed. It is bound to make public disclosures as per Company’s Act and observe compliance to the government regulations. A Public Limited Company is an independent legal entity. Its shareholders may sell their shares to other persons. 13.5.5 Non-Profit Corporations A non-profit corporation can be formed to carry out a charitable, educational, religious, literary, or scientific purpose. A non-profit corporation can raise funds by soliciting public and private “grant money” and “donations” from individuals and companies. The national and state governments do not generally levy any tax on the non-profit corporations as their operations are for non-profit purpose for the benefit of the society. 13.5.6 Cooperatives Cooperatives are a form of business organization formed and run by its members in a democratic manner. People forming the ‘cooperative’ are called its “Members”. Basically, the members co-operate with one another in running the business of which they are the owners. Thus, a ‘cooperative’ is a business structure owned and controlled by its members. They also generally act as the workers, producers and consumers. They generally pool their resources for satisfying their mutual objectives. Members democratically run their business. They elect “members of the management committee” or the “members of the board of directors” for running and managing the business of the cooperative. They may hire professional as well as general workers, as may be required. 13.5.7 ‘Limited by Guarantee’ Companies Limited by Guarantee Companies are generally formed by non-profit organisations (such as Sport Clubs, Workers’ Cooperatives, etc). Such companies enjoy the benefits of limited financial liability. A company ‘limited by guarantee’ does not have ‘shares’ or ‘shareholders’ but is owned by the guarantor(s) who agree to pay a ‘set of amount of money’ towards company debts. The law requires such companies to have at least one guarantor and at least one Director to be able to register such a company. But more numbers of Guarantors and Directors are permitted. Same person can be the guarantor and also the Director. Such a company is a distinct legal entity separate from its owners. As per the regulatory guidelines, the profits cannot be distributed to the guarantor(s) but are re-invested as the company, if formed with no-profit objective. 13.6 Public Sector Organization A public sector organization is one that is operated by the government. This contrasts with private sector organizations, which are controlled by private entities. Public sector organizations often provide


services for citizens regardless of the person's ability to pay. The users of the public sector organisations may get the services free or for a subsidised fee. For example, a public transportation system may charge some ticket-charges from the users. In some cases, public sector and private sector organizations may work together for a common cause. For example, the government may award a contract to a private business to work for the public-service project like hospital, bridge, or roads.

13.7 Accounting Standards The corporations use money from the members of the general public who may not be much knowledgeable about business practices. The Company’s Act, therefore, stipulates that corporations should follow certain prescribed standards of accounting so that there may be certain degree of transparency and accountability towards their shareholders and the society. Till the end of 1990’s, commonly used accounting standards were the ‘International Accounting Standards’ (IAS). These were followed in disclosure of financial information regarding company’s transactions and also for preparation of the Financial Statements. These were issued by the Board of International Accounting Standard Committee (IASC). In 2002, the new set of standards namely the “International Financial Reporting Standards” (IFRS), was issued by the “International Accounting Standards Board” (IASB). Most countries require corporations to use the accounting standards advised by the IAS, for preparing the accounts and the Financial Statements. USA had been using the GAAP Standards but is now changing over to the IFRS standards. The “Generally Accepted Accounting Principles” (GAPP) comprise of guidelines, standards and suggested practices for general accounting and preparation of standardized Financial Statements. IFRS are used in many parts of world, including Australia, Chile, European Union, GCC Countries, Hong Kong, India, Malaysia, Pakistan, Philippines, Russia, Singapore, South Africa, and Turkey. Many other countries including the USA are in process of adopting these standards.

13.8 Tax Rules Business formation is controlled by the law of the State where the business is organized. However, all businesses are required to file their ‘annual return’. Sole proprietorships and corporations file an income tax return. Partnerships and S Corporations file an ‘information return’. Some LCC are automatically classified as a corporation and file return accordingly. Other LLC have an option either to file tax returns as a corporation, or as a partnership. A business with a single member can choose to be classified as either a corporation or disregarded as an entity separate from its owner, that is, a “disregarded entity.” LCC, as a disregarded entity, may not file a separate return; the single owner may show all LCC income or loss as part of his own annual tax return.

13.9 Commercial Laws


In most countries, laws govern the obligations of businesses towards labour welfare, protection and safety of workers, and employee discrimination on the basis of age, gender, disability, and race. Law also prescribes guidelines regarding minimum wage, union affairs, and working hours. Operating licenses are required for certain class of businesses. Professions needing compulsory operating licenses include law, medicine, aircraft-pilots, selling liquor, etc. Some businesses namely banking, insurance, broadcasting, healthcare and aviation have to comply with certain special regulations. Corporations can raise money capital through markets and public through equity, bonds, debentures etc through capital market while observing and complying with specified guidelines and regulations. Commercial laws cover large number of corporate practices. Such laws include:

Employment and Labour Law,

Health-Care Law,

Mergers and Acquisitions,

Employee Benefit Plans,

Food and Drug Regulation, and

Intellectual Property Laws.


UNIT 14. ROLES AND ACCOUNTABILITY

14.1 Accountability Concept 14.2 Accountability towards Stakeholder Interests 14.3 Shareholder vesus Sole Trader 14.4 Manager and Owner 14.5 Decision-Making Interests 14.6 Organisation Strategy 14.7 Corporate Social Responsibility (CSR)

14.1 Accountability Concept

When an individual or an organisation is given some responsibility in the social set-up or society, then the individual or the organisation are said to be ‘accountable’ to the society. The “accountability” refers to the ‘commitment’ and ‘answerability’ of the individual or organization to meet the obligations, as under:

to perform the activities and to produce desired results in ethical and legally correct manner;

to accept responsibility towards the society, and

to disclose the ‘results’ and related information in a transparent manner.

It also includes the responsibility for proper and honest use of money and other entrusted property. Such a person or organisation is duty-bound to produce desired/required results. He is ‘answerable’ for the failure to achieve the desired results. He is also ‘accountable’ for proper use of resources. The accountable person or body is bound to explain the reasons (and provide all related information/answers) for non achievement of desired performance or results. He may have to face the consequences for his non-performance.

14.2 Accountability towards Stakeholder-Interest

The stakeholders have a close relationship with the organisation. In context of business organisations, the term ‘stakeholders’ include the owners, shareholders, employees, suppliers, creditors, debtors, and finally the society. They all work for and support the organisation; and are affected by the business performance of the organisation. “Stakeholders are the individuals and groups who can affect and are affected by the strategy outcomes; and who have enforceable claims on the firm’s performance.” They support the business operations of the organisation. The firm has accountability towards its stakeholders and should attempt to fulfil their expectations.

Figure: The Organisation–Stakeholder Relationship

External Stakeholders

Customers, Suppliers, Unions(s),

Mass Media, Bankers, and

Creditors

Contribution/ Support

Expectations/Claims

Internal Stakeholders

Shareholders, Employees, Managers, Directors

Business Firm

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http://www.businessdictionary.com/definition/disclosure.html

http://www.businessdictionary.com/definition/result.html

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http://www.businessdictionary.com/definition/money.html

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The association of the stakeholders with the organisation is a two-way relationship. Stakeholders provide support to the organisation and contribute in different ways for achievement of the objectives of the organisation. In return, the organisation is accountable to satisfy their expectations and claims.

The external as well as internal stakeholders serve the organisations in many ways. The customers buy and pay for the products & services; the suppliers supply the materials, the creditors provide finance and so on. Similarly, the shareholders buy the shares, the employees provide skills & labour; the managers undertake decision-making; and the Directors guide & supervise the managers. In return, the stakeholders have certain expectations and claims. The shareholders expect good performance and returns on their investment. The employees and managers expect fair dealing from organisation and claim compensation in terms of salary & wages.

14.2.1 Control Issues

Control issues in terms of accountability refer to the specific actions expected to be taken by the management of the business organisation to fulfil the expectations of the stakeholders from the business. These are presented in the figure given below.

Accountability Actions

‘A’ Giving Expected Business-Performance;

Honesty in Use of Resources; Answerability for Performance & Results; Provide Required Information.

Business Stakeholder Operation Interest

Rightfulness in Behaviour; ‘B’ Trustworthiness of Business;

Transparency in Stakeholder Relationship

‘C’ Honour Stakeholder-Relationship; Take Care of Stakeholder-Interest

Fig: Accountability Actions by Business Organisations towards Stakeholders

The accountability control issues may be divided into three broad categories:

‘A’: Accountability/answerability for ‘business-performance results’;

‘B’: Rightfulness and trustworthiness in dealings and providing ‘information’; and

‘C’: Commitment to ‘stakeholder-relationship’. The above actions should be oriented towards meeting the expectations of the stakeholders from the business. It may be noted that different segments of stakeholders may have some different set of expectations. For example, the shareholders expect good level of dividends. Employees expect good level of salary and wages, Suppliers and creditors expect timely payments. Customers expect high quality goods & services meeting their expected level of satisfaction.


14.3 Shareholder versus Sole Trader Both the shareholders and the sole traders are the owners of their business. The difference lies in their day-to-day involvement in decision-making for the business and their liability towards the business. A sole trader is an individual in business who has set-up the business with sole ownership status. He is personally responsible for the debts and liabilities of his business. He has no protection for his personal assets, if the business suffers heavy losses. A shareholder’s personal liabilities are limited to the amount he has invested in the company. The shareholders are responsible for the debts and liabilities of the company only to the extent of their unpaid share capital (if any still left for payment, otherwise not). The personal assets of Directors or shareholders cannot be seized to pay off company debts. The significant differences between legal status of ‘shareholder’ and ‘sole trader’ are as under:

Both are owners or shareholders. Sole Trader is the single shareholder in his business.

Shareholder does not participate in business activities and decision-making for the company. Sole trader is actively involved in business activities and management activities including decision-making for the business.

Sole Trader has full information regarding conduct of business and its final results. But the shareholders have to depend on the management (Directors) of the business to get information regarding business performance report.

Being the sole owner as well as the manager of his business, the ‘aspect of accountability’ for the sole trader does not arise. Rather, he is accountable to his stakeholders, namely his customers, suppliers, financiers, employees, customers, and the society at large. But shareholders are not involved in day-to-day operations and decision-making for the business. Therefore, they expect the management of the company to be accountable to them.

14.4 Manager and Owner In a sole trader organisation, the trader is the owner as well as the manager of his business. He has all information regarding his business and takes all decisions himself. Thus, he is accountable to himself, his business and his stakeholders. But the situation is different for other structures of business, where a manager is not the owner of the business. He takes decisions for the business organisation, which may affect the owners either favourably or adversely, depending on the quality of his decisions and actions. The managers have accountability towards the Owners for the purpose of maximisation of their wealth. They are accountable and liable to follow the corporate and business rules and regulations. They are also accountable to follow ethical and legal requirements & practices. The owners (unless the sole trader or partners in a partnership based business) are not accountable for firms’ activities. They do not have any liability towards such practices and actions by the Directors and management of the company.


Managers including the Directors are accountable for the actions by the business Company and are liable to fulfil the expectations of various segments of stakeholders. They are accountable for ethical expectations and legal regulations stipulated for the business.

14.5 Decision-Making Interests The Directors and managers of a business company take variety of decisions to ensure smooth operation and growth of the business. They are also responsible for ensuring compliance to various regulations and laws of the country. Therefore, the interests of management in decision-making are as under:-

Proper conduct of business;

Protecting the invested capital;

Profitability maximisation;

Timely payments of wages and benefits to the employees;

Ensuring growth of business;

Meeting the expectations of the Stakeholders; and

Meeting the competitive pressure with reasonable success.

14.6 Organisational Strategies The business organisations have accountability towards its stakeholders and to the society. Leading and reputed organisations have well established strategies and action plans to meet stakeholders’ expectations, and to ensure compliance to the various regulations and legal stipulations. Successful companies consider the need to provide information to their stakeholders as an important part of corporate governance. They provide relevant information to their stakeholders regarding business performance, and new investments. They take periodical actions in this regard, such as:

Making presentations to Shareholders in the Annual General Meeting;

Meetings with the Media regarding business results;

Presentations on business performance to institutional investors;

Individual meetings for overseas institutional investors; and

Putting general information material on the company’s website.

14.7 Corporate Social Responsibility (CSR) Corporate social responsibility (CSR) refers to the obligations of the business organisation to accept accountability for its actions and to make best efforts to make ‘positive impact’ on the environment, consumers, employees, and other stakeholders. The CSR concept is gaining ground in post 2000 era. The leading business firms are making all-out efforts to avoid any kind of unethical or socially adverse behaviour. Some business organisations undertake philanthropic activities for benefit of its employees and the local population living around its business site. Some firms are providing scholarships for higher education for the children of their employees. Many organizations are taking positive actions to integrate ‘social


values’ in their business strategies. There is now rising trend of reporting CSR related policies and activities in the annual report of the company. Companies are paying more attention and efforts on CSR related activities. Greater efforts are now being devoted for ensuring environment-friendliness, higher product safety, and fair trade practices. Manufacturing companies are using new environmental friendly technologies, and are undertaking socially beneficial activities.

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