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FINANCE FOR STRATEGIC MANAGERS


FINANCE FOR STRATEGIC MANAGERS S.No Description PageNoI UNDERSTANDTHEROLEOFFINANCIALINFORMATIONINBUSINESSSTRATEGY1. NeedforFinancialInformation

1.1 MajorFinancialActivitiesoftheEnterprise1.1.1 MobilisationofFundsRequiredbytheEnterprise1.1.2 EffectiveUseofFundsoftheEnterprise

1.2 StrategicManagersNeedFinancialInformationforDecision-Making1.3 AssessingFinanceRequirements1.4 ObtainingFinance1.5 InvestmentDecisions1.6 DividendDecisions1.7 SettingandMeetingTargets1.8 AppraisingNewProjects(CapitalBudgeting)1.9 SourcesofLong-TermFinance1.10 ManagingRisks1.11 ReportingtoShareholdersandtheStockExchange

2. TimeValueofMoney 2.1 ConceptofTimeValueofMoney 2.2 ValueofMoneyReceivedatDifferentTime 2.3 CompoundingTechnique

2.4 TechniqueofDiscounting3. FinancialInformation

3.1 CashFlows3.2 Profitability3.3 BusinessValue3.4 FinancialStability3.5 CostProjections

4. BusinessRisks

4.1 ConceptofRisk4.2 Systematic&UnsystematicRisks

4.2.1 SystematicRisks4.2.2 UnsystematicRisks

4.3 ManagingRisk:Trade-OffbetweenRisk&Return4.4 Risk-Modelling

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

MAKINGPURPOSES 5. PublishedAccounts

5.1 PurposeofPublishedAccountsorFinancialStatements5.2 UsersofPublishedInformation5.3 AnnualReportoftheCompany5.4 InternalManagementAccountsversusPublishedFinancialAccounts5.5 WeaknessofPublishedAccounts


6. StructureofFinancialStatements6.1 MainFinancialStatements6.2 BalanceSheet

6.2.1 Equity&Liabilities6.2.2 Assets

6.3 StatementofProfitandLoss6.3.1 Revenue6.3.2 Expenses

6.4 CashFlowStatement6.5 NotestoAccounts

7. Analysis&InterpretationofFinancialStatements

7.1 AnalysisofFinancialStatements7.1.1 ComparativeStatement7.1.2 Common-SizeStatement7.1.3 RatioAnalysis7.1.4 CashFlowStatement

7.2 TypesofFinancialStatementsAnalysis7.3 PurposeofFinancialAnalysis7.4 ComparisonbetweenYears

7.4.1 “ComparisonbetweenYears”basedon‘ComparativeBalanceSheet’7.4.2 FormatofComparativeStatementofProfit&Loss7.4.3 ComparativeFinancialStatementsUsingCommonSizeStatement7.4.4 CommonSizeStatementforProfit&Loss7.4.5 CommonSizeStatementforBalanceSheet

7.5 Company/IndustryComparisons&Benchmarking7.6 DifferencebetweenCapitalandRevenueExpenditure

8. AccountingRatios8.1 AccountingRatios8.2 ReasonsforusingRatios8.3 TypesofAccountingRatios8.4 LiquidityRatio(Short-TermSolvencyRatios)8.5 CapitalStructureorSolvencyRatios(LongTermSolvencyRatios)8.6 Activity/EfficiencyRatios8.7 ProfitabilityRatios8.8 InvestorRatios8.9 LimitationsofRatioAnalysis

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

INVESTMENTSANDWORKINGCAPITAL9. ShortandLong-TermFinance

9.1 FinanceforBusiness9.2 MeaningofShortTermandLongTerm9.3 Short-TermFinance9.4 Long-TermFinance9.5 DifferencesbetweenShort&Long-TermFinance9.6 MatchingFinance-IssueswiththeSpecificBusinessRequirement


10. SourcesofFinance10.1 RangeofSources10.2 InternalandExternalSources

10.2.1 InternalSourceofFinance10.2.2 ExternalSourcesofFinance

10.3 SourcesofShort-TermFinance10.3.1 PurposeofShort-termFinance10.3.2 SourcesofShort-termFinance10.3.3 MeritsandDemeritsofVariousShort-TermFinanceSystems

10.4 SourcesofLong-TermFinance10.4.1 PurposeofLong-termFinance10.4.2 FactorsDeterminingRequirementsofLong-termFinance10.4.3 SourcesofLong-termFinance10.4.4 Merits/DemeritsofPopularSourcesofLong-TermFinance

10.5 RoleofMarketsandGovernment11. CashFlowManagement

11.1 ObjectivesofCashManagement11.2 StrategyforCashManagement11.3 CashFlowForecast11.4 BudgetaryControlProcess

11.4.1BudgetaryControls11.4.2 CashBudget

11.5 ManagingInventory11.5.1 NecessityofHoldingInventory11.5.2 ManagingtheInventory

11.6 ManagingTradePayables11.7 ManagingTradeReceivables

12. InvestmentAppraisalTechniques(CapitalBudgeting)12.1 CapitalBudgeting12.2 CapitalBudgetingDecisions12.3 UseofCash-FlowAnalysisinCapitalBudgetingProcess12.4 TypesofCash-FlowsAssociatedwithCapitalBudgeting12.5 PaybackMethodforAnalysingInvestmentProject12.6 AccountingRateofReturn(ARR)Method12.7 DiscountedValue(PresentValue)Method12.8 NetPresentValue(NPV)Method12.9 InternalRateofReturn(IRR)Method12.10 ProfitabilityIndex(PI)orBenefits-CostRatioMethod

IV. UNDERSTAND DIFFERENT OWNERSHIP STRUCTURES AND HOW THEY INFLUENCE AND

MEASUREFINANCIALPERFPRMANCE13. OwnershipStructure

13.1 SoleTraderorSoleProprietorship13.2 Partnership13.3 TypesofPartnership13.4 PrivateCorporation13.5 OtherTypesofCorporations

13.5.1‘S’Corporation


13.5.2 LimitedLiabilityCompany(LLC)13.5.3 PrivateLimitedCompany13.5.4 PublicLimitedCompany13.5.5Non-ProfitCorporations13.5.6 Cooperatives13.5.7 ‘LimitedbyGuarantee’Companies

13.6 PublicSectorOrganisation13.7 AccountingStandards13.8 TaxLaws13.9 CommercialLaws

14. AccountabilityandRoles14.1 AccountabilityConcept14.2 AccountabilitytowardsStakeholderInterests

14.2.1 ControlIssues14.3 ShareholderversusSoleTrader14.4 ManagerandOwner14.5 Decision-MakingInterests14.6 OrganisationStrategy14.7 CorporateSocialResponsibility(CSR)


I. UNDERSTAND THE ROLE OF FINANCIAL INFORMATION IN BUSINESS STRATEGY


UNIT 1. NEED FOR FINANCIAL INFORMATION

1.1 MajorFinancialActivitiesoftheEnterprise1.2 StrategicManagersNeedFinancialInformationforDecision-Making1.3 AssessingFinanceRequirements1.4 ObtainingFinance1.5 InvestmentDecisions1.6 DividendDecisions1.7 SettingandMeetingTargets1.8 AppraisingNewProjects(CapitalBudgeting)1.9 SourcesofLong-TermFinance1.10 ManagingRisks1.11 ReportingtoShareholdersandtheStockExchange

1.1 MajorFinancialActivitiesoftheEnterpriseAllbusinessactivitieshavecertainfinancialimplications.Theobjectivesofabusinessorganisationismostlyexpressedinfinance-relatedtermslikebusinessshareormarketleadership,costleadership,profitability,wealthmaximisation etc. Financialmanagement at corporate level is concernedwithtaking decisions regarding planning, organising, and controlling of financial activities of theorganisation. There are two major areas of financial management relating to: (i) arranging therequired funds for the organisation; and (ii) effective-utilisation of these funds for achieving theobjectivesoftheorganisation.1.1.1 MobilisationofFundsRequiredbytheEnterpriseFundsforabusinessenterprisecanbeobtainedfromdifferentsourceswhichhavedifferentdegreeof cost, risk and control factors for the organisation. Finance managers have an importantresponsibilitytoensurethatfundsareprocuredatminimumcost,atrelativelylowriskandcontrolfactors.Different sources of funds namely equity shares, bank-loans, other credits, debts, foreign directinvestments(FDI)etccarrydifferentlevelofannualpay-backs,andposedifferentlevelsoffinancialrisks.Therefore,seniormanagersoftheenterpriseneedappropriatefinancialinformationfortakingvariousstrategicdecisions,suchas:

• Optionsforraisingfundsfromvarioussources;• Determining theoptimal finance-mix (financial packages fromvarious sources) for the

organisation;• Action-planforraisingthefundsatminimumpossiblecost(s);and• Allocation of profits into (i) dividends for shareholders and (ii) retention within the

organisation.1.1.2 EffectiveUseofFundsoftheEnterpriseAn important responsibility of a Senior Financial Manager is ensuring optimum allocation andutilisationoffundstovariousactivities.Hehasdualresponsibility:fundsshouldnotbekeptidle;andfunds must be used optimally to get best possible returns to the organisation. A fundamentalrequirementisthat“thefundsmustgeneratemoreincomefortheenterprisethanthecostofthe(procurement of) the funds”. The Finance Managers require proper financial information and


knowledge regarding capital-budgeting techniques and also for working capital managementtechniques.1.2 StrategicManagersNeedFinancialInformationforDecision-MakingVarious types of decisions taken by strategic managers of an enterprise require extensiveinformation,knowledgeandskillsoffinancialnaturesothattheymaycarryoutproperquantitativeanalysis of all related issues to arrive at optimal decisions. As discussed above, managers needvarietyoffinancialinformationfor:

• assessingthefinance-requirementsoftheenterprise;and• procuring‘finance’atminimumpossiblecostandmanageablerisks.

Manyfinancialdecisionsareinter-related;andsuchissuesareconsideredsimultaneouslytoarriveatproper decisions in the short-term and long-term interests of the enterprise. Various importantcorporatedecisionsneedingdetailedandaccuratefinancialinformationinclude:

• Assessingthe‘requirementsoffunds’fortheenterprise;• Understandingshort-term&long-termrequirementoffunds;• Decidingpropercapitalstructureformeetingthefund-requirement;• Working-capitalmanagement;• Cashmanagement;• Financialnegotiations;• Investmentdecisions;and• Dividenddecisionsetc.

Some of these important examples of financial information required by the corporate decision-makersaredescribedbrieflyinsubsequentsectionsofthisUnit.ThesearealsotheimportantrolesofSeniorFinanceManagerinabusinessenterprise.1.3AssessingFinanceRequirementsAbusinesscompanyneedsfinanceforitsshort-termandlongtermneeds.Asapractice,thesearecarefully forecasted or assessed. For this, the business managers need extensive informationregardingvariousactivitiesneedingallocationoffunds.Majoractivitiesneedingfundallocationsincludethefollowing:

• Investmentsforfixedlong-termassets;• Workingcapitalrequirements;• Estimationoffundsblockedincurrentassets;and• Otherliabilitiesneedingpaymentsintheperiodunderconsideration.

Techniques namely ‘budgetary-control’ and ‘long-range planning’ are used for forecasting therequirement for finance. Based on such forecasting regarding all business activities, a properestimateispreparedforfund-requirements.1.4 ObtainingFinanceAdequatefinancial informationisrequiredforunderstandingoffundamental issues&activitiesforwhichfundsarerequiredtoberaised.Theseactivitiesinclude:

• Identifyingthepossiblesourcesoffinance;• Analysingthe‘costoffinance’fromeachpossiblesource;


• Carryingoutcost-benefitsanalysisforraisingfundsfromdifferentsources;and• Takingdecisionsregardingthefund/source-mixorthecapitalstructure.

After deciding on requirement of finance, a decision is taken regarding the sources from wherefundsaretoberaisedandalsoapropersource-mixhastobedecidedasvarioussourcesof fundshave different risks and control issues. The management has to decide on the proper ‘capitalstructure’byevolvingbalancebetween long-termfundsandshort-termfunds.Duecarehas tobetakentoensurethatsufficientfundsareavailableforuseasthe‘working-capital’.Both‘profitability’and ‘liquidity’ issues have to be considered simultaneously by the Financial Managers. Themainobjectiveinarrangingforcorporatefinanceistoprocurefundsatminimumcost.1.5 InvestmentDecisionsThe fundsraisedhavetobeproperlyutilised forgenerationofrevenueandprofits.Thisactivity isaimingateffectiveuseoffundsraisedfortheorganisation.TheFinanceManagershaveto:

• analysetheinvestmentproposalsreceivedfromvariousgroupsoftheorganisation;• analysevariousinvestment-proposalsusingtheestablishedtechniques;• ranktheinvestment-proposalsonthebasisoftheevaluationcriterion;and• decideon‘most-attractive’investmentproposalfortheorganisation.

Takinginvestmentdecisionsaboutthelong-termassetsinvolvesuseofafinancialtechniquecalled‘CapitalBudgeting’.Decidingonshort-termassetsinvolvesuseoftechniquecalled‘WorkingCapitalManagement’. The investment proposals are analysed to calculate cost of funds and also thebenefits and financial-returns from the investment. The timing and magnitude of the cash-flowslikelytobegeneratedarealsoassessedandanalysed.Workingcapitalmanagement isalsocalledshort-termfinancialmanagement. It takescareofcashrequirementsforday-to-daydealingsinvolvingcurrentassets.Itisimportantasmeetingthe‘short-terms requirements’ is crucial for ensuring success of the business in the long-term. Sufficientavailabilityofcashwithvariousunitsoftheorganisationisessentialforensuring“liquidity”fortheorganisation.Butontheotherside,keepinglargeamountof‘cashmoney’intheorganisationmeansthat 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‘revenuegenerationforprofitability’.1.6 DividendDecisionsSenior managers have important responsibility in taking dividend related decisions for theenterprise. The company earns certain ‘net profit’ after providing for ‘depreciation’ and makingpaymentof ‘taxes’asapplicable.This ‘netprofit’canbepartlydistributedas ‘dividend’amongtheshareholdersofthecompany,andthebalancecalled“retainedprofit”remainswiththecompanyasthe“reserve”over theexistingequity capital.Retainedprofit canbeusedas ‘internal finance’ forbusiness investment. It thus helps in further generation of revenue and helps the organisation inearningfurtherprofitfortheshareholders.Thoughtheabovementioneddividendrelateddecision-making looksverysimple, itcanaffect themarket price of company’s shares and also the sentiments of the shareholders. It can have animportantimpactonshareholders’interestininvestingforfurtherequitycapital,ifsuchanofferismadebythecompany.However,theaccumulatedretainedprofitcanalsobeusedasthebasisofa“right-issueoffer”fornewequitycapitalfortheexistingshareholders.Suchrightissuesaregenerally


madeatapricelesserthanthenetworthvalueofexistingshare(tomaketheofferattractivefortheshareholders).1.7 SettingandMeetingTargetsTheseniormanagerssetgoalsandtargetsforachievementofprogressforthecompanyformeetingitsobjectives. Such targetsmaybe in termsof sales-targets, production-quality targets, employeeproductivity targets, ‘accident-free days’ targets, cost-reduction target, market-share targets, orcustomersatisfactiontarget.Thesebusiness-relatedtargetshavecertainfinancialimplications.Forexample,‘salestargets’arerelatedtoproductionquality,productpricing,andmoreimportantlyproviding customers’ satisfaction. Each of these issues has cost implications which need to beresolved through a “balanced approach”. The production may be organised to produce betterquality products; which have higher customer-value, result in higher level of satisfaction for thecustomersatrelativelylesserprice.Suchacombinationprovidesawinningstrategyforthecompanyleadingtohighersales,cost-reductionfortheproduct,andhigherprofitabilityforthecompany.1.8 AppraisingNewProjects(CapitalBudgeting)Anynewprojecthasthreecommoncharacteristics:

• Itneedsfundsforinvestment(whichmaybeforlong-term);• It has potential for providing good ‘financial returns’ for the organisation in terms of

revenuegenerationandgoodprofitability,and• Every investment proposal has inherent financial-risks which require careful analysis

beforetakinganyfinaldecision.Thenewprojects need large capital outlays andhave to undergo careful appraisal from technicalandfinancialaspects.Thefinancialappraisalofnewlong-termprojectproposalsiscarriedoutusingtheCapitalBudgetingtechnique.Some commonly used methods/techniques to arrive at capital budgeting decisions (for projectappraisal)arementionedbelow:

• TraditionalCapitalBudgetingTechniques;• AverageRateofReturn;• PayBackMethod;• DiscountedCashFlow(DCF)/Time-AdjustedTechniques;• CashFlowAnalysisMethod;• NetPresentValueMethod;• ProfitabilityIndexMethod;and• InternalRateofReturn.

These are described in a subsequent unit on long-term financing. Various capital budgetingtechniquesareusedtoeither(i)toassesstheprofitabilityofaninvestmentproposal,or(ii)torankvariousproposalsonthebasisoffinancialreturnsorpayback.1.9 SourcesofLong-TermFinanceA business enterprise needs funds to purchase (and to build) fixed assets namely land, buildings,office furniture, equipment, plant andmachinery. Such funds are called “fixed capital”. A part ofworkingcapitalisalsoofpermanentnature.Long-termfinanceisrequiredforfollowingpurposes:

• Tofinance‘fixedassets’oftheenterprise;


• Tofinancepermanentpartofthe‘workingcapital’;and• Tofinancegrowthandexpansionofbusiness.

Numbers of sources are available to meet the requirements of long-term finance. Broadly thesesources are of two types: (i) share capital, and (ii) debt financing. Various sources of long-termfinanceareasunder:

• OrdinaryEquityCapital;• PreferenceShareCapital;• DebenturesandBonds;• LoansfromBanks&OtherFinancialInstitutions;• RetainedEarnings;and• BridgeFinance.

1.10 ManagingRisksAll financial actions namely investments, loans, or any other activity have uncertainty regardingfuture outcome; and therefore have inherent financial risk. Such a risk arises as the financialoutcomecannotbeestimatedorforecastedwithaccuracy.Itisnotpracticallypossibletoaccuratelyforecast the possibility of occurrence of an event. In real-life situation, there may be threepossibilities:

• Certainty:TheriskassociatedisNIL.• Risk:Theoutcomeisnotknown,andtheuncertaintyposesafiniteamountofrisk.• Uncertainty:Thelikelyevent,ortheoutcomeis‘notknown’.Thus,thereistotalrisk;as

noideaispossibleregardingthefuturestate.Inbusinessactivities,therecanbevarioustypesofrisks:

• Market Risk: Its examples may include sudden change in equity price, or change inforeigncurrencyrates,orsuddenfluctuationsincommodityprices.

• InterestRateRisk:Theremaybechangeintheinterest-bearingassetsnamelyloan,bondduetochangeintheinterestrates.

• PurchasingPowerRisk:Theremaybeimpactofinflationordeflationonaninvestment.Pricesofgoodsorservicesmaychangeduetochangesindemand-supplyconditions.

Inanybusiness,changesinthebusiness-riskconditionsinfluencethefinancial“returns”.Generallyahigh-riskinvestmentmayleadtohigherfinancialreturns,thoughnotalwaystrue.Itissaidthatthe‘risk’and‘return’gotogether.Therefore,businessmanagersattempttomakesomekindof“trade-off”betweentheriskandthereturns.1.11 ReportingtoShareholdersandtheStockExchangeTheBoardofDirectorsofacompanyhavealegalisticresponsibilitytomakea“summaryreporting”aboutthecompany’sperformanceandthefinancialresultstotheshareholdersduringtheirAnnualGeneralMeeting(AGM).An‘AnnualReport’isanessentialrequirementaspercompanylawsofthecountry,andcomprisesoffollowingdocumentsauthenticatedbytheBoardofDirectors:

• AReportpreparedbytheBoardofDirectors,presenting:Ø ReportintermsoftheCompaniesAct;Ø Directors’Statementregardingtheirresponsibilities;Ø CorporateGovernanceReport;

• Board’sanalysisoftheprevailingbusinessenvironmentandthebusiness-progressmadebythecompany.


• ReportoftheCompany’sAuditorspreparedasperthelaiddownAccountingStandards;• “Financial Statements” prepared as per the Accounting Standards, giving summary of

financialactivitiesandachievementsoftheCompanyfortheyearunderconsideration,presenting:

Ø ‘BalanceSheet’asontheendoflastfinancialyear;Ø ‘Profit&LossStatement’forthelastfinancialyear;Ø ‘Cash-FlowStatement’.Ø ‘NotestotheAccounts’ofthelastYear.

A copy of the Annual Report is required to be provided to the respective Stock Exchangewherecompany’sequityshares(andotherfinancialinstruments)arelistedforthepurposeoftrading.TheAnnualReportcanthusbeaccessedbyanybodyinthegeneralpublicthroughtheStockExchange.Thus,theannualreportanditsconstituentfinancialstatementsmeetthe‘externalneed(s)’forthefinancialinformationaboutthecompany.Externalinvestors,lenders,suppliers,generalpublicandeven the competitorsuse this information forassessing the financial stateof the company.Othercompaniesinterestingtoformjointventuresalsoneedsuchfinancialinformation.Further,decisionsregardingacquisitionsandmergersarealso takenbyexternalagencies/companieson thebasisofsuchfinancialinformationprovidedbythecompanyintheopenpublic-domain.


UNIT 2. TIME VALUE OF MONEY 2.1 Conceptof‘Time-Value’ofMoney 2.2 ValueofMoneyReceivedatDifferentTime 2.3 CompoundingTechnique

2.4 TechniqueofDiscounting2.1 Conceptof‘Time-ValueofMoney’Inbusinessenvironment,moneyisnotkeptidleasitdoesnotearnfurthermoneywhenidling.Thebasic concept in business operations is that rather than keeping the money idle, it should beinvestedtogeneratemorerevenue.Therefore,if$1000isearnedandisavailableinabusinessorganisation,itistobeinvestedfurtherandisnotkeptidle.Iftheinterestrateis4%,thaninoneyear,itcanearninterestof$40,andthusthenthetotalamountbecomes$1040.Infinancialterms,wemaystatethatatinterestrateof4%,thepresentvalueofmoneyavailableis$1000,butitsfuturevalueafter12monthsis$1040.Statedinotherway,if$1040islikelytobereceivedafter12months,thenitspresentvalue in$1000.Inyetanothermanner,wemaysaythatthediscountedvaluetoday(atinterestratepf4%)of$1040receivable after 12 months, is $ 1000. It may be noted that interest rate is the yardstick forcomputationof‘valueofmoney’atdifferenttime.2.2 ValueofMoneyReceivedatDifferentTimeMoneyreceivedinfutureislessvaluablethanthemoneyreceivedtoday.Thetimevalueofmoneyhelpsinconvertingthedifferent‘moneyamounts’arisingatdifferentpointsoftimeinto‘equivalentvalues’ofaparticularpointoftime.Theseequivalentvaluescanbeexpressedasfuturevaluesoraspresentvalues.Bycompoundingtechniques,thepresentvaluecanbeconvertedintoafuturevalueandbydiscountingmethod,a‘futurevalue’canbeconvertedinto‘presentvalue’.Forthispurpose,weuse‘rateofinterest’asthediscountingfactor.TimeValueofMoney isan importantconcept infinancialmanagement. It isoneofthe importanttoolsusedin‘projectappraisal’tocomparevariousinvestmentalternatives.‘TimeValueofMoney’isbasedontheconceptthatmoneyinvestedtodayisworthmorethanthesameamountexpectedtobereceivedinfuture.Forexample,$1000onhandnowismorevaluablethan$1000receivableafterayear.A key concept behind ‘Time Value ofMoney’ is that a single sum ofmoney or a series of equal,evenlyspacedpaymentsorreceiptspromisedinthefuturecanbeconvertedtoan‘equivalentvalue’today.Conversely,theremaybesome‘cashflows’ofasinglesumoraseriesofpaymentsatsomefuturetimes,thenthesefuturepaymentsmaybeconverted intotheirpresentmoney-values. TheformeriscalledtheFutureValueofCashFlows.AndthelateriscalledthePresentValueof(future)CashFlows.PresentValueisanamountthatisequivalenttoafuturepaymentoraseriesofpayments,thathasbeendiscountedbyanappropriateinterestrate.


Discountingoffuturevalueistheprocessofdeterminingthepresentvalueoffuturecashflows.Itisan important concept, which is used in project appraisals. The opportunity cost rate is the rateavailableonthe‘nextbestalternative’withsameequalriskasthecurrentinvestment.FutureValue istheamountofmoneythataninvestmentwithafixed,compoundinterestratewillgrowto,atafuturedate.2.3 CompoundingTechniqueTheprocessofputtingthemoneyandanyaccumulatedinterestonaninvestmentformorethanayear’speriod,therebyreinvestingtheinterestiscalledcompounding.FutureValueofaSingleCashFlow:-Suppose that an infant-baby wins a Baby-Show, and wins $ 5000 gift receivable when the childattains the age of 18 years. This money can be invested at 10% per annum until the baby-childattainsageof18years.Future-valueconcepthelpsindetermininghowmuchthechildwillreceivewillbeintheaccount18yearsfromnow.TheFutureValueofasinglesumisgivenbytheformula:

FV=PV(1+r)n

Here,r=RateofInterest,Andn=Nosofyearsforwhichcompoundingisdone.

Inthiscase,wehaveFV=$5000(1.10)18=$27,8002.4 TechniqueofDiscountingDiscountingthefuturevalueistheprocessoffiguringoutwhatthatthe‘futurevalue’isintermsofpresentdaymoney.Bycompounding technique, thepresentvaluecanbeconverted intoa futurevalueandbydiscountingmethodfuturevaluecanbeconvertedintopresentvalue.PresentValueofaSingleFutureAmount:-Presentvalue=FutureAmountX(1/(1+r)n)herer=Interestrate;n=numberofperiods,and‘X’isthesignofmultiplication.PresentValueofanOrdinaryAnnuity:-Presentvalue=AnnuityAmountX(1/r)X[1–1/(1+r)n]Here,r=interestrate,andn=numberofperiods.


UNIT 3. FINANCIAL INFORMATION USEFUL IN DECISION MAKING

3.1 CashFlow3.2 Profitability3.3 BusinessValuation3.4 FinancialStability3.5 CostProjections

3.1 CashFlowThe movement of ‘cash’ in a business enterprise is seen as the ‘flow of cash’ in and out of theenterprise.Suchamovementofcashisreferredasthe‘cash-flow’inthebusinessorganisation.The ‘cash flow’ related information regarding a business enterprise forms the basis for preparingfinancial statements for the enterprise. It thus provides a basis to assess: (i) the ability of theenterprisetogeneratecashandcashequivalentsand(ii)theneedsoftheenterprisetoutilisethesecashflows.Theterm‘cash’broadlycoversboth,thecurrencyandothergenerallyacceptedequivalentsofcash,suchascheques,drafts,anddemanddepositsinbanks.Thebroadtermofcashalsoincludesnear-cashassetssuchasmarketablesecuritiesandtimedepositsinbanks.Theseareincludedintheterm‘cash’asthesecanbeconvertedintocash.Thus,thesesupporttheliquidityoftheorganisationbyprovidingcashinshorttime,whenneeded.Thus,theexcesscashavailablecanbekeptasashort-terminvestmentinstrumentwhichmaybeencashedwhenneedarises.There are four primary motives of maintain cash balances: transaction motive; precautionarymotive,speculativemotive,andcompensatingmotive.There are inflows and outflows of cash and cash equivalents. When cash is paid out toreceive/procuresomeasset,itiscalledoutflowofcash.Ontheotherhand,whencashisreceivedonsellingsomeassetoronmaturityofotherasset,oronsaleofgoods&services,itiscalledinflowofcash.Acash flow informationwhenusedwith financialstatements,provides information thathelps inevaluatingthechangesinnetassetsofanenterprise.Cashflowinformationisusefulinassessingtheabilityoftheenterprisetogeneratecashandcashequivalents;andenablesuserstodevelopmodelsforassessingandcomparingthepresentvalueofthefuturecash-flowsofdifferententerprise.Infinancialterm,costandbenefitsaremeasuredthroughcash-flows.Thecostsaredenotedascashoutflowsandbenefitsaredenotedascashinflows.Thus,allestimatesofreceiptsandpaymentsarealsobasedintermsof likely/expectedcashflowsinfinancialanalysis.Cashinflowsareshownwithpositive sign and cash outflows are shown with negative sign for the purpose of quantitativeanalysis.At the end of the operating cycle (generally the year-end) the annual report submitted toshareholdersisaccompaniedbytheCashFlowStatement(CFS).Herethecashflowsfromdifferenttypesofactivitiesarereportedunderfourmajor-headsasunder:


• CashFlowfromOperatingActivities;• CashFlowfromInvestingActivities;• CashFlowsfromFinancingActivities;and• NetIncreaseinCashandCash-equivalents

3.2 ProfitabilityAlltypesofcapitalraisedforthebusinesshavecertaincost(liketheinterestpayable)whichmaybecalledas the ‘pay-out’.The fundsavailablewith thecompanyare invested forgenerating revenue(income) fortheenterprise.Thedifferencebetween such ‘revenueearned’and the ‘costpaid’onthecapitaliscalled‘profit’,andthisprocessiscalledasthe‘profitabilityprocess’.Basic aim of business is profit generation through positive difference between income andexpenditure. The business process is based on the principle of revenue generation through salesgeneratedbymeetingcustomers’ requirementsandprovidingsatisfaction to thecustomers.Thus,productionandmarketingarethebasicworkhorsesforprofitgeneration.Externalbusinessenvironmentalfactorshavestronginfluenceofprofitabilityofthefirm.Therefore,differenttypesofbusinessstrategiesareadoptedtoensureoptimumdegreeofprofitabilityfortheenterprise.Intradeandbusiness: Profit=Price–{Costsofproduction(andallalliedexpenditures)}

–(Depreciation)–(Taxesaspayable)Therefore, ‘cost reduction’ and ‘competitive advantage’ are the two very important strategies forenhancingprofitabilityfortheenterprise.Profitability is closely linked with effective utilisation of funds, particularly the cash funds of theenterprise.Thuscashmanagementhasaninfluenceonprofitability.Companiesgenerallyfacetherisk of ‘running out of cash’ when the need arises to make payment through cash money. Allcompanieswanttoensureliquidityandavoidriskofbecomingtechnicalbankruptcy.Therefore,allbusinessenterprisetrytokeepcertainadditionalcashthenwhatisnecessary.But,keepingexcesscashmoneymeansidlemoneywhichisnotearningrevenue.Thishasadverseeffectofprofitabilityofthecompany.Thereforethereisaneedfortrade-offbetweenliquidityandprofitability.3.3 BusinessValuationTheterm‘valuation’impliesestimationofvalueoftheasset,security-instrument,orabusiness.Thepurchasingdecisionregardinganassetisbasedonsuchavaluation.Butthereisnospecificmethodof valuationof any asset; it is onlybasedonestimation. Twodifferentbuyersmayhavedifferentunderstandingregardingtheworth/valueofanasset.Businessvaluationisrequiredtobedonebothfortangibleaswellasforintangibleassets.Similarlythe business liabilities may be both recorded liabilities and also unrecorded liabilities. Thus, thevaluationprocessisaffectedbysubjectiveconsiderations.BookValue:Theassetsareshowninthe‘BalanceSheet’andcertainvalueismentionedthere.Thisvalueiscalledthe‘bookvalue’oftheasset.Generally,thisamountisthe‘initialacquisitioncost’of


the asset less the accumulated depreciation. Thismethod of valuation is as per the principles ofaccounting.This‘bookvalue’ofanassetmaydifferwithitssalevalue.The sum of book values of all assets of a business firm less the total of its ‘external liabilities’includingpreferencesharesgivesthebookvalueornetworthofabusinessentity.MarketValue:Thevalueatwhichtheassetcanbesoldinthemarket,iscalleditsmarketvalue.Thisvaluationcanbeappliedonlytothetangibleassetsofabusinessentity.Theintangibleassetscannotbe soldorpurchased in themarket.Therefore, theydonothavemarketvalue.Marketvalueofacompany,listedinstockexchange,referstothetotalpriceofallsharesofthecompanyasperthequotationinastockexchange.Intrinsic Value: The intrinsic value of an asset is given by the discounted values of future cash-inflows likely tooccurdue to theparticular asset.Whenanasset is acquiredandput touse, it islikely to earn certain cash flows in coming time. These cash-inflows are discounted at theappropriate‘rateofreturn’togettheintrinsicoreconomicvalueoftheasset.Itisalsoanindicationofmaximumpriceabuyermaybewillingtopay.Thismethodofvaluationusing‘discountedvalues’offuturecashflowissimilartothemethodologyusedfor‘CapitalBudgetingDecision-Making’.(For‘presentvalue’and‘discountedvalue’,seethepreviousUniton‘Time-ValueofMoney’.)ValueofGoodwill:Ithasbeennoticedthatbusinessentitiesenjoyingmarket‘goodwill’,earnhigherrateofreturn(ROR)oninvestedfundsthanbyasimilarfirmswithoutgoodwill.Asperthisconceptofgoodwill,thevalueofgoodwillisequivalenttothe‘discountedpresentvalue’ofsuch“additionalprofitsduetogoodwill”,likelytoaccrueinfuture.FairValue:The‘fairvalue’ofanassetorabusinessisinfactthehybridofthebookvalue,intrinsicvalue,andmarketvalue.Itismostoftenistheaverageofthesethreevalues.3.4 FinancialStabilityA 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 thecreditors as per the general business practice. ‘Owners equity’ (paid by owners/promoters andgeneralpublic)istheinternalorowner'sfund.Ifthe liabilitiesaregreaterthantheowner'sequity,thanthefirmcanfaceafinancialproblem;asthecreditorscandemandtheirmoney,whichthefirmmaynotbeabletopayatthatparticulartime.This is a risk, which the business must avoid. In such a circumstance, if the creditors demandpayment,‘owner’maynotbeabletomeetthatobligationandthefirmmayfail.Therefore,thebusinessshouldbeabletodemonstratethat:

• Itcanpaythecreditorswhenpaymentisdue.• Theprofitabilityofthebusinessisincreasing.• Ithasenoughprofitstocovertheinterestsonliabilities.• Itsnetcashflowispositive.

3.5 CostProjectionsBefore starting any venture or project, a proper estimate is needed for the total cost involved indifferentkindsofexpenditures.Atapreliminarystage,whenexactcostfiguresarenotavailable,abroad‘projectionofcostsinvolved’ismadetopreparethefirstestimateofthetotalcostinvolved.


Compilationof“costprojections”forproposedtask/investment/projectinvolvesfollowingsteps:

• Identificationofbroadheadsofexpenditures;• Further, identificationof“minorheadsofexpenditure” involved foreachbroadmajor-

headsofexpenditurefortheproposedtasks/activities;• Making best possible financial estimates of costs for each expenditure-head so

identified;• Summingup the estimated expenditures for allwork-packages identifiedunder above

steps;• Adding any further cost due to any other activities required to be undertaken to

completetheproceduralrequirementsorothernecessities.Thus“costprojection”iscarriedoutduringtheprojectplanningstageforaprojectneedingfinancialinvestments. ‘Cost-projectionstatement’and itsanalysisare theessential steps forestimating thefutureinvestments.Thecostprojectionsforabusinessprojectcoverthecostofprocurementofallassets, lease-basedprocurementcosts,andalsotheamountsforallpayabletaxes.Further,there isaneedforaddingthe capital required for purchasing the hardware-equipment required for business and theassociatedsoftware;andalsocostoftrainingofemployees.


UNIT 4. BUSINESS RISKS

4.1 ConceptofRisk4.2 Systematic&UnsystematicRisks4.3 ManagingRisk:Trade-OffbetweenRisk&Return4.4 Risk-Modelling

4.1 ConceptofRiskExactguess regarding the ‘future returnson investment’canbemadeonly incaseof investmentscarryingafixedrateofreturn.Forothertypeof investments, it isnotpossibletoguessthefuturerateofreturn.Thesituationwhererateofreturncanbeguessed,posesfinancial‘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 meanfinancialrisks.A ‘stateofcertainty’meanszero levelofrisk.Risk isasituationbetween‘certainty’and‘uncertainty’.Higherthedegreeofuncertainty,higheristhedegreeofrisk.4.2 Systematic&UnsystematicRisks4.2.1 SystematicRisksSystematicrisksrefertosituations,wherethecauseofriskcanbeunderstoodandexplained.Suchfactorsaffectallbusinessinasimilarway.Itssystematicnaturemakesitexplainable.Forexample,marketrelatedriskfactorsaffectallbusinessorganisationsoperatinginthemarket.Suchmarket-relatedfactorsincludechangesininterestrates,andtaxationpoliciesetc.Thesetypesofrisksarenotmanageablebyindividualinvestororbusinessentity.Systematicriskscanbedividedintofollowingcategories:marketrisks,interestraterisk,andpurchasingpowerrisk.

(a) MarketRisk:Thisriskreferstothesituationwhenchangesinmarketrelatedfactorsreducetheprofitabilityofbusiness.Thismaybeduetochangeincostoffinanceorrelatingtocostofcommoditiesrequiredforbusiness.Fourfactorsmaycontributetosuchrisks:

Ø EquityRiskarisingoutofchanges(generallybigfall)inequitysharepricesmakingitdifficulttoraisemarketfinance;

Ø Loan-InterestRateRiskarisingfromvariation(increase)inLoan-Interestrateetc,Ø CurrencyRiskarisingfromvariationinforeignexchangerate,andØ Commodity Risk arising due to change (increase) in commodity prices due to

changesindemand-supplyconditionsandorduetoinflation.

(b) Interest Rate Risk: Change in the interest-rate affects the ‘net cost of assets’ which areacquiredusing such loans.Thismay increase thecostof future investment,and introduceuncertaintiesinthelikelyincomefromsuchassets.

(c) Purchasing Power Risk: Changes in inflation or deflation bring a change in the prices ofgoods and services, needed for running the business operations. Further, there may bechangesinmarketdemand-supplyposition.


4.2.2 UnsystematicRisksUnsystematicrisksrefertothefactorswhichdonotaffectallbusinessunitsinthesamemanner,butdifferently.Forexample,suchfactorsmayrelatetochanges in import/exportpolicies,pricerise incertainrawmaterials,and labourunrestetc.Thesearespecifictocertaintypesofbusinesses,andnotthemarketasawhole.Unsystematicrisksmayhavevarietyofreasons.Oneexampleisincreaseincostofrawmaterialandother inputsforsometypesofbusiness.Suchrisksarespecificonlytofewtypesofbusinessesforsomeperiodoftime.Theserisksarecommonlycalled“BusinessRisks”.Financial Risks refer to “the situations where the revenue generated from the business areinsufficienttocoverthefixedchargeslikeinterestpaymentsondebtpayable.ManagementRisk refers to the situationwhen themanagersof abusiness firm lack the requiredmanagerialknowledgeandexpertisemanagethebusinessoperationsandthecompetition,therebynot able to ensure profitably of business in a particular situation arising due to external businessenvironment.4.3 ManagingRisk:Trade-OffbetweenRisk&ReturnIt is generally said that “risks are inevitable and have to be faced”. Business practices show thatgreatertherisk,greaterthegain.Asstatedearlier,‘return’isdefinedasthevariabilityofexpectedreturns froman investment. “Return is thegainor lossexpectedoveraperiodof time”.Businessmanagersattempt tomaximise/optimise thereturns fromtheir investmentsbyadoptinga“trade-off”betweenriskandreturn.In business operations, returns and risks go together. Business decisions are based on findingoptimal “risk-return trade-off”. If riskcanbeassessedproperly,a comparisonof returnand risk ismeaningful;andtrade-offcanbeattempted.Riskariseswhen‘expectedreturn’isnotknownprecisely.Astheriskarisesduetovariabilityintheexpectations, risk canbeassessed throughmeasurementofvariabilityusing statistical techniques,namely (i) standard deviation, (ii) variance, (iii) co-efficient of variation, (iv) skewness, and (v)probabilitydistribution.4.4 Risk-ModellingCapitalAssetPricingModel(CAPM):Thestandarddeviationofthereturnsontheportfolioisusedas an indicator of increase or decrease of risk. Thus, if adding a stock to a particular portfolioincreasesitsstandarddeviation,thenitmeansthatthenewstockaddstotheriskoftheportfolio.Avariable‘Beta’isusedtoassessthesystematicrisks.Betaisdefinedasunder. RiskoftheMarketPortfoliowhenNewAssetisaddedit

Beta= RiskoftheMarketPortfolioThus, ‘Beta’ isameasureofthesystematicriskofanassetrelativetothatofthemarketportfolio.Beta value of 1, indicates an asset of average risk. Beta value > 1, indicates that the selectedinvestment is riskier than the average level of market-risk. Beta value < 1, indicates that newinvestmentislessriskierthanthemarketlevel.


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

PURPOSES


UNIT 5. PUBLISHED ACCOUNTS

5.1 PurposeofPublishedAccountsorFinancialStatements5.2 UsersofPublishedInformation5.3 AnnualReportoftheCompany5.4 InternalManagementAccountsversusPublishedFinancialAccounts5.5 WeaknessofPublishedAccounts

5.1 PurposeofPublishedAccountsorFinancialStatementsAs per companies Act, business companies are required to disclose and publish their financialaccountsorfinancialstatementseveryyear.TheFinancialStatementsaresummarisedstatementsof‘accountingdata’preparedattheendofanaccountingyear.“Asrequiredbythelaw,theseserveasamediumofdisclosingaccountinginformationforusebytheinternalandexternalusers”.FollowingdocumentsformpartoftheYearlyFinancialStatementsofacompany:

• BalanceSheet:Itisastatementof‘assets’and‘liabilities,andtheirconstituents,ofthecompanyataparticulardate,generallytheendoftheaccountingyear.

• StatementofProfitandLoss:Itisastatementshowingtheresultofbusinessoperationsintermsoftheincomeandexpendituremadeduringtheaccountingyear.

• NotestoAccounts:Itprovidesthedetailsofitemsmentionedinthe‘BalanceSheet’andthe‘StatementofProfitsandLoss’.

• CashFlowStatement:itshowstheflowofcashintothecompany(calledCashIn-FlowsortheReceipts)andthecashflowingoutofthecompany(calledCashOut-FlowsorthePayments).

Theobjectivesoffinancialstatementsaretodisclose:

• Financialdataonassetsandtheliabilitiesofthecompanyattheendoftheaccountingyear.

• Implicationsoffinancialprofitsonthefinancial-performanceofthecompany.• Summarised financial information about the company for use by various interested

parties.• Fairandcorrectpictureofthe“financialpositionofthecompany”asrequiredunderthe

Laws.Italsoservesasthebasisoffurtherreportingonthebusinessoperationsofthecompany.5.2 UsersofPublishedInformation

(a) InternalUsersTheinternalusersoffinancialstatementsofacompanymaybeclassifiedinthreecategoriesasunder:

• Shareholders:Theyhaveinvestedinthe“equityofthecompany”andhavearighttoknowthe‘truepicture’regardingthefinancialpositionofthecompany,particularlyitsprofitability,assets,liability,andcashposition.

• Company’s Management: They are responsible to manage the operations andprofitability of the company. For this purpose, they need summarised financialpositionfortakingappropriatedecisions.


• Company’sEmployees:Theemployeeshaveinterestinthegrowthandprofitabilityof the company, as their bonus is liked with the profits and the reserves of thecompany.

(b) ExternalUsers

Theexternalusersoffinancialstatementsofacompanymaybecategorisedasunder:

• Investors:Theyneedauthenticatedstatementoffinancialpositionofthecompanysoastodecideaboutcontinuingwiththeirinvestments.

• Creditors:Asperbusinesspractice,materialsandsemi-finishedgoodsaresuppliedto the company on credit basis. The terms and conditions of credit varywith thefinancialpositionofacompany.Therefore,thesuppliers(ascreditors)needtoknowauthenticstatementsoffinancialpositionofacompany.

• Banks andOther Lenders: As providers of loans, they are interested to know thetruefinancialpositionsofthecompanysoastosafeguardtheirloansandtoensuretimelyrecoveryoftheir loans.CashFlowStatementsprovideuseful informationtoassessthecashpositionofthecompany.

• IndustryBodiesandGovernmentAgencies:Governmentagenciesmakeassessmentofbusinessrelatedfactorsandtomakeassessmentaboutvariousindustrysegmentssoastomakeappropriatepoliciesforindustrialdevelopmentandgrowth.

5.3 AnnualReportoftheCompanyA company is required, as per the law, to publish its Annual Report and provide prescribedinformation tohelp theusers inmakingappropriate financial judgementsanddecisionsabout thecompany.TheinformationisrequiredtobedisclosedintheFinancialStatements,BoardReport,andbyaseparatestatementbeingpartoftheannualreport.TheAnnualReportofacompanycomprisesoffollowingdocuments:

• AReportsubmittedbytheBoardofDirectorshaving:Ø A report prepared according to the Company’s Act and summarising the business

environment,company’sperformance,andtheresultsinbrief;Ø Director’sResponsibilityStatement’;Ø ReportonCorporateGovernance’;andØ Discussion/CommentsbytheManagement.

• Auditor’sReport,aspertheprovisionsoftheCompany’sAct.• FinancialStatementsincluding:

Ø BalanceSheetasonthelastdayoftheaccountingyear;Ø StatementofProfits&Lossfortheyearended;andØ CashFlowStatement.Ø NotestotheAccounts,providing:

o AccountingPolicyfollowedbytheCompany;o NotestotheAccountsgivingdetailsoftheItemsmentionedinthe‘Balance

Sheet’ and the ‘Statement of Profit & Loss’; and Other additionalinformationrequiredtobedisclosedintermsoftheCompany’sAct.

Asperthecompany’sAct,acompanyisrequiredtoholdameetingofallshareholdersonceayear,calledtheAnnualGeneralMeeting(AGM).Thismeetingisconvenedtoadopt,considerandapprovetheBoard’sReport,BalanceSheet,StatementofProfitandLoss,andtheCashFlowStatement.ThemeetingalsoconsidersthereportoftheAuditorsappointedforthecompanyinthelastAGM.


TheAuditors are required to examine theBooksofAccountsof the company,makea consideredprofessionalopiniononthefinancial figuresprovided inthe ‘BalanceSheet’andthe ‘StatementofProfitandLoss’.TheAuditorsrecordtheirexpert-views,whichareincludedintheAuditor’sReport.The Annual Report is submitted to the shareholders for consideration in the Annual GeneralMeeting.5.4 InternalManagementAccountsversusPublishedFinancialAccountsFinancial accounting is prepared to meet the requirements of the Companies Act for providinginformation regarding ‘financial performance in the last accounting year’ to the shareholders,bankers,creditors,andotherswhoareoutsidetheorganisation.Management Accounting is defined as the “process of identification, measurement, analysis,interpretation, and communication of information for use by the management in planning,evaluating,andcontrollingthebusinessoperationswithintheorganisation.”Management accounting refers to (i) analysing the financial performance of a company and (ii)generatingfinancialinputsforthemanagementoftheorganisation,foruseinfinancialplanning(forthe future) and for appropriate decision-making (for the present). Management accounting ispreparedtomeetthespecificrequirement(s)ofthebusiness-managers.Managerial accounting generates financial data for running the business activities of theorganisation.Financialaccountingprovidesthesummarisedauthenticated“financialresults”usefulforevaluatingthecompany’spastperformance.Majordifferencesbetweenfinancialaccountingandmanagerialaccountingareasunder:-

• Financialaccountingcoversbusinessresultsoftheentireorganisation,butmanagementaccountingmaybepreparedforapartoftheorganisation.

• Financialaccountingdisclosesthefinancialresultsofthebusinessforitsstakeholdersasper the requirement stipulated in the Company’s Act. But management accountinginformation is prepared to provide to generate certain information required by themanagementoftheorganisationforplanningandgoal-setting.

• Financial accounting provides “reports on the past performance” whereas themanagementaccountingaimsatsupportingtheactivitiesofthefuture.

• Financial accounting reports are prepared as per a specified format, butmanagementaccountingreportsmaybepreparedinanyformat.

5.5 WeaknessofPublishedAccountsThefinancialstatementsprovidesummarisedfinancialinformationaboutacompany,foraparticularaccountingperiod.Whilemakingasummary,specificdetailsarenotmentionedandarelostintheprocess.Theirlimitationsaredescribedasunder:

• Useofdifferentaccountingpracticesmaypresentalltogetherdifferentpicture.• Presentsonlythehistoricsummarisedstatements,butnotfullyear’spicture.• Thesearebasedonaccountingpractices.• Financial statementspresent company’sposition inmonetary terms.Onlyquantitative

pictureispresented,andqualitativeexplainationisnotprovided.• Only a summarised picture is presented; details of various transactions of business

activitiesarenotpresented.


UNIT 6. STRUCTURE OF FINANCIAL STATEMENTS

6.1 MainFinancialStatements6.2 BalanceSheet6.3 StatementofProfitandLoss6.4 CashFlowStatement6.5 NotestoAccounts

6.1 MainFinancialStatementsAsmentionedinthelastunit,financialstatementsarethe‘summarisedstatements’of‘accountingdata’asonthelastdayofthe‘accountingperiod’.Thesecompriseof:

• BalanceSheet,• StatementofProfitandLoss,• CashFlowStatement;and• NotestoAccounts

6.2 BalanceSheetFormatoftheBalanceSheet

NameoftheCompany:..............................; BalanceSheetason......................................

Particulars Note Figuresasatthe Figuresasatthe No endofthecurrent endofthePrevious ReportingPeriod ReportingPeriodIEQUITY&LIABILITIES

• Shareholders’Funds:o ShareCapitalo Reserves&Surpluso MoneyReceivedagainstShareWarrants

• ShareApplicationMoneyPendingAllotment• Non-CurrentLiabilities:

o Long-TermBorrowingso DeferredTaxLiabilities(Net)o OtherLong-TermLiabilitieso Long-TermProvisions

• CurrentLiabilities:o Short-TermBorrowingso TradePayableso OtherCurrentLiabilitieso Short-TermProvisions

TOTAL=

IIASSETS• Non-CurrentAssets:

o FixedAssetso Non-CurrentInvestmentso DeferredTaxAssets(Net)o Long-TermLoansandAdvanceso Other/Non-CurrentsAssets

• CurrentAssets:o CurrentInvestmentso Inventorieso TradeReceivableso CashandCash-Equivalentso Short-TermLoans&Advanceso OtherCurrentAssets

TOTAL=.


BalanceSheetprovidesasummarisedstatementofcompany’sequity,assetsandliabilities,asonthelastdayof theaccountingyear. It ispresented intwosegments: (i)equity& liabilities;andthe(ii)assets.6.2.1 Equity&LiabilitiesEquity istreatedasa liabilityas it isasumprovidedbyshareholders;andthecompanyis liabletoearnprofitontheequitycapital.Itincludesthefollowings:

• OrdinaryShareCapital• PreferenceShareCapital• ReservesandSurplus(accumulatedamountof‘retainedprofit’overearlieryears),and• MoneyReceivedagainstShareWarrants(awaitingallotmentofsharesatalaterdate).

Liabilities:

Liabilities of a company refer to the amounts/loans/debts payable by the company. These arepresentedintwosets:(i)CurrentLiabilitiesandthe(ii)Non-CurrentLiabilities.

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

whicharelikelytobesettled:• Within12monthsfromthe‘reportingdate’;• WithintheOperatingCycleoftheCompany;

CurrentLiabilitiesinclude:

• Short-TermBorrowings;• Short-TermProvisionsforotherpaymentslikelytobecomeduein12months;• Debtsoflongtermnaturepayablewithin12months;• AmountpayableinTradeCircleforgoodsobtainedoncreditbasis;• Interestsnotyetpayablebutwillbecomeduelater;• Incomereceivedinadvance;and• Dividendsnotyetcollectedbyshareholders.

(b) Non-CurrentLiabilities

As per the Companies Act, non-current liabilities are those which are payable in time ofmorethan12months,andincludethefollowings:

• LongTermBorrowings:Repayableafter12monthsofdateofbalancesheet.Thesemayincludebonds,debentures,termloans,anddepositsreceivedfrompublic.

• Deferred Tax Liabilities (Net): These relate to the taxes on income, which willbecomepayableonalaterdateasfixedbytaxauthorities.

• Other LongTermLiabilities:These include (i) ‘tradepayables’ forgoods&servicesprocured, and the payments becoming due after 12 months from the date ofbalancesheet,and(ii)otheramountspayablesafter12monthsofbalancesheet.

• LongTermProvisions:Theseareamountskeptasidetomeetthefutureliabilities.6.2.2 AssetsAsperCompaniesAct,assetsareoftwotypes:(i)currentassetsandthe(ii)non-currentassets.Non-currentassetsaredefinedinanegativemanner;meaningthe“non-currentassetsarethoseassetswhicharenotthecurrentassets”.


CurrentAssets:CurrentassetsaredefinedintheCompaniesAct,astheassetswhichare:

• Expectedtobeencashedorsoldwithinthenormaloperatingcycle;• Acquiredandheldforshort-termforsolepurposeoftrading;• Cashandcash-equivalent,encashablewithin12monthsofthedateofbalancesheet.

Theseareclassifiedunderfollowingheadings:

• CurrentInvestments:Theseinvestmentsareexpectedtobeconvertedintocashwithin12monthsofdateofpurchase.

• Inventories: These include raw material, work-in-progress, finished goods, stock-in-trade,stores,sparesandtoolsetcusedaspartofthemanufacturingprocess.

• Trade Receivables: These relate to cash to be received within 12 months of balancesheet,forthegoodssoldoncredit-terms.

• CashandCashEquivalents:Thisincludescashinhand,cashheldinbanks,chequesanddrafts yet tobe encashed, andbankdepositswithmaturity datewithin 12monthsofbalancesheet.

• ShortTermLoansandAdvances:Theseareexpectedtoberealisedwithin12monthsofbalancesheet.

• OthercurrentAssets.Non-CurrentAsset:Theseareclassifiedasunder:

• FixedAssets:Theseassetssupportrevenue-generationprocessofthecompanyandaregenerallynotintendedforsale.Theseincludeboththetangibleandintangibleassets.

• Non-CurrentInvestments:Theseassetsareintendedtobeheldforlongtime.• DeferredTaxAssets (Net): If theaccounting income is less than the taxable income, it

resultsinDeferredTaxAsset(Net).• Long Term Loans&Advances to other parties, expected to be received back after 12

monthsofbalancesheet.• OtherNonCurrentAssets, like the long-termtradereceivables tobereceivedafter12

monthsofbalancesheet.6.3 StatementofProfitandLossTheformatofStatementofProfitandLossisgivenonthenextpage.Thisstatementshowsthe financialperformanceof thecompany in termsof the ‘profitearned’or‘loss incurred’ during the particular accounting period. The difference between ‘revenue’ and the‘expenses’showstheprofitorthelossfortheaccountingyear.Thecolumnfor“NoteNo”isprovidedforthepurposeofcreatinga‘cross-referencenumber’whichalsoappearsinthe“NotesforAccounts”wherethedetailsaboutthisentrycanbeseenagainstthisparticular“NoteNo”.Varioustermsusedin‘StatementofProfitandLoss’aredescribedbelowinsucceedingparagraphs.


FormatofStatementofProfit&LossNameoftheCompany:.................,StatementofProfitandLossfortheYearendedon......................

Particulars Note Figuresasatthe Figuresasatthe No endoftheCurrent endofthePrevious ReportingPeriod ReportingPeriodIRevenuefromOperationsIIOtherIncomeIIITotalRevenue(I+II)

IVExpenses:o CostofMaterialsConsumedo PurchaseofStock-in-Tradeo ChangeinInventoriesofFinishedGoodso Work-in-ProgressandStock-in-Tradeo EmployeesBenefitExpenseso FinanceCostso DepreciationandAmortisationExpenseso OtherExpensesTotalExpenses

VProfitbeforeTax(III–IV)VILessTaxVIIProfitorLossforthePeriod(V–VI)6.3.1 Revenue

(a) Revenue from theOperations: ‘Revenue from operations’means ‘income’ earned by thecompanyfromitsbusinessoperations.

(b) OtherIncome:Acompany,besidesearningrevenuefromitsmainoperations,mayalsoearnincome from sources other than its main activities. Such incomes are shown as ‘OtherIncome’inthestatementofprofitandloss.

6.3.2 Expenses:

(a) Cost ofMaterial Consumed:The term ‘material’means rawmaterial and othermaterialsused inmanufacturing of goods. ‘Cost ofmaterial used’means cost of rawmaterials andothermaterialsconsumedinmanufacturingthegoods.

(b) PurchaseofStock-in-Trade:PurchaseofStock-in-Trademeansgoodspurchasedfortradingor resalepurposes. For example, if a companybuys steel formaking steel-components aspartofmanufacturingprocess,thenthisexpenditurewillbeshownunder“costofmaterialused”.However,ifsteelifboughtfortradingpurposestoberesoldonprofit,thanitwillbeshownunder“PurchaseofStock-in-Trade.”.

(c) Change in Inventories of FinishedGoods,Work-in-Progress and Stock-in-Trade: ItmeansdifferencebetweentheOpeningandClosingInventories(Stock)ofFinishedGoods,Work-in-ProgressandStock-in-Trade.

(d) EmployeesBenefitExpanses:ItmeanspaymentsmadetowardsexpenditurerelatingtotheEmployees of the business. This may include payment for wages, salaries, bonus, andemployeewelfareactivities.

(e) FinancialCosts:Financialcostsmeansexpenditureincurredbythecompanyonthefinancialactivities, like the interests paid on its borrowings from banks and other sources (likedebenturesandbondsetc).

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


6.4 CashFlowStatement

TheFormatofCashFlowStatementisasgivenbelow.

NameofCompany:............., CashFlowStatementfortheYearended:..................

Particulars Amount Totalforthe forthisItem MainHeadICashFlowfromOperatingActivitiesA.NetProfitbeforeTaxandExtraordinaryItem(asperWorkingNote) ---AdjustmentforNon-CashandNonOperatingItemsBAdd:Itemstobeadded

v Depreciation ---v Goodwill,PatentsandTrademarksandAmortised ---v InterestonBankOverdraft/CashCredits ---v InterestonBorrowings(Short-termandLongTerm)andDebentures ---v LossonSaleofFixedAssets ---v IncreaseinProvisionforDoubtfulDebts --- ---

CLess:ItemstobeDeductedv InterestIncome ---v DividendIncome ---v RentalIncome ---v Gain(Profit)onSaleofFixedAssets ---v DecreaseinProvisionforDoubtfulDebts --- ---

DOperatingProfitbeforeWorkingcapitalChanges(A+B–C) ---EAdd:DecreaseinCurrentAssetand

IncreaseinCurrentLiabilitiesv DecreaseinInventories(Stock) ---v DecreaseinTradeReceivables(Debtors/BillsReceivable) ---v DecreaseinAccruedIncome ---v DecreaseinPre-PaidExpenses ---v IncreaseinTradePayables(Creditors/BillsPayables) ---v IncreaseinOutstandingExpenses ---v IncreaseinAdvanceIncome --- ---

FLess:IncreaseinCurrentAssetsandDecreaseinCurrentLiabilitiesv IncreaseinInventories(Stock) ---v IncreaseinTradeReceivables(Debtors/BillsReceivables) ---v IncreaseinAccruedIncomes ---v IncreaseinPre-PaidExpenses ---v DecreaseinTradePayables(Creditors/BillsPayables) ---v DecreaseinOutstandingExpenses ---v DecreaseinAdvanceIncomes --- ---

GCashGeneratedfromOperations(D+E–F) ---HLess:IncomeTaxPaid(NetofTaxRefundreceived) ---ICashFlowbeforeExtraordinaryItems ---

v ExtraordinaryItems(+/-) ---JCashFlowfrom(orUsedin)OperatingActivities ---IICashFlowfromInvestingActivities

v ProceedfromSaleofFixedAssets ---v ProceedsfromSaleofInvestments(OtherthanCurrentInvestments

(tobeincludedinCashandcashequivalents)andMarketableSecurities) ---v ProceedsfromSaleofIntangibleAssets ---v InterestsandDividendReceived(ForNon-financialCompaniesonly) ---v RentReceived ---v PaymentforPurchaseofFixedAssets (---)v PaymentsforPurchaseofInvestments(OtherthanMarketableSecurities) (---)v PaymentsforPurchaseofIntangibleAssetslikeGoodwill (---)v ExtraordinaryItems(e.g.InsuranceClaimsonMachineryagainstfire)(+/-) ---

CashFlowfrom(orUsedin)InvestingActivities ---


IIICashFlowfromFinancingActivitiesv ProceedsfromIssueofSharesandDebentures ---v ProceedsfromOtherLongTermBorrowings ---v Increase/DecreaseinBankOverdraftandCashCredit ---v PaymentofFinalDividend ---v PaymentofInterimDividend (---)v PaymentofInterestonDebenturesandLoans(ShortTermandLongTerm) (---)v RepaymentofLoans (---)v RedemptionofDebentures/PreferenceShares (---)v PaymentofShareIssueExpanses (---)v PaymentsforBuy-backofSharesasExtra-OrdinaryActivity (---)

CashFlowfrom(orUsedin)FinancingActivities ---IVNetIncrease/DecreaseinCashandCashEquivalents(1+2+3) ---VAdd:CashandCashEquivalentsinthebeginningoftheYear

v Cash-in-Hand ---v CashatBank ---v Short-termDeposits ---v CurrentInvestments ---v MarketableSecurities --- ---

---VICashandCashEquivalentattheendoftheYear

v Cash-in-Hand ---v CashatBank ---v Short-termDeposits ---v CurrentInvestments ---v MarketableSecurities --- ---

WorkingNote:NetProfitbeforeTaxandExtraordinaryItemsNetProfitasperStatementofProfitandLossorDifferencebetweenClosingBalanceandOpeningBalanceofSurplus,i.e.BalanceinStatementofProfitandLoss. ---Add: TransfertoReserves ---

ProposedDividendforCurrentYear ---InterimDividendpaidduringtheYear ---ProvisionforTaxfortheCurrentYear ---Extra-OrdinaryItems,ifany,debitedtotheStatementofProfitandLoss ---

---Less: Extra-OrdinaryItems,ifany,creditedtotheStatementofProfitandLoss ---

RefundofTaxcreditedtotheStatementofprofitandLoss --- ---NetProfitbeforeTaxandExtra-OrdinaryItems ---CashFlowStatementisastatementthatshowstheflowof‘CashandCashEquivalents’duringtheaccounting period. Receipt of cashmoney is shown as “Cash-inflows” and the cash payments areshownasthe“Cash-outflows”.The‘AccountingStandards’requireCashFlowStatementstobepreparedshowingcashflowsunderthreeheads:

• CashFlowfromOperatingActivities,• CashflowfromInvestingActivities,and• CashflowfromFinancingActivities.

The“CashFlowStatement”ispreparedbycomputingcash-flowsfromeachoftheaboveactivities.Followingstepsarefollowed:

• For each of above three activities, ‘cash inflows’ and ‘cash outflows’ for varioustransactionsarecomputed.Summingupsuchindividualcasesofcashflows,netsumofcash flowsof thesethreeactivities isobtained.Thisgives thenetchange incash flow,whichmaybeapositiveornegativenumberorevenbezero.


• ‘Cash and cash equivalent’ balance in the beginning of the year is added to the netchangeincashflow.Thisprovidesthenet‘cashandcashequivalents’attheyearend.

6.5 NotestoAccounts ‘Notes to Accounts’ is the statement attached to the Financial Statements. It has the details ofitems/entries coveredunder ‘BalanceSheet’and the ‘StatementofProfit andLoss’. Inaddition, italsomentionstheAccountingPoliciesadoptedandadditional informationrequiredtobedisclosedaspertherequirementsoftheCompanyAct.


UNIT 7. ANALYSIS & INTERPRETATION OF FINANCIAL STATEMENTS

7.1 AnalysisofFinancialStatements7.2 TypesofFinancialStatementsAnalysis7.3 PurposeofFinancialAnalysis7.4 ComparisonbetweenYears7.5 Company/IndustryComparisons&Benchmarking7.6 DifferencebetweenCapitalandRevenueExpenditure

7.1 AnalysisofFinancialStatementsFinancialStatementsofbusinesscompaniesprovideinformationabout‘assets’,‘liabilities’,‘equity’,‘revenues’,‘expenses’,and‘profitorloss’ofanenterpriseinabsoluteamountsasonthelastdayofa particular accounting year. These are analysed with the financial statements of (i) the sameenterprise for earlier years, or (ii) with that of another similar enterprise operating in similarbusinessenvironment.MethodsusedforanalysisofFinancialStatements,andarebrieflydescribedinthisUnit.7.1.1 ComparativeStatement‘ComparativeStatement’ isalsocalledthe‘ComparativeFinancialStatement’. It isusedformakingcomparativestudyofvariousitemscoveredintheFinancialStatements,namely‘BalanceSheet’and‘StatementofProfit&Loss’oftwoormoreyearsofacompany.InComparativeStatement,amountsof twoormoreyears, foreach item,areplaced sideby side.Then in the next two columns, the ‘change in amount’ is written in absolute amount and inpercentage terms. Thus, comparisonof yearly figures canbemade anddifference canbe seen inabsolutevalueandalsointermsofpercentagechange.Thismethodcanbeusedbothfor‘BalanceSheet’andfor‘StatementofProfit&Loss’.7.1.2 Common-SizeStatement‘Common Size Statements’ are also called ‘Common Size Financial Statements’. In this method,variousitemsoftheFinancialStatementsoftwoormoreyearsareplacedsidebyside;andtheninthenextcolumn,theseareconvertedintopercentagetakinga‘commonbase’.The‘commonbase’normally taken is (i) “Total of Assets” or “Total of Equity & Liabilities”, for Common Size BalanceSheet;and(ii)“RevenuefromOperations”forCommonSizeStatementofProfit&Loss.IntheBalanceSheet,thetotalof‘Assets’or‘Equity&Liabilities’istakeas100;andallthefiguresareexpressed as percentage of the total. Similarly in the Statement of Profit & Loss, ‘Revenue fromOperations’ is taken as 100 and all amounts are converted as percentage of ‘Revenue fromOperations’.7.1.3 RatioAnalysisRatioexpressesarithmeticrelationshipbetweentwoitemsofFinancialStatement,whichrelatedorinter-dependentinnature.Thismethodcanbeusedforboth,the‘BalanceSheet’and‘StatementofProfit&Loss’.


7.1.4 CashFlowStatementCash Flow Statement is a statement showing flow of ‘Cash and Cash Equivalents’ during theaccountingperiod. Itshowsfromwheretheflowstartedandwhere itwasreceived.This isshownboth for expenditure (Cash-outflows) and for income/receipts (cash-inflows). It also shows thechangesin‘net-cashpositions’fromoneaccountingperiodtoanother.7.2 TypesofFinancialStatementAnalysisGenerally,therearefourtypesofFinancialStatementAnalysis,asdescribedbelow.External Analysis: External analysis is conducted by people/agencies external to the businessorganisation,whodonothaveaccesstothefinancialrecordsofacompanyand,therefore,havetodepend on the published accounts, i.e. Statement of Profit and Loss, Balance Sheet, Directors’ &AuditorsReport.InternalAnalysis:Internalanalysisisconductedbythemanagementoftheorganisationtoknowthedeeper insights of financial position and operational efficiency. As total financial records areavailabletothemanagement,suchanalysiscanbeveryelaborate.Horizontal (or Dynamic) Analysis: It refers to comparative analysis of specific items of financialstatementsfordifferentyearsofoperationofbusiness.Itpresentscomparisonoffiguresforcertainfinancialdatafordifferentyearsbytaking‘valuesofaparticularyear’asthebasevalue.Itfacilitatestrendanalysisand isuseful formakingforecastingandplanningforthecompany. Itgenerallyusescomparativefinancialstatementformakingyear-wiseanalysis.Vertical (or Static) Analysis: Such an analysis compares different figures of the same yearstatementsbyexpressingtheresultasratioorpercentage.RatioAnalysisoftheFinancialStatementforoneaccountingyearisalsoverticalanalysis.Thisanalysisisusefulincomparingtheperformanceofseveralcompaniesofthesametypeordivisionsordepartmentsinonecompany.7.3 PurposeofFinancialAnalysisFinancialanalysisservesthefollowingpurposesandbringsoutthesignificanceofsuchanalysis.AssessmentofEarningCapacityorProfitability:FinancialStatementsprovideinformationregardingyearlyearningsandprofitabilityofacompany.Using‘trendanalysis’and‘extrapolationtechnique’,future earning in coming years may also be forecasted for purpose of planning and budgeting.Further,long-termcreditorsaregenerallyinterestedinearning-capacityforecast.AssessingtheManagerialEfficiency:‘Financial-StatementAnalysis’isusedtogeneratecomparativeinformation regarding various heads of business performance. It thus helps to identify the areaswherethemanagementhavebeenefficient.Anyvariationcanbe identifiedandanalysedto focusonvariousdegreesofmanagerialefficiency.AssessingtheShort-TermandtheLongTermSolvencyoftheCompany:Long-termandtheshort-termsolvencyofacompanycanbeassessedonthebasisoffinancialstatementanalysis.Both‘cashflowanalysis’and‘ratioanalysis’provideinformationregardingliquidityandsolvencypositionofthecompany.


ForecastingandBudgeting:Usingthemethodof‘ComparativeFinancialStatements’,itispossibletocarryouttrendanalysisforvariousfinancialparameters.Usingextrapolationtechnique,thefinancialtrendscanbeextendedorextrapolated tomake forecast regardingthenextyearor futureyears.Suchinformationisveryusefulforbudgetingexercises.7.4 ComparisonbetweenYearsUse of Comparative Statements or Comparative Financial Statements facilitates comparisonbetween financialperformances for twoormoreaccountingyears.ComparativeStatements showthechanges ineach itemwith respect to the figuresof thebaseyear in ‘absoluteamount’and in‘percentage’.7.4.1 “ComparisonbetweenYears”basedon‘ComparativeBalanceSheet’TheformatofComparativeBalanceSheetisasgivenbelow:

NameoftheCompany:..............................; BalanceSheetason......................................

Particulars Note FiguresforFiguresforAbsoluteChangePercentageChange No PreviousYearCurrentYearIncrease/DecreaseIncrease/Decrease

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

(A) (B)(B–A)1/A{(B–A)x100}IEQUITY&LIABILITIES1Shareholders’Funds

v ShareCapitalv Reserves&Surplusv MoneyagainstShareWarrants

2MoneyPendingShareAllotment3Non-CurrentLiabilities

v Long-TermBorrowingsv DeferredTaxLiabilities(Net)v OtherLong-TermLiabilitiesv Long-TermProvisions

4CurrentLiabilitiesv Short-TermBorrowingsv TradePayablesv OtherCurrentLiabilitiesv Short-TermProvisions

TOTAL=

IIASSETS1Non-CurrentAssets

v FixedAssetsv Non-CurrentInvestmentsv DeferredTaxAssets(Net)v Long-TermLoans&Advancesv Other/Non-CurrentsAssets

2.CurrentAssetsv CurrentInvestmentsv Inventoriesv TradeReceivablesv CashandCash-Equivalentsv Short-TermLoans&Advancesv OtherCurrentAssets

TOTAL=


Two additional columns are added to the standard format of Balance Sheet. The first ‘additionalcolumn’ is used to compute ‘difference in values’ for current year and previous year. The otheradditionalcolumnisusedtoconvertthe‘differenceinvalues’tothepercentageofvalue(usingthevalueforthepreviousyearasthebasis).Thisindicatesthechangeinvaluebetweenthetwoyearsasthepercentagevaluewithrespecttovalueforpreviousyear.As shown in format given above, the “Comparative Balance Sheet” has six columns which areconstructedasmentionedbelow:

• Column1:ThisColumnissameasthatoftheBalanceSheetforthecurrentyear.• Column 2: in this column, the “Note No” given against each line in the Balance Sheet is

repeatedhere.• Column3:Heretheamountsforthepreviousyear(Amount‘A’)arewritten,foreachitem.• Column4:Heretheamountsforthecurrentyear(Amount‘B’)arewrittenforeachitem• Column5:Here“difference”invalueforcurrentyearandforpreviousyear(AmountB–A)is

writtenagainsteachitem.• Column 6: Here, the “difference” computed above, is expressed as percentage of the

‘amountforthepreviousyear’(asthebaseforthecalculations).

As seen for the format, a comparison ismadewith the data for the base year, and it generatesfollowingdata/informationforother(desired)yearinfollowingways:

• Thevaluesinabsoluteamounts;• Increaseordecreaseinabsoluteamounts;• Increaseordecreaseintermsofpercentages;

7.4.2 FormatofComparativeStatementofProfit&LossTheformatforcomparativestatementofprofit&Lossisasgivenunder:NameoftheCompany:.................,StatementofProfitandLossfortheYearendedon......................

Particulars NoteFiguresforFiguresforAbsoluteChangePercentage

NoPreviousYearCurrentYearIncrease/Increase/DecreaseDecrease

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

(A) (B)(B–A)1/A{(B–A)x100}

IRevenuefromOperationsIIOtherIncomeIIITotalRevenue(I+II)IVExpensesCostofMaterialsConsumedPurchaseofStock-in-TradeChangeinInventoriesofFinishedGoodsWork-in-ProgressandStock-in-TradeEmployeesBenefitExpensesFinanceCostsDepreciationandAmortisationExpensesOtherExpensesTotalExpensesVProfitbeforeTax(III–IV)VIIncomeTaxPayableVIIProfitorLossforthePeriod(V–VI)


7.4.3 ComparativeFinancialStatementsUsingCommonSizeStatementIn the ‘Common-Size Financial Statement’, the amounts of various items of Balance Sheet orStatementofProfit&Loss,forthepreviousandcurrentyearsarewrittenintheirrespectivecolumns(as in comparative statement). In next two columns, these are converted into percentages to a‘commonbase’.ThiscommonbaseforStatementofProfitandLossis‘RevenuefromOperations’.Thecommonbasefor Balance Sheet is taken as the ‘total of Balance Sheet’. The percentage so calculated can becomparedwiththecorrespondingpercentagesinotherperiodsoftime.For example, in case of Common Size Statement for Profit & Loss, the value of ‘revenue fromoperations’ is taken as 100 (i.e. 100%). All other items are expressed as percentage of ‘absolutevalueofrevenuefromoperations’.CommonSizeStatementofProfitandLossmaybepreparedfordifferentperiodoftimeforthecompanyorforthesameperiodfortwocompanies.7.4.4 CommonSizeStatementforProfit&LossTheformatof‘CommonSizeStatementofProfit&Loss’isgivenbelow:-NameoftheCompany:.................,StatementofProfitandLossfortheYearendedon...................... AbsoluteAmounts PercentsofRevenuefrom

Operations(NetSales)

Particulars NoteFiguresforFiguresforPreviousYearCurrentYear NoPreviousYearCurrentYearPercentagePercentage

(1) (2)(3) (4) (5) (6) IRevenuefromOperations --- --- --- 100% 100%IIOtherIncome --- --- --- --- ---IIITotalRevenue(I+II) --- --- --- --- ---

IVExpenses CostofMaterialsConsumed --- --- --- --- ---PurchaseofStock-in-Trade --- --- --- --- --- ChangeinInventoriesofFinishedGoods--- --- --- --- ---Work-in-ProgressandStock-in-Trade--- --- --- --- ---EmployeesBenefitExpenses--- --- --- --- ---FinanceCosts --- --- --- --- ---DepreciationandAmortisationExpenses--- --- --- --- ---OtherExpenses --- --- --- --- ---TotalExpenses --- --- --- --- ---VProfitbeforeTax(III-IV) --- --- --- --- ---VILessIncomeTax --- --- --- --- ---VIIProfitorLossforthePeriod(V–VI)--- --- --- --- ---

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

• FirstColumn:Inthiscolumn,theusualitemsofStatementofProfit&Lossi.e.‘revenue’and‘expenses’arewritten.

• Second Column: In this column, “Note No” given against the Item(s) in the Statement ofProfit&Lossiswritten.

• Third Column: In this column, amounts of previous year are written as the Statement ispreparedfordifferentperiodoftimeforthesamecompany.


• FourthColumn:Theamountsofcurrentyeararewritteninthiscolumn.• Fifth Column: Here, percentages of different Items of Statement of Profit & Loss of the

previousYear,calculatedwithrespecttothe‘RevenuefromOperations’arewritten.• Sixth Column: Here, percentages of different Items of Statement of Profit & Loss of the

CurrentYearcalculatedwithrespectto‘RevenuefromOperation’arewritten.7.4.5 CommonSizeStatementforBalanceSheetTheformatoftheCommonSizeBalanceSheetisasgivenunder:-NameoftheCompany:.................,CommonSizeStatementofBalanceSheetfortheYearendedon......................

AbsoluteAmounts Percentsof

BalanceSheetTotal

Particulars NoteFiguresforFiguresforPreviousYearCurrentYear NoPreviousYearCurrentYearPercentagePercentage

(1) (2)(3) (4) (5) (6) IEQUITY&LIABILITIES1Shareholders’Funds

ShareCapital --- --- --- --- ---Reserves&Surplus --- --- --- --- ---MoneyagainstShareWarrants--- --- --- --- ---

2MoneyPendingShareAllotment--- --- --- --- ---3Non-CurrentLiabilities

Long-TermBorrowings --- --- --- --- ---DeferredTaxLiabilities(Net) --- --- --- --- ---OtherLong-TermLiabilities --- --- --- --- ---Long-TermProvisions --- --- --- --- ---

4CurrentLiabilitiesShort-TermBorrowings --- --- --- --- ---TradePayables --- --- --- --- ---OtherCurrentLiabilities --- --- --- --- ---Short-TermProvisions --- --- --- --- ---

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

IIASSETS1Non-CurrentAssets

FixedAssets --- --- --- --- ---Non-CurrentInvestments --- --- --- --- ---DeferredTaxAssets(Net) --- --- --- --- ---Long-TermLoans&Advances--- --- --- --- ---Other/non-CurrentsAssets --- --- --- ---- ---

2.CurrentAssets (a)CurrentInvestments --- --- --- --- --- (b)Inventories --- --- --- --- --- (c)TradeReceivables --- --- --- --- --- (d)CashandCash-Equivalents--- --- --- --- --- (e)Short-TermLoans&Advances--- --- --- --- --- (f)OtherCurrentAssets--- --- --- ---- ---TOTAL= --- --- --- 100% 100%Common Size Balance Sheet shows the percentage relation of each asset/liability to the totalasset/liabilities including capital. InCommonSizeBalanceSheet, total assetsor total liabilities aretakenas100%andallotherfiguresareexpressedaspercentageofthetotal.


Common Size Balance Sheet for different periods/years helps to highlight the trends in differentitems. If it is prepared for different companies in an industry, it facilitates to assess financialsoundnessandhelpsinunderstandingtheirfinancialstrategy.Its six columns are complied in similar manner as for Statement of Profit & Loss. Here the totalassetsaretakenas100%andfiguresforotheritemsareexpressedaspercentageoftheamountoftotalasset.Similartreatmentisgiventotheliabilityfigures,bytakingtotalliabilitytobe100%.7.5 Company/IndustryComparisons&BenchmarkingAs mentioned earlier in section 7.4 above, “Comparative Statements: and the “Common SizeStatements”canbepreparedfor:

• Comparisonoffinancialperformanceofsamecompanyfortwoormoredifferentyears;• Comparisonoffinancialperformancesoftwoormorecompaniesinaparticularyear;• CompilingIndustryComparisonregardingfinancialperformance.• Benchmarkingthefinancialperformanceofacompanywiththe“Industry-BestCompany”to

bringoutthe“strengths”and“weaknesses”inperformance-results.Thus, themethodologyof ‘comparison for twodifferent companies’or for ‘industry comparison’ isjustthesameasforcomparingdifferentyear’sperformanceforthesamecompany.7.6 DifferencebetweenCapitalandRevenueExpenditureRevenueExpenditure:

• Itbringsbenefitsforthecurrentaccountingyear.• Itsbenefitsarenotcarriedforwardtothenextyearoryears.• Itisincurredinthenormalcourseofbusinesstorunthebusinessandtomaintainthefixed

assetsofbusiness.• Itisincurredtopurchasegoodsmeantforresaleortopurchasematerialswhichwillbeused

inconvertingitintofinalproduct.Therevenueexpenditureisarecurringexpendituremadecontinuousoperationofthebusiness.Theamountspentisgenerallysmallandthebenefitisforashortperiod,notmorethanoneyear.CapitalExpenditure: Itsbenefit isnotfullyconsumedinoneyearbut isspreadoverseveralyears.Suchexpenditure is incurred forpurchaseoracquisitionofassetorproperty. It isalso incurred toupgradeanoldasset,andalsoforrepairorimprovementofexistingasset.Capitalexpenditurebenefitsthebusinessformanyyearsinfuture.Theexpenditureisgenerallynon-recurringandtheamountspentwillbenormallylarge.However,alllargeexpendituresneednotbecapitalexpenditure.CapitalexpendituresareshowninBalanceSheet.


UNIT 8. ACCOUNTING RATIOS

8.1 AccountingRatios8.2 ReasonsforusingRatios8.3 TypesofAccountingRatios8.4 LiquidityRatio(Short-TermSolvencyRatios)8.5 CapitalStructureorSolvencyRatios(LongTermSolvencyRatios)8.6 Activity/EfficiencyRatios8.7 ProfitabilityRatios8.8 InvestorRatios8.9 LimitationsofRatioAnalysis

8.1 AccountingRatio“Ratio” isanarithmeticalexpressionofrelationshipbetweentwointerdependentorrelateditems.Ratios,whencalculatedonthebasisofaccountinginformation,arecalledAccountingRatios.Ratioanalysisisastudyofrelationshipamongvariousfinancialfactorsinabusiness.Ratio analysis is a process of determining and interpreting relationship between the items ofFinancial Statements (‘Balance sheet’ and/or ‘Statement of Profit & Loss’) to provide a deeperunderstandingofthefinancialperformanceofacompany.8.2 ReasonsforusingRatiosThe ‘ratio analysis’ is useful in understanding financial performance of the company, as statedbelow:

• Usefulinunderstandingtheoverallfinancialpositionofacompanyinasimpleandeasy-to-understandmanner.

• AccountingRatiosareusefulforassessingliquidity,solvency,andprofitabilityofacompany.• Itishelpfulinbusinessplanningandforecasting.• AccountingRatiosassistinlocatingtheweakareasofthebusiness.• RatioanalysisfacilitatesInter-FirmComparison.

8.3 TypesofAccountingRatiosAccountingRatiosmaybeclassifiedintofollowingcategories:

• LiquidityRatios(ShortTermSolvency);• CapitalStructureorSolvencyRatios(LongTermSolvency);• ActivityorEfficiencyRatios;• ProfitabilityRatios;and• ProfitabilityRatiosrelatedinInvestments(Investors’Ratios)

TheseratiosaredescribedinsubsequentsectionsofthisUnit.8.4 LiquidityRatios(Short-TermSolvency)Liquidity ratios are computed to evaluate the capability of the company to meet its short termliabilities.Commonlyusedliquidityratiosare:CurrentRatios,andLiquidorQuickRatios.


(a) Current Ratio: It is a relationship of current asset and current liabilities. This ratiomeasuresability of the company to pay its short term financial obligations, that is, liabilities. Thus, currentratioisameasurementoffinancialhealthofthecompany.Thisratioiscomputedas:

CurrentAssetsCurrentRatio=

CurrentLiabilitiesAcceptable value of Current Ratio varies from industry to industry. Generally acceptable value inmostindustriesofCurrentRatiois2:1.Generally,thecurrentassetsaretwiceofcurrentliabilities.WhenvalueofCurrentRatiofallsbelow1,itimpliesthatthecompanymaynotbeabletomeetitsshort term financialobligations if theybecomedueon thatdate. Itmeans the companydoesnotenjoygoodfinancialhealth.However, value of Current Ratio above 1 indicates that the current liabilities of the company arelower than its current assets. High Current Ratiomeans better liquidity position. But a very highCurrent Ratio means large investments in assets which may not be getting utilised properly orgeneratingpoorrevenue.(b)LiquidRatioorQuickRatioorAcid-TestRatio:LiquidRatioorQuickRatioorAcid-TestRatioisthe liquidity ratiowhichprovidesa relationshipof liquidassetswithcurrent liabilities.This ratio iscalculatedasunder:

LiquidAssetsofQuickAssets

Liquid/QuickRatio= CurrentLiabilitiesLiquidorquickassetsareeitherintheformof‘CashandCashEquivalents’orcanbeconvertedintocashwithinaveryshortperiod.Thus,theseassetsarethemostliquidassets.Quick/LiquidRatioof1 :1 isanacceptedstandard.ThevalueofQuick/Liquid ratioof less than1,indicates that current liabilities aremore than liquid/quick assets, and consequently the companymaynotbeabletomeetitscurrentliabilitiesortheshorttermfinancialobligations.8.5 CapitalStructureorSolvencyRatios(LongTermSolvency)‘CapitalRatios’or ‘SolvencyRatios’ showwhether thecompanywillbeable tomeet its long termobligations or its long term liabilities. Important Capital/Solvency Ratios include: (i) debt : equityratio;(ii)totalassets:debtratios;(iii)proprietaryratio,and(iv)interestcoverageratio.(a)Debt:EquityRatio:Thisratiohelpsinassessingthelongtermfinancialhealthofthecompany.It expresses the relationship between long term external debts and the internal equity or theshareholders’fundsofthecompany.Liabilities like external debts payable to outsiders include ‘long-term borrowings’ and ‘long-termprovisions’.TheseareshownasNonCurrentLiabilitiesinthe‘Equity&Liabilities’partoftheBalanceSheet.Thisratioiscomputedasunder: Debt

Debt:EquityRatio= Equity(ShareholdersFund)


Ahigh‘Debt:EquityRatio’meansthatthecompanyisdependingmoreontheexternaldebtsthanontheShareholdersFund.Therefore,itmeansthattheagenciesprovidingloansaretakinghighrisk.Lowvalueofthisratiomeansthatthecompany isdependingmoreonShareholdersFundthanontheexternaldebts. Therefore, theagenciesproviding loansarenot facinghigh risk. ‘Debt : EquityRatio’of2:1isconsideredasatisfactorylevel.(b)DebttoTotalCapitalRatioThe‘debttototalcapitalratio’establishesrelationshipofexternalliabilitiesordebtswiththetotalcapitalisation of the company. This is a variant of the Debt to Equity Ratio (D/E Ratio). It can beexpressedandcalculatedindifferentways,asmentionedunder:

• DebttoTotalCapitalRatio:Itrelatesthe‘longtermdebt’tothe‘permanentcapital’ofthecompany. Permanent Capital includes both shareholders’ equity and also the long termdebts.ThisratioprovidesrelationshipbetweenCreditor’sFundandOwner’sCapital.

LongTermDebt

Thus,Debt:TotalCapitalRatio= PermanentCapital

• Debts : TotalAssetsRatios : This ratio calculates ‘debt to capital ratio’, and relates totaldebt to the totalassets.Thetotaldebtof thecompanycomprisesof long-termdebtspluscurrentliabilities.Thetotalassetscompriseofpermanentcapitalpluscurrentliabilities.

TotalDebt(LongTermDebt)DebttototalAssets/CapitalRatio=

TotalAssets

Thisratioreflectsthe‘safetymargin’availabletothelendersoflongtermdebt.Higherthisratio,higheristhesafetymarginforthelenders.

• ProprietaryRatios: It is another variant ofD/ERatio and relates theOwners’/Proprietors’fundwithtotalassets.Itiscomputedasunder:

Proprietors’FundProprietaryRatio=

TotalAssets(c)InterestCoverageRatiosThis ratio establishes the relationship between ‘Net Profit before Interest& Tax’ and ‘Interest onLong-termDebts’.Thisratioassessestheamountofprofitavailabletocover intereston longtermdebt.Theresultisexpressedinnumberof‘times’. ProfitbeforeInterest&TaxInterestCoverageRatio= =......Times InterestonLongTermDebt


8.6 Activity/EfficiencyRatiosActivityRatiosalsocalled‘PerformanceEfficiencyRatios’or‘Turn-OverRatios’,measurehowwellthe resources have been used by the company. In other words, these ratios measure theeffectivenesswithwhichthecompanyusesitsavailableresources.Theresultisexpressedinnumberof‘times’.Theactivityratiosinclude:(i)inventoryturnoverratio;(ii)tradereceivableturnoverratio;(iii)tradepayableturnoverratio;and(iv)workingcapitalturnoverratio.(a)InventoryTurnoverRatioInventoryTurnoverRatioexpressesrelationbetween‘costofrevenuefromoperations’and‘averageinventory’carried. It isanactivityaswellasefficiencyratioandmeasures thenumberof timesacompanysellsandreplacesitsinventoryinanaccountingyear.Theratioiscomputedasfollows: CostofRevenuefromOperations(CostofGoodsSold)InventoryTurnoverRatio= =.....Times AverageInventoryThisratioattemptstoascertainwhetherinvestmentininventoryhasbeenwellutilisedornot.Thus,thisratiomeasurestheefficiencyofcarryingandmanaginginventory.(b)TradeReceivableTurnoverRatioTradeReceivableistheamountreceivableagainstgoodssoldorservicesrendered(oncredit)inthenormalcourseofbusinessbythecompany.Itistheamountremainingoutstandingagainstthesaleof goods or services rendered. It includes debts and bills receivables. This ratio is computed asfollows:TradeReceivableRatio= TradeRevenuefromOperationsi.e.NetCreditSales = =......Times AverageTradeReceivablesItshowshowquicklytheamountof‘tradereceivables’isrecoveredorcollectedandthusshowstheefficiencyincollectionofamountsdue.(c)TradePayableTurnoverRatioTradepayablemeans‘amountpayableforpurchaseofgoodsorservicestakenbythecompany’ inthe normal course of business. This ratio expresses the relationship between the ‘net creditpurchases’and‘averagepayables’.Itiscalculatedasunder: NetCreditPurchasesTradePayableTurnoverRatio= =......Times AverageTradePayableHigh‘tradepayableturn-overratio’orshorterpaymentperiodshowstheavailabilityoflesscreditorearly payments. However, a high ratio also indicates that the company is not availing full creditperiod.A lowratioor longerpaymentperiod indicatesthatcreditorsarenotbeingpaid intimeorcreditperiodhasincreased.Thismayaffectthecreditworthinessofthecompany.


(d)WorkingCapitalTurnoverRatioWorkingcapitalturnoverratioshowstherelationshipbetween‘workingcapital’and‘revenuefromoperations’.Theobjectiveofcomputingthisratioistoascertainwhetherornottheworkingcapitalhasbeeneffectivelyusedingeneratingrevenue.Thisratioiscomputedasfollows: RevenuefromOperationsWorkingCapitalTurnoverRatio= =.....Times WorkingCapital CostofRevenuefromOperations(CostofGoodsSold) = WorkingCapitalHighertheratio,betteritisforthebusiness.ThisratioisconsideredtobeabettermeasurethantheInventoryTurnoverRatio.8.7 ProfitabilityRatiosTheseratiosmeasureprofitabilityofbusinessoperations.Importantprofitabilityratiosare:(i)grossprofitratios;(ii)operatingratios;(iii)operatingprofitratios;(iv)netprofitratios;and(v)returnoninvestment(ROI)orreturnoncapitalemployedratios.(a)GrossProfitRatioIt establishes the relationship of ‘gross profit’ and ‘revenue from operations’, i.e., net sales of acompany.Theratioiscalculatedandisshowninpercentage.Thisratioiscomputedasfollows: GrossProfit

GrossProfitRatio= x100 RevenuefromOperationsGrossprofit is thedifferencebetween ‘Revenue fromOperations’ (i.e.,NetSales)andthe ‘CostofRevenuefromOperations’(CostofGoodsSold).(b)OperatingRatioOperatingratioestablishestherelationshipbetween‘operatingcost’and‘revenuefromoperation’.Operatingcostsarethecostsincurredfrom‘operatingactivities’ofthebusiness.Itdoesnotincludenon-operating incomeandexpenseswhicharenot incurred foroperatingactivityof thebusiness.Thisratioiscomputedasfollows: CostofRevenuefromOperations+OperatingExpensesOperatingRatio= x100 RevenuefromOperations OperatingCost

OR = x100 RevenuefromOperations


OperatingProfitRatioandOperatingRatioarecomplementarytoeachother,andthus,ifoneofthetworatiosisdeductedfrom100,anotherratioisobtained.Theobjectiveistoassesstheoperationalefficiencyofthebusiness.LowerOperatingRatioisbetterforbusiness.(c)OperatingProfitRatioOperating Profit Ratio measures relationship between ‘Operating Profit’ and ‘Revenue fromOperations’,i.e.NetSales.OperatingProfitRatioiscomputedbydividing‘OperatingProfit’by‘RevenuefromOperations(NetSales)’andisexpressedaspercentage. OperatingProfit

OperatingProfitRatio= x100 RevenuefromOperations(Netsales)Theobjectiveofcomputingthisratioistodetermine‘operationalefficiency’ofthebusiness.Highervalueof this ratioover the lastaccountingperiodmeans that therehasbeen improvement in theoperationalefficiencyofthebusiness.(d)NetProfitRatioNet Profit Ratio establishes the relationship between ‘net profit after tax’ and ‘revenue fromoperations (i.e., net sales)’. It shows the percentage of ‘net profit’ earned on ‘revenue fromoperations’.Thisratioiscomputedasfollows: NetProfitafterTax

NetProfitRatio= x100 RevenuefromOperations,i.e.NetSalesNet Profit Ratio is an indicator of overall efficiency of the business. Higher the Net Profit Ratio,betteristhebusiness.Thisratiohelpsinassessingtheoperationalefficiencyofthebusiness.8.8 InvestorRatiosTheseratiosaredescribedunder:

• ReturnonInvestment(ROI)orReturnonCapitalEmployedRatio‘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 bydividing ‘profit before interest and tax & dividend’ by ‘capital employed’. This ratio isexpressedas:

NetProfitbeforeInterest,TaxandDividend ROI= X100 CapitalEmployed

This ratio is expressed as a percentage. ‘Return on capital employed’ or ‘return oninvestments’ assessesoverall performanceof thecompany. It assesseshowefficiently theresourcesofthebusinessareused.


• ReturnonTotalShareholders’Equity

Accordingtothisratio,profitability ismeasuredbydividingthe‘netprofitaftertaxes’ (butbeforepreferencedividend)bythe‘averagetotalshareholders’equity.Thus,

NetProfitafterTaxes ReturnonTotalShareholders’Equity= X100 AverageTotalShareholders’Equity Theratiorevealshowprofitablytheowners’fundshavebeenutilisedbythecompany.• ReturnonOrdinaryShareholders’Equity(NetWorth)

Theordinaryshareholdersownallequityofthecompany.Theybearrisksandarethereforeentitled to all earning i.e. profits aftermeeting all liabilities. From owners’ point of view,profitability of the company should be accessed through the return on ordinaryshareholders’equity.Thisratioiscalculatedasunder:

NetProfitafterTaxes–PreferenceDividend

ReturnonOrdinaryShareholders’Equity= x100 AverageOrdinaryShareholders’Equity(NetWorth)• EarningperShare(EPS)

This ratiomeasures the profit available to the equity shareholders on a ‘per share basis’,thatis,theamountthattheycangetoneveryshareheld.Itiscalculatedasunder:

NetProfitavailabletoEquityHolders

EarningperShare(EPS)= TotalNumberofOrdinaryEquityShares• CashEarningPerShare

This ratio is computed using cash flows from business operations as the numerator. Thisvalueisdeterminedbyaddingnon-cashexpenses,suchasdepreciationandamortisationto‘netprofit’availabletoequityowners.Thus,

(NetProfitavailabletoEquity-Owners+Depreciation+ +Amortisation+NonCashExpanses)

CashEarningPerShare= TotalNumberofEquityShares• DividendperShare(DPS)

This denotes the dividend paid to the equity shareholders on a per share basis. In otherwords,DPS is thenetdistributedprofit belonging to theordinary shareholdersdividedbythenumberofordinarysharesoutstanding.

DividendPaidtoOrdinaryShareholders

DPS=


NumberofOrdinarySharesOutstanding• Price/Earnings(P/E)Ratio

Thisratioiscomputedasunder: MarketPriceoftheShare

Price/EarningRatio= EPS

Here,EPSisthenetearningpershare.TheP/EratioreflectsthepricecurrentlybeingpaidbythemarketforthecurrentlyreportedEPS.

8.9 LimitationsofRatioAnalysis

• The financial ratios or the accounting ratios are based on the ‘figures’ presented in theFinancialStatementsofacompany.Theysufferfromalimitationthatthesearenotbasedonfullfinancialdataforbusinessperformanceduringtheaccountingyear.

• AccuracyofratioanalysisislimitedtotheaccuracywithwhichtheFinancialStatementsareprepared.

• RatioanalysisisbasedoncertainnumberspresentedinFinancialStatements.Therefore,theanalysisprovidesonlyquantitativeresultswithoutpresentinganyqualitativeexplaination.

• Eachratiopresentsonlyoneaspectofthebusinessperformance.Nosingleratioexplainsthefinancialperformanceofthecompany.

• Pricelevelchangesarenotreflectedintheaccountingratios.• Interpretationofaccountingratiosissubjecttopersonaljudgementofpersonsinterpreting

theratioanalysis.


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

AND WORKING CAPITAL


UNIT 9. SHORT AND LONG-TERM FINANCE

9.1 FinanceforBusiness9.2 MeaningofShortTermandLongTerm9.3 Short-TermFinance9.4 Long-termFinance9.5 DifferencesbetweenShort&Long-TermFinance9.6 MatchingFinance-IssueswiththeSpecificBusinessRequirement

9.1 FinanceforBusinessBusinessactivitiesofalltypesneedfinancialinvestments.Thefinancemaybearrangedfrominternalor external sources. Further, need for finance for different requirements may of different timedurations,andofdifferentlevelsofcapital.Somerequirementsmayneedfinanceforshort-termandothersmayneedfinanceforlongterm.Long-termfinancingisrequiredmostlyforprocuringassetsorforsettingupprojectfacilities.Ontheother side, normal types of business operations for business activities need funds for shorterdurationoftime.Businessorganisationshaveneedsforboth,short-termfinanceaswellasforlong-termfinance.Thiscombinationoftwinneedsshouldbemetbya judiciousmixofsourcesof financekeeping inviewtherequiredcashflowsatcompanylevel.9.2 MeaningofShort-TermandLong-TermIn termsof business accounting, “short term” refers to holding an asset for a period “less than ayear”.Theterm“current” isoftenmentionedregarding ‘assets’or ‘liabilities’having less thanoneyear time for ‘being converted into cash’ or for ‘being paid out’. Terms like “current assets” and“currentliabilities”areusedwheretimescheduleislessthanoneyear.“Longterm”inbusinessaccountingmeansassociated‘timeperiod’ismorethantheoperatingcycleorsayoneyear.Longtermfinancingreferstoseekingfinanceforlong-termdurationi.e.morethanoneyear,andisgenerallyusedforfinancingprocurementsofcapitalassets.Insuchcases,theassetsareestablishedover longperiodof timeandneed largeamountof capital.The time ismore thanoneyear;andtimeframesof3to25yearsarealsocommon.9.3 ShortTermFinanceShorttermfinancegenerallyhastimespanoflessthanoneyear.Butinsomecases,thetimeperiodcanbeabout3yearsinviewofcertainspecialrequirements.Mortgageisonesuchexamplewhererequirementsmayspanfromfewyearsto15-20years,whichisconsideredlongtermfinance.Therecanbeacaseofshorttermfinancingwhentimeperiodisof3yearsorless;andtherecanbecaseoflongtermfinancingwhentimeperiodismuchlongi.e.10-15years.Short-termfinancing isgenerallyusedforperioduptooneyear. Itsexamplesmaybethecasesofinventory-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 capitalrequirements.


Asshort termfinancing involvesshorter timeperiods forpayments, the interestschargedarealsocomparatively lower,and the risk involved isalsomuch lesser.Therefore, it iseasy toarrange forshort term financing. Short-term loans, bank over draft facility, trade-payables, and short termleasesareexamplesofshort-termfinancing.9.4 LongTermFinanceLongtermfinancinggenerallyhastimeperiodsof3to20years,dependingonthetypeandnatureofassetbeingfinanced.Purchaseofcostlycapitalequipment,settingupofnewprojects,researchanddevelopment tasks, all have long gestation periods and therefore are financed through long termfinancing.Assuchfinancingisforlongterm,theassociateduncertaintiesarealsomoreandtheriskinvolvedisalsoofhigherorder.Further,theamountsrequiredarealsoofhigherorder.Financingagenciesgenerallyhesitategivingloans for high amounts for longer periods which also involve high risks. As a practice, financialinstitutions like banks demand certain collateral against which the loan is provided. Thearrangementofcollateralcoverstheriskforthebankandmotivatestheborrowerfornotdefaultingonrepayments.Capitalassetsestablishedinproject-modearefinancedthroughlongtermfinancing.9.5 DifferencesbetweenShort&LongTermFinance

Short-termFinancing Long-termFinance1. Generallyneededfor‘operations’requirements. 1.Neededforcapitalassetsandprojects2. Neededforperiodsaboutoneyear. 2.Generallyneededfor3-20years.3. Generallyneedsmalleramount. 3.Needlargeamountsofcapital.4. Involvelesserrisk. 4.Involvelargerisks.5. Comparativelyeasiertoobtain. 5.Difficulttoobtain,collateralrequired.9.6 MatchingFinance-IssueswiththeSpecificBusinessRequirementFinances needed for business are for different amounts and for different periods of repayments.Therefore,theycarrydifferentratesofinterest,astherisksinvolvedarealsodifferent.Highinterestrates can have adverse impact on the profitability. Therefore, attempt should be to reduce theoverallinterestliabilityofthecompany.Thisisachievedbymatchingthefinancerequirementswithtime periods and interest payable. Even some part of long term requirements may be financedthroughshort-termfinancing,iftherepaymentcanbedoneinshortertimeframe.Therefore, there isa standardpractice toplan foraproper finance-mix. For short term financing,finance-mixislimitedtoselectionofsourceoffinanceandtheirassociatedinterestsandotherterms&conditions.Thecapitalassetsneed long termfinanceassuchprojectsneed largeamountsand involve longerperiod of time for completion and consequent repayment. However, certain flexibility may beadoptedincaseofcurrentassets.Twooptionsmaybeusedforshorttermfinancing:(i)shorttermsources (current liabilities) and (ii) from long term sources such as share capital, long termborrowingsetc.Managementshoulddecideregardingwhatpercentageofcurrentassetsshouldbefinancedthroughcurrentliabilitiesandhowmuchthroughlongtermsources.


UNIT 10. SOURCES OF FINANCE

10.1 RangeofSources10.2 InternalandExternalSources10.3 SourcesofShort-TermFinance10.4 SourcesofLong-TermFinance10.5 RoleofMarketsandGovernment

10.1 RangeofSourcesAsdiscussedinlastUnit,thefinancialsourcesaretwogeneraltypes:sourceforshort-termfinanceand source for long-term finance. The funds required for short period of time, say for about oneoperatingcycle(oroneyear)arecalledshorttermfinance.Thefundsrequiredforlongertime,say3to 30 years are called long term finance. As short term finance is needed for lesser time, theassociateriskismuchlesserascomparedtolongtermfinance.The source of financemay be fromwithin the business organisation (internal source) ormay beoutside the organisation, like a bank. The source of finance can therefore be classified into twotypes:internalsourcesandexternalsourcesoffinance.10.2 InternalandExternalSourcesAll businesses require funds to finance their day-to-day operations; and also for their businessexpansionandgrowth.Oneoptionforfindingasourceoffinanceistousetheretainedearningsorprofits;anditiscalledinternalsourceoffinance.Anotheroptioncanbetoraiseloanfrombanksandothercreditors;andthisiscalledexternalsourceoffinance.10.2.1 InternalSourceofFinance‘Retained earnings’ is an easy and readily available source of finance as these are liquid assets.Thesearepartof ‘netearnings’ofpreviousyearswhichhavebeenretainedbythecompanyafterpayingdividendstotheshareholders.‘Currentassets’canalsobeusedforshorttermfinanceastheseconsistofcashorother-thingwhichcaneasilybedisposedtogetthecashmoneytofinanceimportanturgentrequirements.Acompanymay be holding shares in other company. These can be sold to get money for using as internalsourceoffinance.‘Fixed assets’ are used as basic facilities to support business operations for generating revenue.Thesearebasicallyestablishedfor longtimeuse;andarenotsupposedtobeconverted intocash.Suchassetsincludeland,building,equipmentandmachinery.Theseassetscannotbeconvertedintocashinshortperiodoftimeandarethereforenotusedassourceofshorttermfinance.Therearetwosourcesofinternalfinance:

• Retainedearnings,and• Increasing‘working-capitalmanagementefficiency’.


RetainedEarningsRetainedearnings is surplus cash fromearningofprevious years,whichhadnotbeenneeded foroperating costs, interest payments, tax liabilities, asset replacement or cash dividends. Retainedearningsbasicallybelongtotheshareholders.AdvantagesofusingRetainedEarnings:

• Retainedearningsareavailablewithinthecompany,and,ifused,arenotrequiredtobepaidback.

• Usingretainedearningsdoesnotdilutemanagement-control.• Retainedearningshaveno‘issue-costs’.

DisadvantagesofusingRetainedEarnings:

• Asitbasicallybelongstotheshareholders,theywilllikeittobespentondividendpayouts.• Using this fundmeans thataopportunityof issuing furtherequityas “right-issue”maybe

lost.Anotherwayoffundingshorttermrequirementsoffinancecanbethroughsavinginworkingcapitalrequirements by increasingWorking Capital efficiency. Efforts can be made to generate savingsthrough efficient management of trade receivables, inventory, cash and trade payables. Bettermanagement of working capital can facilitate reduction in use of bank overdraft and interestcharges.Itcanalsohelpinfastercollectionofcash-receivables.10.2.2 ExternalSourcesofFinanceItreferstoraisingfinancefromsourcesexternaltothecompany.Suchsourcesmayinclude:

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

• CapitalMarketmaybeapproachedforissueofshares,debenturesandbonds.• Creditors likesuppliersmayberequestedtosupplyrawmaterialsandsemi-finishedgoods

oncredit(forcertainspecifiedperiodoftime)10.3 SourcesofShort-TermFinance10.3.1 PurposeofShort-termFinanceShort-termfinanceisusuallyneededbybusinessestoruntheirday-to-dayoperationslikepaymentof employeewagesand inventory.Businessesneed funds tomakepaymentsonday-to-daybasis.Thus,thereisacontinuousrequirementofliquidcashformeetingsuchrequirements,otherwisetheorganisationmayfacesituationoftechnicalinsolvency.Short-termfinancesupportsfollowingactivitiesofthebusinessorganisation:-

• Meetingdaytodayfinancialrequirements.• Holdingstockofrawmaterialsandfinishedproduct.• Sellingofgoodsoncredit-basis,forincreasingthebusiness-sales.• Increasingthevolumeofproductionatashortnotice.• Supportingthecash-flowsduringtheoperatingcycle.

10.3.2 SourcesofShort-termFinanceThereareanumberofsourcesofshort-termfinancewhicharelistedbelow:


• Tradecredit,i.e.gettingsuppliesoncreditbasis,• Bankcredit,• Customers’advances,• Instalmentcredit,• CommercialPaper,and• PromissoryNote

TradeCredit:Tradecreditreferstocreditgrantedtomanufacturesandtradersbythesuppliersofrawmaterial,finishedgoods,components,etc.Usuallysuppliersgivegoodsandservicestobusinessorganisationsonacreditof30to90days.Paymentsarecollectedtowardstheendof thisperiod.Thistypeofcreditfacilitatespurchaseswithoutmakingimmediatepayment.BankCredit:Commercial banks grant short-term finance tobusiness firms. This is knownasbankcredit.Theborrowermaydrawtheamountofcreditatonetimeor inanynumberof instalments,subjecttothetermsandconditionsspecifiedinthecredit-document.Suchcreditmaybegrantedbywayof(i)loan,(ii)cashcredit,(iii)overdraftand(iv)discountedbills.Customers’ Advances: Sometimes, businessmen insist on their customers tomake some advancepayment. It is generally demanded when the ‘value of order’ is quite large. Customers’ advancerepresentsapartofthepaymenttowardspriceontheproduct(s)whichwillbedeliveredatalaterdate.Customersgenerallyagreetomakeadvanceswhensuchgoodsarenoteasilyavailableinthemarketorthere isanurgentneedofgoods.Afirmcanmeet itsshort-termrequirementswiththehelpofcustomers’advances.InstalmentCredit: Instalment credit is popular sourceof finance forpurchaseof consumer goodslike television, refrigerators aswell as for industrial goods. Small amount ofmoney is paid at thetimeofpurchaseandthebalance ispaid inanumberof instalments.Thesupplierchargescertaininterest for providing credit. The amount of interest is includedwhile deciding on the amount ofinstalment.Anothersimilarsystemisthehirepurchasesystemunderwhichthepurchaserbecomesownerofthegoodsafterthepaymentoflastinstalment.CommercialPaper:Thisinstrumentfacilitatesraisingshort-termloansthroughmoneymarket.Itisanunsecuredpromissorynote issuedbybig reputedcompanies,witha fixedmaturityof1 to364days in the global money market. It is backed by an issuing bank or promise by the businesscompanytopaytheamountonthematuritydate.PromissoryNote:Thisisanegotiableinstrument,whereinoneparty(themakerorissuer)makesanunconditionalpromiseinwritingtopayadeterminatesumofmoneytotheother(thepayee),eitheratafixedordeterminablefuturetimeorondemandofthepayee,underspecificterms.10.3.3 MeritsandDemeritsofVariousShort-TermFinanceSystemsMeritsanddemeritsofcommonlyusedsourcesofshort-termfinancearediscussedbelow:-

(a) Overdraft: Overdrafts are deficits financed by the bank. Overdrafts can be arrangedrelatively quickly, and are flexible with regard to the amount borrowed at any time, andinterestisonlypaidwhentheaccountisoverdrawn.

(b) Short-termLoans:Itisdrawninfullatbeginningoftheloanperiodandrepaidataspecifiedtimeorindefinedinstalments.Atermloanisnotrepayableondemandbythebank.

(c) AdvantagesofaTermsLoan:Bothcustomerandbankknowexactly(i)whattherepaymentsoftheloanwillbe,and(ii)howmuchinterestispayable;and(iii)wheninterestarepayable.


The customer does not have toworry about the bank deciding to reduceorwithdrawanoverdraft facility. Loans normally carry a letter setting out the precise terms of theagreement.

10.4 SourcesofLong-TermFinanceMajor operational facilities, land, buildings,machinery andmajor equipment need large outlay ofcapital. Further, these have long gestation period. The repayment of finance is therefore done inlonger time frameof the order of 3-20 years. The capital required for these assets is called fixedcapital. A part of working capital is also of a permanent nature, as this does not rotate in theaccountingperiod.10.4.1 PurposeofLong-termFinanceLong-termfinanceisrequiredforthefollowingimportantpurposes:

• Tofinanceprocurement/setting-upoffixedassets;• Tofinancethepermanentpartofworkingcapital;and• Tofinancegrowthandexpansionofbusiness.

10.4.2 FactorsDeterminingRequirementsofLong-termFinanceThe amount required to meet the ‘long term capital needs’ of a company depends upon manyfactors.Theseare:

• NatureofBusiness:Amanufacturingcompanyrequiresland,buildings,machineryetc.Soithastoinvestalargeamountofcapitalforalongperiod.Butatradingcompanydealingin,say,microwaveovensetcrequiressmalleramountfundsaslongtermfinance.

• Nature ofGoods Produced:A business engaged inmanufacture of simple itemswill needsmalleramountof fixedcapitalascomparedtoacompanymanufacturingheavymachinesor heavy consumer items like cars, refrigerators etc, which will require more amount ofcapital.

• TechnologyUsed:Industrieslikesteel,cars,aeroplanesetcusehightechnologyandrequiremuchlargelevelofcapital.

10.4.3 SourcesofLong-termFinanceThere are different sources of funds available tomeet long-term financial needs of business. Thesourcesgenerallyareoftwobroadcategories:(i)sharecapital(includingowners’equity,preferenceshare capital, retained earnings, and Bonds) and (ii) debt (including debentures, bank loans andotherlong-termborrowinginstruments).Commonlyusedsourcesoflong-termfinancearedescribedbelow.EquityFinancing:Thisincludespreferredstocksandcommonstocks.Itislessriskyasnorepaymentof equity is required. However, increased number of shares in the hands of public and outsidersdilutesthestrengthoforiginalownersandtheircontroloverbusiness.Anotherdisadvantageisthatthecostofequityishigherthanthecostofdebt.Butcostofraisingequityistreatedasexpensesdeductiblefromthegrossearnings.CorporateBond:Acorporatebondisissuedbycorporationstoraisemoneyfromgeneralpublicandinterested agencies. It is a long-term debt instrument. Some corporate bonds have an option toapplyforequityatalaterdata;andarecalledconvertiblebonds.


CapitalNotes:Capitalnotesareaformofconvertiblesecuritywhichmaybeconvertedintoequityshares.Capitalnotesaresimilartowarrants.Sometimes,capitalnotesareissuedwithprovisionofdebt-for-equityexchangeonaparticulardate.Theholdersofcapitalnoteshaveoptionofnottakingequityshares,buttogettheiramountwithpre-specifiedrateofinterestonaparticulardate.Asset-basedLoan:Banksandfinancialinstitutionsprefertoissue‘highriskloans’,securedwiththebackingofcompany'sassets. Such loansmaybebackedbyassetsnamely land,buildings,plant&machineryetc.Letterof Credit:This ‘letter’ is issuedby abankor financial institution to a businessorganisationengagedinsellingofgoodsorprovidingservicestocustomersoncreditbasis.Thisletterprovidesaguaranteeforpaymentsofgoodsorservicessoldtothirdparty.10.4.4 Merits/DemeritsofPopularSourcesofLong-TermFinance

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

• Itispermanentsourceoffinance.• Possibletoissuesharescapital,atpremium,bymakinga‘rightissue’.• Noneedof‘re-payments’(asforloans)toshareholdersofequityshares.

(b) Preference Share Capital: The advantages of raising finance through preference sharescapitalareasfollows:

• Thereisnoriskoftake-overbyhostileshareholders.• Thereisnodilutionofmanagerialcontrol.• Itcanberedeemedonlyafteraspecifiedperiodoftime.

(c) Raising Debentures or Bonds: There are advantages as well as certain disadvantages ofissuingdebenturesforraisingfinance,asdescribedunder:

• Advantages:Ø TheInterestpayableonDebentureistax-deductible.Therefore,thenetcost

ofdebenturesismuchlessthanthecostofequity.Ø Thereisnodilutionofcontrol.

• Disadvantages:Ø There is liability of interest payment and capital repayment at specified

date.Ø Itenhancesthefinancial-riskforthecompany.

(d) BankLoans:• Interestonbankloansistax-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

banksandfinancialinstitutions;andhavetobepaidbackasperagreedrepaymentschedule.

10.5 RoleofMarketsandGovernmentThe ‘FinancialMarkets’ and the ‘GovernmentalAgencies’ act as facilitators for business financing.Capitalmarketsandinstitutionalinvestorsarethesourcesoflong-termfinance.A capital market provides trading platform in financial securities for individuals, corporate andinterested institutions. It facilitatesbuyingofsecurities for investmentandalsoselling forbookingprofitorforraisingcapitalinthetimeofneed.Capitalmarketiscomposedofboththeprimaryand


secondarymarkets.Theprimarymarket iswherenewissuesarefirstoffered,withanysubsequenttradinggoingon inthesecondarymarket. Intheprimarymarket,pricesareoftensetbeforehand,whereas in thesecondarymarket onlybasicmarket-forces like supplyanddemanddetermine theprice of the security. Stock markets allow investors to buy and sell shares in publicly tradedcompanies.Themoneymarket is a segment of the financialmarket in which financial instruments with highliquidityandveryshortmaturitiesaretraded.Themoneymarketisusedbyparticipantsasameansforborrowingandlendingintheshortterm.Financial institutionsandfinancialmarketshelpbusinessfirmstoraisemoneyinthetimeofneed.Manygovernmentshavealong-termfinancialplanningprocesstogeneratealong-rangeperspectivefordecisionmakers.


UNIT 11. CASH FLOW MANAGEMENT

11.1 ObjectivesofCashManagement11.2 StrategyforCashManagement11.3 CashFlowForecast11.4 BudgetaryControlProcess11.5 ManagingInventory11.6 ManagingTradePayables11.7 ManagingTradeReceivables

11.1 ObjectivesofCashManagementTheobjectivesofcashflowmanagementare:

• toreducetheliquidityrisks;• tomakecashavailableforday-to-daypurposes;• tominimisetheneedsofcash;• toinvestthe‘balancecash’inmostoptimalmanner;and• tomaintainoptimalcashbalance.

Companieshold cashbalance tomeet thepayment requirements. This becomesnecessary as thetimings and amount of cash inflows do not match the timings and amount of cash outflows.Followingsaretherequirementsforwhich“optimalcash”isrequiredtobekept:

• Cash money is required to settle day-to-day payment requirements, namely payment ofcreditor’sbills,paymentofwagesofemployees,andtopayforsundrypurchases.

• In business environment, it cannot be assumed that cash-inflows will occur as per theestimates. Further, the future cashneeds are alsouncertain. The companyhas to protectitselffromsuchcontingenciesbyholdingadditionalcash.

• Thecompanymaygetsomeattractiveopportunitiesforinvestmentsinfuture.Therefore,ithastokeepsomecashbalanceforthispurpose.

11.2 StrategyforCashManagementThemaincomponentofstrategyforeffectivecashmanagementistoensureuninterruptedsupplyofcash for the business operations during the operating cycle. The strategy has three importantcomponents:

• MakingForecastofCash-Flows:Thecash-flowforecast fornextyearperiod ispreparedbymakingcloserestimatesforlikelytransactionsandresultingcashflows.

• ReducingtheTimeinCollectingtheTradeReceivables:TheCompanyhastomakeeffectivestrategyandactionplanformakingspeedycollectionoftradereceivables.

• ManagingtheTradePayables inLongerTime:TheCompanyshouldattempttospreadoutthetradepay-outsaswideaspossible.

11.3 CashFlowForecastFollowingpointsareusefulinpreparingcash-flowforecastforabusinessorganisation:

• Arealisticforecastoflikelycashflowsshouldbepreparedforthenextaccountingperiod.• The firstpartof forecastoriginates from the sales forecast for the year;while the second

partoriginatesfromthecapitalbudget.• Acushionisaddedtotheforecastedfigurestocaterforthenormalcontingencies.


• Forrealisticcashflowforecast,thesaleprojectionsandcapitalbudgethavetobedrawnupafterextensivedeliberationswithseniormanagersofthecompanyalongwithotherexperts.

• Involvement of operational level people, both from production and sales departments, isessentialforrealisticcashflowforecast.

11.4 BudgetaryControlProcess11.4.1BudgetaryControlsAbudgetispreparedtomakeeffectiveutilisationofresourcesandfortherealisationofobjectives,inanefficientmanner.“Abudget isamonetaryandquantitativeexpressionofbusinessplansandpolicies,preparedinadvance,tobepursuedinthefutureperiodoftime”.Budgetingisamethodoffinancialplanningforthefuture.Budgetsarepreparedforvariousareasofthe business, namely (i) purchases, (ii) sales (revenue), (iii) production, (iv) labour payments, (v)tradereceivables,and(vi)tradepayables.CharacteristicsofaBudget:Thebudgetispreparedinadvanceforadefiniteperiod,formeetingacomprehensive business plan for the organisation. It is expressed in quantitative form. Financialbudgetsarepreparedusingapropersystemofaccounting.Budgetary Control is a systemwhich uses budgets as ameans of planning and controlling. Threestagesarerelevant:

• Inthefirststage,thebudgetsareprepared.• Insecondstage,theactualperformance-resultsarerecorded.• In the third stage, comparison is made between the planned progress and the actual

progress;andthevariancesareidentifiedandcomputed.Oncethediscrepanciesareknown,remedialmeasuresaretakenforachievingtheplannedresults.Abudgetisameans;andbudgetarycontrolleadstothedesiredresults.11.4.2 CashBudgetCash budget is a ‘cash management’ tool to plan and control the use of cash. It reflects theestimatedcashoutflowsandinflowsfortheaccountingperiod.Thecashbudgetisusedtomonitorandmanagethecashflowsofabusinessbudget.Generally,cashbudget areused tomanage short termcash flowsby creating anorganised systemof keeping-upwithcashreceiptsandbalancingthemagainstthecashpaymentsduringtheaccountingperiod.Thecashbudgetshowsthecash-relatedeffectsofallplansmadewithinthebudgetaryprocess.Itspreparationcanleadtoamodificationofbudgetifitshowsthatthereareinsufficientcashresourcestofinancetheplannedoperations.Cashbudgethelpsthemanagementinthefollowingways:

• Identificationoftheperiodandamountof‘cashshortage’sothatappropriateplanmaybemadeaboutarrangingthefundattherequiredtime.

• Identificationofperiodandamountof‘cashsurplus’positionsothatplansmaybemadetoinvesttheexcesscashamountinanappropriatemanner.

• Proper coordination of timings of cash inflows and cash outflows, so that chances ofshortagesorsurplusofcashmaybeavoided.


PreparationofCashBudget:

• First of all, budget-duration is finalised. It is generally one year; butmay be divided intosmallerperiodssaysixmonthsorthreemonthsperiod.Sometime,smallerbudgetcyclecanalsobeadoptedtomeetthespecialrequirements.

• Nextstepistoidentifyandestimatethe‘cashitems’coveringtheinflowsandoutflows.Forthis purpose, cash flows relating to Operations, Investing, and Financing activities areseparatelyidentifiedandlisted.

• Third step relates to preparation of cash budget wherein both inflows and outflows areplottedagainstthetimehorizon;andexcess/shortageofcashattheendofeachintervalisidentified.

• Fourth,action-plansarepreparedformeetingthesituationofexcessorshortageofcash.11.5 ManagingInventory11.5.1 NecessityofHoldingInventoryInanybusinessoperation,certainitems/goodsareprocuredandstoredinadvanceforuseatalaterstage, as getting the required items at time of actual requirement is generally not possible. Suchitemsandgoodsarecalledtheinventoryofabusinessoperation.Therearethreeimportantobjectivesofholdingsufficientlevelofinventoryofabusinessfirm.Theseareasfollows:

• Thecompanymustholdcertainitemsandmaterialsnecessarytofacilitatethesmoothanduninterrupted production and sales operation. In real-life situation, it is not possible toprocure the rawmaterials immediatelywhen required. Theremay be a time-lag betweenthedemandforthematerialanditsreceipt.Therefore,certainminimalstockofinventoryisessentialtocontinuewithoperationsrelatedactivitiesinanuninterruptedmanner.

• The company should guard against risk of unpredictable changes in demand and supply.Hence,companyshouldmaintainsufficientlevelofinventorytotakecareofsuchsituation.

• If any attractive offer of incentiveonbulk purchase is available, the companymay like topurchase and stock the inventory in the quantity which ismore thanwhat is needed forproductionandsalespurposes.

11.5.2 ManagingtheInventory

The objective of inventory management is to ensure that: (i) optimal levels of inventory ismaintainedatalltimes,andsimultaneously(ii)thecostofholdingtheinventoryisalsominimisedorkeptatlowestlevelsasfeasible.To reduce the requirement of cash in business, inventory turnover should be maximised andmanagement should avoid chances of loss of production and sales, if the stock of inventory isexhausted. Themain objective of inventory management is to maintain inventory at appropriatelevel so that it isneitherexcessivenor shortof requirement. Thus,management is facedwith twoconflictingobjectives:

• To keep inventory at sufficiently high level to perform production and sales activitiessmoothly.

• Tominimiseinvestmentininventoryatminimumleveltomaximiseprofitability.

Theobjectivesofinventorymanagementcanbeexplainedasunder:


• To ensure that uninterrupted supply of raw material and finished goods so thatproductionprocessisnothalted.

• Tominimisecostofcarryingtheinventory.• Tokeepinvestmentininventoryatoptimumlevel.

11.5.3 InventoryControlInventory control refers to keeping inventories at an optimal level so that production is notinterruptedandcostofcarryinginventoryiskeptatlowestlevelsasmaybefeasible.Inventory management and inventory control must be designed to meet the changing marketconditions and to also support the company’s strategic plan. Variousmodels adopted for QualityControlaredescribedunder.

(a) EconomicOrderQuantity(EOQ)ModelInventorylevelcanbemanagedbyadoptingaEconomicOrderQuantity(EOQ)Model.Thismodeldeterminesthe ‘ordersize’ thatwillminimisethetotal inventorycost.Accordingtothismodel,threeparametersarefixedforeachitemoftheinventory:

(a) Minimum levelof each inventory item tobedecidingbasedon its ‘rateofusage’,and‘supplytime’.

(b) The inventory-level at which next order for the item must be placed to avoidpossibilityofzerostock.

(c) Thequantityforwhichthereordershouldbeplaced.

(b) ABCClassificationModelThe ABC classification model is based on the analysis of inventory items into threecategories:

• Category‘A’:Itemsofextremelyhighlevelofimportance;• Category‘B’:Itemsofaverageimportance,and• Category‘C’:Itemswhicharerelativelyunimportant.

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 safetystocklevelfor‘C’items.

(c) StockLevelModelThismodelisbasedonthreeguidingparameters,asunder:ReorderLevel:Thestorekeeperstartspurchasing-processwhentheinventoryintheStoresreachesthislevel.MinimalLevel:Inventoriesarenotallowedtofallbelowthislevel.Maximum Level: This is considered to be the highest level beyond which holding ofinventoriesimpliesblockingoffundsunnecessarily.Re-OrderPoint:Thisistheinventorylevelatwhichtheprocurementordermustbeplaced.

(d) F-S-NModel(Fast-Moving,Slow-Moving,Non-MovingModel)Inventory itemsarealsoclassifiedandmanagedonthebasisof fast-moving, slow-moving,andnon-movingitems(FSNAnalysis).Thenon-movingitemsarecriticallyexaminedfortheirneeds;andthe itemsthatarenotcriticalaredisposedoff inasuitablemanner.Theorderlevelsandeconomicorderquantityforslowmoving itemsarereviewedtocheck,whethertheycanbefurtherreducedwithoutaffectingthepurchaseprocess.


Theabove inventorycontrolmodelsarenotused inexclusivemanner. In fact, theseareused inacombinedmannertoachievethemostoptimalresults.11.6 ManagingTradePayablesMost firms attempt to spread-out the payments on items ‘bought through trade’ for routinebusiness. As a practice, the market-suppliers provide the raw materials and others items/goodsneededforoperationpurposes,oncreditbasis,generallyforperiodsof1to3months.Credit-worthycompaniesalsospreadouttheir ‘tradepayablecommitments’toadateclosetothecredit limiting date. As a prevalent practice, if credit period is available in some cases, businesscompaniesutiliseitfully.Bunchingofpaymentsisgenerallyavoided.11.7 ManagingTradeReceivablesReceivable management means collection of payments for the goods and services provided tocustomers on credit basis. These payments are referred as “receivables”. Goods and services areprovidedoncreditasthispracticeisexpectedtoincreasethesalesofthecompany.Thepurposeofmaking‘creditsales’isasunder:

• If the company sells goodson credit, it should result inhigher levelof ‘total sales’ than ifgoodsaresoldon‘immediatecash’payment.

• Itshouldleadtoincreaseinprofit.• To grant better credit facilities than those offered by its competitors, for achieving even

higherlevelsofsales.Receivablemanagementinvolvesthefollowingaspects:

• Formulationofcreditpolicy;• Creditevaluation;• Adoptmethods(likeprovidingcashincentives)tofacilitatefastercollectionofpayments;• Monitoringreceivables.

Somecompaniesadoptanovelmethodforcollectingtradereceivables.Suchcompaniesprovidingcredit,selltheir ‘accountsreceivable’toanagencycalled‘factor’.Afactorisaspecialisedfinancialintermediarywho purchases ‘accounts receivables’ at a discount.Under a factoring agreement, acompanysellsorassignsits‘accountsreceivables’toa‘factor’inexchangeforacashadvance.Thefactortypicallychargescertaininterestontheadvanceplusacommission.Factoring is a technique used by companies to manage their ‘accounts receivables’ and providefinancing. Typically, companies that have excess to suitable ‘sources of financing’ that is lessexpensivethan‘factoringcharges’,wouldnotusesourceoffactoring.


UNIT 12. INVESTMENT APPRAISAL TECHNIQUES (CAPITAL BUDGETING)

12.1 CapitalBudgeting12.2 CapitalBudgetingDecisions12.3 UseofCash-FlowAnalysisinCapitalBudgetingProcess12.4 TypesofCash-FlowsAssociatedwithCapitalBudgeting12.5 PaybackMethodforAnalysingInvestmentProject12.6 AccountingRateofReturn(ARR)Method12.7 DiscountedValue(PresentValue)Method12.8 NetPresentValue(NPV)Method12.9 InternalRateofReturn(IRR)Method12.10 ProfitabilityIndex(PI)orBenefits-CostRatioMethod

12.1 CapitalBudgetingThe term Capital Budgeting refers to long term planning for proposed capital outlays and theirfinancing.Itincludesbothdecidingontheinvestmentproposalsandthenraisingoflongtermfundsfor the specified purpose. It is, thus, “firm’s formal process for acquisition and investment ofcapital”.Capitalbudgetingdecisionmaybedefinedas“thefirm’sdecisiontoinvestitscurrentfundmoreefficiently in long termactivities inanticipationofanexpected flowof futurebenefitsoveraseriesofyears”.12.2 CapitalBudgetingDecisionsAcapital investmentdecision involvesacommitmentofresourcesthat isgenerallysubjecttohighdegree of financial risk. The capital investment decisions are important decisions for a businessorganisation,duetothefollowingreasons:

• CapitalBudgetingdecisionsinvolvetheinvestmentsoflargeamountsoffund;• Acapitalbudgetingdecisionhasitseffectoveralongperiodoftime;• Mostofsuchinvestmentdecisionsareirreversibleinnature.• Capitalinvestmentdecisionsinvolveissueswhicharespreadoveralongperiodoftime,and

aredifficulttopredict.TypesofCapitalInvestmentDecisions

• Decisionsrelatingtoreplacementand/ormodernisationofassets.• Decisionsregardingsettingupofnewassetsorprojects.• Decisionsregardingexpansionofbusiness.• Decisionsregardingdiversificationofbusiness.

12.3 UseofCashFlowAnalysisinCapitalBudgetingProcessIncapitalbudgeting,thecostsandbenefitsaremeasuredintermsofcashflows.Theterm‘cashflow’is used to describe the cash oriented measures of ‘return’ generated by proposal. Using theaccountingdata,exactcash-effectmeasurementmaynotbepossible;butusefulapproximationsarepossiblefordrawingconclusions.Thecosts(payments)aretermedas ‘cashoutflows’;andbenefits(receipts)aretermedas‘cashinflows’.


Accrualprincipleisconsideredbetterforthepurposeofaccounting;butforalongterminvestmentdecision-making,cashprincipalisbetter.Paymentofcashforallcasesistermedas‘outflow’,andallcashreceiptsaretermedas‘cashinflow’.Followingprinciplesshouldbefollowedforestimatingcashflowsforprojects:

• Calculationsof cash flowsaremadeon incremental (additionalamount)basis; andnotonaggregate/totalbasis.

• Cashflowsaretakenon‘aftertax’basis.• Cash needs for ‘working capital’ should be treated as a cash outflow at the time of

commencementofaproject.Onclosureoftheproject,cashamountof ‘workingcapital’ isreleased.Then,itistreatedasinflow.

• Increasesordecreasesofworkingcapitalshouldbetreatedasoutflowsandinflows.12.4 TypesofCash-FlowsAssociatedwithCapitalBudgetingCashflowsassociatedwithproposalsmaybeclassifiedinto:

• Initial Cash Outflow: This represents the amount ofmoney paid when the investment orprojectisstarted.Becausetheinitialoutlayismadeatthestartoftheproject(timezero),itisnotdiscounted.

• Subsequent Cash Flows: The original investment is expected to generate series of cashinflows contributed by the project. Sometimes, cash outflows are also incurred duringsubsequentyearslikerepairs,renovationcostsetc.

• TerminalCashFlows:Terminalcashflowsrefertothecashflow,occurringwhentheprojectlifecomestoanend.

12.5 PaybackMethodforAnalysingInvestmentProjectThistechniqueassessesaprojectonthebasisoftimerequiredtorecover(payback)theamountofinvestment. In this method, different projects are arranged as per the time required to recover(payback)theinitialinvestment.Thepaybackperiodforeachinvestmentproposaliscomparedwiththemaximumperiodacceptabletothemanagement.Theproposalswithpaybacktimemorethantheacceptabletimearerejected.Otheracceptableproposalsarethenrankedinorderofpaybacktime.Theprojecthavingminimumpayout-period is selected.Here, the cash benefits (receipts) or the cash inflows are calculatedon“after taxbasis” (CashFlowAfterTax). Thus, thepaybackperiod isusedasadecisioncriterion toacceptorrejectaproject.Merits:

• Itiseasytocalculateandsimpletounderstand.• Thepaybackmethodisanimprovementovertheaveragerateofreturnapproach.

Demerits:

• Ignoresthetimevalueofmoney.ThisweaknessiseliminatedwiththeDiscountedPaybackMethod.

• Doesnotreflectalldimensionsoftheprofitability.• Ignorescashflowsoccurringafterthepaybackperiod.


12.6 AccountingRateofReturn(ARR)MethodThismethod covers oneweakness of paybackmethod i.e. it considers the relative profitability ofdifferentproposalforcapitalinvestmentandusesthiscriterionasbasisforrankingtheprojects.Inthismethod,the‘rateofreturn’iscalculatedbydividingtheearningsbythecapitalinvested.

AverageProfitAfterTax(PAT)ARR=

InitialInvestmentAcceptanceorrejectionofproposaldependsonvalueofARRbeingmoreorlessthantheminimumrate of return expected by the management of the business organisation. Therefore, the firmacceptstheproposaliftheARRismorethantheminimumexpectedrateofreturn(cut-offrate).ThefirmrejectstheprojectifthecalculatedARRislessthantheminimumexpectedrateofreturn(cutoffrate).AdvantagesofARRMethod:

• Earningsovertheentirelifeoftheprojectareconsidered.• Thismethodiseasytounderstand,simpletofollow.• Itisbasedontheaccountingconceptsofprofit,calculatedfromfinancialdata.

DisadvantagesofARRMethod:

• Ignoresthetime-valueoffunds.• Themethod ignores the shrinkageoforiginal investmentas thisamountdecreasesdue to

depreciationchargeablebeforecalculatingthenetearning.12.7 DiscountedValue(PresentValue)MethodThemethodofDiscountedCashFlow(DCF)takesintoconsiderationthe‘timevalueofmoney’whileevaluating the cost and benefits of an investment project. The DCF based capital budgetingtechniquestakeintoaccountallbenefitsandcostsoccurringduringtheentirelifeoftheproject.In thismethod, all cash flows are expressed in terms of their present values. Various cash flowsoccurringatdifferenttimesintheproject,canbecomparedonlywhentheseareexpressedintermsofacommondenominator,thatis,theirPresentValues.It, thus, takes intoaccount theconceptof ‘timevalueofmoney’ fordeterminingPresentValueofdifferentcashflowsoccurring intheproject.The ‘presentvalues(PV)ofcash inflows’ iscomparedwith the ‘PV of cash outflows’. If the present values of sumof all cash inflows of the investmentprojectarehigherthanthecashoutflowsoftheinvestment-project,thentheprojectproposalcanbeaccepted.12.8 NetPresentValue(NPV)MethodNetPresentValue(NPV)Methodisthebestavailablemethodforevaluatingthecapitalinvestmentproposals. Under this method, the cash outflows and inflows associated with each project areascertained. Cash inflows are calculated by adding depreciation to profit after tax arising to eachproject.Sincethecashoutflowsandinflowsariseatdifferentpointoftimeandcannotbecompared,sobotharereducedtotheirPresentValuesattherateofreturnacceptabletothemanagement.


The first step of the method is to discount each cash flow (both the cash-inflows and the cash-outflows)backtoitspresentvalue(PV).ThenetPresentValuesofallcash-inflowsaredeterminedbysumming these. The ‘net present value’ can be computed by subtracting the initial cash outflowfromthesumofallcash-inflows.Netpresentvalue(NPV)isthedifferencebetweenthesumtotalofpresentvalues(discounted)ofallthefuturecash‘inflows’and‘outflows’.Ifthisvalueispositive,thentheinvestmentproposalmaybeaccepted.Merits:

• Itexplicitlyrecognisesthetimevalueofmoney.• Itconsidersthetotalbenefitsarisingoutofproposaloveritslifetime.• Itisusefulforselectionofmutuallyexclusiveprojects.

Demerits:

• It is difficult to calculate as well as to understand and use, in comparison with PaybackMethodorARRMethod.

• Itinvolvescalculationofthe‘requiredrateofreturn’todiscountthecashflows.• Thismethodaccepts theprojectwhichhashigherpresent values.But, it is likely that this

projectmayalsoinvolvealargerinitialoutlay.12.9 InternalRateofReturn(IRR)MethodThe internal rate of return is defined as ‘the interest rate’ that equates the present value of theexpected future cash flows, or receipts, to the initial outlay. Here the future cash flows arediscountedtogettheirequivalentpresentvalues.Theequationforcalculatingthe‘internalrate’ofreturnis: CF1 CF2 CF3 CFnIRR= + + +................. + -I0 (1+IRR) (1+IRR)2 (1+IRR)3 (1+IRR)n ORnCFtIRR= -I0t=1(I+IRR)tHereweknowthevalueoftheinitialinvestmentI0andalsothevaluesoffuturecashflowsCF1,CF2,CF3,CF4,and.......CFn,butwedonotknowtheIRR,whichistobedeterminedfromthisequation.Thus,wehaveanequationwithoneunknown,andwecansolveforthevalueofIRR.SomevalueofIRRwillcausethesumofthediscountedreceiptstoequaltheinitialcostoftheproject,makingtheequationequaltozero,andthatvalueofIRRisdefinedastheInternalRateofReturn.Here,theInternalRateofReturnisfoundbytrialanderror.First,computethepresentvalueofthecash flows from an investment using an arbitrarily selected interest rate (for example, 10%). Thepresentvaluesoobtainediscomparedwiththeinvestmentcost.Ifthepresentvalueishigherthanthecostfigure,tryahigherinterestrateandgothroughtheprocedureagain.


Merits:• TheIRRiseasiertounderstand.• Itprovidesarateofreturnwhichisindicativeoftheprofitabilityofproposal.• 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 theminimum rate,which investorsexpectontheirinvestment.

Demerits:

• Itinvolvestediouscalculations.• Inevaluatingmutuallyexclusiveproposals,theprojectwithhighestIRRwouldbepickedup.

But,itmaynotbethemostprofitable.• It is assumed that all intermediate cash flows are reinvested at the IRR. This is rather

unrealistic.12.10 ProfitabilityIndex(PI)orBenefits-CostRatioMethodProfitabilityIndex(PI)orBenefits-CostRatioistheratioof‘thepresentvalueoffutureexpectedcashflowssubsequenttoinitialinvestment’dividedbythe‘amountoftheinitialinvestment’.It shows the relative profitability of an investment by showing the ratio of the benefit from aninvestment(thepresentvalueofcashinflows)tothecost(thepresentvalueofcash-outflows).

PresentValuesofFutureCash-FlowsProfitabilityIndex(PI)= PresentValueofInitialInvestment

Theaboveratio(PI)isanindicatoroftheprofitabilityoftheinvestmentproject.IfvalueofPIisequalorgreaterthan1,thenitshowsthattheprojecthasanexpectedrateofreturnequaltoorgreaterthanthediscountrate.IfPIvalueislessthan1,theprojecthasanexpectedrateofreturnlessthanthediscountrate.DecisionRule:

• IfPI>1,accepttheproject;• ifPI=1,managementcanbeindifferent;and• ifPI<1,rejecttheproject.

Merits:

• Itconsiders‘timevalueofmoney’.• Itisasoundinvestmentcriterion.• Itcanbeusedtorankprojectsofvaryingcashandbenefitsinorderoftheirprofitability.

Demerits:

• Itisratherdifficulttocompute.• Itdoesnottakeintoaccountthesizeoftheinvestment.


IV. UNDERSTAND DIFFERENNT OWNERSHIP STRUCTURES AND HOW THEY INFLUENCE AND MEASURE

FINANCIAL PERFPRMANCE


UNIT 13. OWNWERSHIP STRUCTURE

13.1 SoleTraderorSoleProprietorship13.2 Partnership13.3 TypesofPartnership13.4 PrivateCorporation13.5 OtherTypesofCorporations13.6 PublicSectorOrganisation13.7 AccountingStandards13.8 TaxLaws13.9 CommercialLaws

13.1 SoleTraderorSoleProprietorshipItisabusinessownedandoperatedbyasingleindividual;andisthemostcommonformofbusinessstructure for small businesses. Such firms are owned by one person, who also has day-to-dayresponsibilityforrunningthebusiness.Soleproprietorshipsownalltheassetsofthebusinessandtheprofitsgeneratedbyit.Theproprietorhascompleteresponsibilityandliabilitiesforallaspectsofthebusiness.Thesoleproprietorshipcanbestartedwitheaseandneeds lowcapital for its formation.Onecanstartsuchbusinesssimplybyfillingfewformstoprovidenecessary informationandtorequestforlicenses/permitsasrequiredbythelocalauthorities.Theownerhasfullclaimovertheprofits.Theowner has good degree of flexibility in decision making and running the business. Further, thebusinesscanbeendedwithease.Majorproblemhereisthatsuchbusinesshasunlimitedliabilityasall‘businessdebts’areconsideredpersonaldebts,underthelaws.Thedebtsandotherliabilitiesmayberecoveredfrompropertyandassets owned by the owner. There is limited scope of finding sources of finance, which can beavailedonlyonthebasisofcreditworthinessoftheowner.The owner has to playmany roles for the business. He himself is hismanager,market-staff, andaccountant,etc.Thebusinesshastopayincometaxaspayablebyanindividual.Theownerpaysalltaxesaspersonaltaxes.Merits:

• Easiestandleastexpensivetostartbusiness.• Soleproprietorsareincompletecontroloftheirbusinessandmaymakealldecisions.• Ownerhasallrightsoverthe‘profits’.• Thebusinessiseasytodissolve,ifdesired.

Demerits:

• Soleproprietorhasunlimitedliabilityandisresponsibleforalldebts.• Canraisefinanceonlyonthebasisofowner’scredit-worthiness.• Some employee-benefits such as owner’s medical insurance premiums are not directly

deductiblefrombusinessincome.


13.2 PartnershipThey are governedby theU.K. PartnershipActof 1890. Partnershipbasedbusiness is ownedandoperated by two or more persons, who share the ownership of a single business. Likeproprietorships, the law does not distinguish between the business and its owners. It is mostuncommonformofbusinessinmostofthedevelopednations.There are two basics forms of partnerships, general and limited. In a general partnership, allpartnershaveunlimited liability. Ina limitedpartnership,oneormorepartner(s)has/have limitedliability,butatleastonepartneracceptsfullliabilityforallaspectsofbusiness.Mostcountriesrequirealegaldocumentinformofanagreement,generallycalledthe“Articles(orterms & conditions) of Partnership”. This agreement of partnership defines detailed mode ofbusiness operation and liability of various partners; and also of the investment and role of eachpartner.Itstipulatesthe‘agreedframework’defining:

• Howdecisionswillbemade,• Howtheprofitswillbeshared,• Howthedisputeswillberesolved,• Howfuturepartnerswillbeadmittedtothepartnership,• Howpartnerscanbeboughtout,and• Ifneeded,whatstepswillbeinitiated/takentodissolvethepartnership.

Merits:

• Easytoestablish;onlyanapplicationtoauthoritiesalongwitha ‘partnershipagreement’ isneededtostartthebusiness.

• VerylittleGovernmentalregulations.• Morepartnersmeanbetterdecisionmaking.• Withmorethanoneowner,theabilitytoraisefundsmaybeincreased.• Thebusinessbenefitsfrompartnerswhobringcomplementaryskills.

Demerits:

• Unlimitedpersonalliability.• ProfitssharedamongpartnersasperArticlesofPartnership.• Partnershipendswhenapartnerdiesorleaves.• Allpartnersareaccountableforthedecisionstaken.

13.3 TypesofPartnerships

(a) GeneralPartnership

Partnersdivideresponsibilityformanagementandsharetheprofitorlossaccordingtotheirinternal agreement. Equal shares are assumed unless there is a written agreement thatstatesotherwise.Otheraspectsareasstatedintheprevioussection.

(b)LimitedPartnershipandPartnershipwithLimitedLiability

This type of partnership is governed by the ‘Limited Partnership Act 1908'. The word‘limited’meansthatmostofthepartners(acceptatleastonepartner)havelimitedliability(totheextentoftheirinvestment)aswellaslimitedroleregardingday-to-daymanagementdecisions.


(c)JointVenture

This is anassociationof twoormoreparties fora specificpurpose fora limitedperiodoftimetillallpartiesagreetocontinueorasspecified in theiragreement. It is likeageneralpartnership, but is for a limited period of time and for a single specified project. If thepartners repeat the activity beyond the initially agreed period of time, they will berecognizedasan‘ongoingpartnership’.

13.4 PrivateCorporationIt isa legalbusinessentitywhoseassetsand liabilitiesareseparate from itsowners. Itsstocksarenotlistedandnottradedonstockexchange.Mostsmallbusinessesare(oratleaststartas)privatecorporations.Aprivatecorporationisownedbyasmallgroupofpeoplewhoalsomanagethebusiness.Alegaldocument,“Articlesof Incorporation”isrequiredtobesubmittedtotheStateinwhichthecorporationwishestooperate.Asperthe law, it isconsideredtobeauniqueentity,separateandapart from those who own it. A corporation can be taxed, it can be sued, and it can enter intocontractualagreements.Theshareholdersarethecollective-ownersofthecorporation.TheyelectaBoardofDirectorstooverseethemajorpoliciesanddecisions.Thecorporationhasalifeofitsownanddoesnotdissolvewhenownershipchanges.Merits:

• Shareholdershavelimitedliabilityforthecorporation.• Thereisunlimitedlifespanforsuchcompany.• Easeoftransferofownership.• Corporationscanraisefundsthroughthesaleofstock.• Employeebenefitsaretax-deductible.• CanelectS-corporationstatusifcertainrequirementsaremet.

Demerits:• Incorporationprocessrequiresmoretimeandmoneythanotherformsoforganization.• Incorporatingmayresultinhigheroveralltaxes.• The corporation pays taxes on its income, and then shareholders also pay taxes on any

dividendsreceived.13.5 OtherTypesofCorporationsOthertypesofownershipofbusinessorganizationsarediscussedinthissection,asunder.13.5.1 ‘S’CorporationItprovidesthe‘best’oftwoformsofownerships:partnershipstructureandcorporationstructure.Inthis structure, the liability of the owners is limited like in a corporation. Further, owners i.e. theshareholders,havetotalclaimovertheprofit.Taxisnotpaidbethecorporation,butbytheowners.Thenumberandtypeofshareholdershastobekeptinaccordancewiththeguidelinesofthelocalgovernment.


Thus, this corporation is taxed like sole proprietorships and partnerships. It has shareholders,directors,andemployees.Theshareholdershavethebenefitoflimitedliability.RegulatoryGuidelines:

• Maximumnumberof75shareholders,whomaybetheindividualsororganisations.• Onlyonetypeofsharescanbeissued.• Morethan75%ofincomeshouldbefrommaindeclaredbusiness.• Lessthan25%incomemaybethe‘incomefromothersources’.

13.5.2 LimitedLiabilityCompany(LLC)It is now popular in the U.S. as it provides limited liability and is taxed as a partnership or soleproprietorship.This typeofcompanycanbe incorporatedbysubmittingarticlesoforganizationtotheGovernment.Suchcompaniesenjoyhighdegreeofflexibility,andeaseofgettingincorporation.Ithasliabilitylikeacorporation,andtaxationandflexibilityadvantagesofapartnership.13.5.3 PrivateLimitedCompanyAPrivateLimitedCompanyinAsian&othercountriesissimilartoaC-CorporationintheUSA.Likeaconventional (C) corporation, such companies are state-chartered legal entity, and enjoy limitedliabilityfortheowners/shareholders.Private Limited Company has rights to select its shareholder-owners who pay the share capitalamountsasdecidedbythecompany.Itisalegalentityintermsoftaxationandlimitedliability.A private limited company canbe formedby registering the companynamewith the appropriateauthority. “MemorandumofAssociation” and “ArticleofAssociation” arepreparedand signedbythe promoters (initial shareholders) of the company. These have to submitted to the concernedauthoritiesatthetimeofregistration.Itcanhavelimitednumberofshareholders(asspecifiedbylocalauthorities)withsharecapitalpaidby themasper local rules.The shareholdersappointDirectors (minimumof02 innumber)of thecompany,wholookaftertheoperationsandmanagementofthecompany.Thecompanymaintains itsaccount inproperstyleasper the requirementsofCompany’sActandthetaxationrequirements.Thecompanypaystaxonitsprofit,andthe‘balanceprofit’ispassedtotheownershareholders,whoalsopaytaxontheirpersonalincome.13.5.4 PublicLimitedCompanyPublicLimitedCompanyissimilartoPrivateLimitedCompanywiththedifferencebeingthatnumberofshareholdersofaPublicLimitedCompanycanbeunlimitedwithaminimumsevenmembers.APublicLimitedCompanycanbeeitherlistedinastockexchangeorremainunlisted.Thesharesofa listedPublicLimitedCompanyaretradedonstockexchangewhere it is listed. It isboundtomakepublicdisclosuresasperCompany’sActandobservecompliancetothegovernmentregulations.APublic LimitedCompany isan independent legalentity. Its shareholdersmay sell their shares tootherpersons.


13.5.5Non-ProfitCorporationsAnon-profitcorporationcanbeformedtocarryoutacharitable,educational,religious,literary,orscientificpurpose. A non-profit corporation can raise fundsby solicitingpublic andprivate “grantmoney”and“donations”fromindividualsandcompanies.Thenationalandstategovernmentsdonotgenerallylevyanytaxonthenon-profitcorporationsastheiroperationsarefornon-profitpurposeforthebenefitofthesociety.13.5.6 CooperativesCooperativesarea formofbusinessorganization formedand runby itsmembers inademocraticmanner. People forming the ‘cooperative’ are called its “Members”. Basically, the members co-operatewithoneanotherinrunningthebusinessofwhichtheyaretheowners.Thus, a ‘cooperative’ is a business structure owned and controlled by its members. They alsogenerally act as the workers, producers and consumers. They generally pool their resources forsatisfyingtheirmutualobjectives.Membersdemocraticallyruntheirbusiness.Theyelect“membersof the management committee” or the “members of the board of directors” for running andmanagingthebusinessofthecooperative.Theymayhireprofessionalaswellasgeneralworkers,asmayberequired.13.5.7 ‘LimitedbyGuarantee’CompaniesLimited byGuarantee Companies are generally formed by non-profit organisations (such as SportClubs,Workers’Cooperatives,etc).Suchcompaniesenjoythebenefitsoflimitedfinancialliability.A company ‘limited by guarantee’ does not have ‘shares’ or ‘shareholders’ but is owned by theguarantor(s)whoagreetopaya‘setofamountofmoney’towardscompanydebts.ThelawrequiressuchcompaniestohaveatleastoneguarantorandatleastoneDirectortobeableto register such a company. Butmore numbers ofGuarantors andDirectors are permitted. SamepersoncanbetheguarantorandalsotheDirector.Suchacompanyisadistinctlegalentityseparatefromitsowners.Aspertheregulatoryguidelines,theprofitscannotbedistributedtotheguarantor(s)butarere-investedasthecompany,ifformedwithno-profitobjective.13.6 PublicSectorOrganizationApublicsectororganizationisonethatisoperatedbythegovernment.Thiscontrastswithprivatesector organizations, which are controlled by private entities. Public sector organizations oftenprovideservicesforcitizensregardlessoftheperson'sabilitytopay.Theusersofthepublicsectororganisationsmaygettheservicesfreeorforasubsidisedfee.Forexample,apublictransportationsystemmaychargesometicket-chargesfromtheusers.In some cases, public sector and private sector organizations may work together for a commoncause. For example, the governmentmay award a contract to a private business towork for thepublic-serviceprojectlikehospital,bridge,orroads.


13.7 AccountingStandards The corporations use money from the members of the general public who may not be muchknowledgeableaboutbusinesspractices.TheCompany’sAct,therefore,stipulatesthatcorporationsshould follow certain prescribed standards of accounting so that theremay be certain degree oftransparencyandaccountabilitytowardstheirshareholdersandthesociety.Till the end of 1990’s, commonly used accounting standards were the ‘International AccountingStandards’ (IAS). These were followed in disclosure of financial information regarding company’stransactionsandalsoforpreparationoftheFinancialStatements.ThesewereissuedbytheBoardofInternationalAccountingStandardCommittee(IASC).In2002,thenewsetofstandardsnamelythe“International Financial Reporting Standards” (IFRS), was issued by the “International AccountingStandardsBoard”(IASB).Most countries require corporations to use the accounting standards advised by the IAS, forpreparingtheaccountsandtheFinancialStatements.USA had been using the GAAP Standards but is now changing over to the IFRS standards. The“GenerallyAcceptedAccountingPrinciples”(GAPP)compriseofguidelines,standardsandsuggestedpracticesforgeneralaccountingandpreparationofstandardizedFinancialStatements.IFRS are used inmany parts of world, including Australia, Chile, European Union, GCC Countries,HongKong,India,Malaysia,Pakistan,Philippines,Russia,Singapore,SouthAfrica,andTurkey.ManyothercountriesincludingtheUSAareinprocessofadoptingthesestandards.13.8 TaxRulesBusinessformationiscontrolledbythelawoftheStatewherethebusinessisorganized.However,allbusinessesarerequiredtofiletheir‘annualreturn’.Soleproprietorshipsandcorporationsfileanincome tax return.Partnerships and S Corporations file an ‘information return’.Some LCC areautomaticallyclassifiedasacorporationandfilereturnaccordingly.OtherLLChaveanoptioneithertofiletaxreturnsasacorporation,orasapartnership.Abusinesswithasinglemembercanchoosetobeclassifiedaseitheracorporationordisregardedasanentity separate from itsowner, that is, a “disregardedentity.” LCC,asadisregardedentity,maynotfileaseparatereturn;thesingleownermayshowallLCCincomeorlossaspartofhisownannualtaxreturn.13.9 CommercialLawsInmostcountries,lawsgoverntheobligationsofbusinessestowardslabourwelfare,protectionandsafetyofworkers,andemployeediscriminationonthebasisofage,gender,disability,andrace.Lawalsoprescribesguidelinesregardingminimumwage,unionaffairs,andworkinghours.Operating licenses are required for certain class of businesses. Professions needing compulsoryoperatinglicensesincludelaw,medicine,aircraft-pilots,sellingliquor,etc.Somebusinessesnamelybanking, insurance, broadcasting, healthcare and aviation have to comply with certain specialregulations.Corporationscanraisemoneycapitalthroughmarketsandpublicthroughequity,bonds,debenturesetcthroughcapitalmarketwhileobservingandcomplyingwithspecifiedguidelinesandregulations.


Commerciallawscoverlargenumberofcorporatepractices.Suchlawsinclude:

• EmploymentandLabourLaw,• Health-CareLaw,• MergersandAcquisitions,• EmployeeBenefitPlans,• FoodandDrugRegulation,and• IntellectualPropertyLaws.


UNIT 14. ROLES AND ACCOUNTABILITY

14.1 AccountabilityConcept14.2 AccountabilitytowardsStakeholderInterests14.3 ShareholdervesusSoleTrader14.4 ManagerandOwner14.5 Decision-MakingInterests14.6 OrganisationStrategy14.7 CorporateSocialResponsibility(CSR)

14.1 AccountabilityConcept

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”referstothe‘commitment’and‘answerability’ofthe individualororganizationtomeettheobligations,asunder:

• to perform the activities and to produce desired results in ethical and legally correctmanner;

• toacceptresponsibilitytowardsthesociety,and• todisclosethe‘results’andrelatedinformationinatransparentmanner.

Italsoincludestheresponsibilityforproperandhonestuseofmoneyandotherentrustedproperty.Suchapersonororganisationisduty-boundtoproducedesired/requiredresults.Heis‘answerable’for the failure toachieve thedesired results.He isalso ‘accountable’ forproperuseof resources.The accountable person or body is bound to explain the reasons (and provide all relatedinformation/answers)fornonachievementofdesiredperformanceorresults.Hemayhavetofacetheconsequencesforhisnon-performance.14.2 AccountabilitytowardsStakeholder-Interest

The stakeholders have a close relationship with the organisation. In context of businessorganisations, the term ‘stakeholders’ include the owners, shareholders, employees, suppliers,creditors,debtors,and finally thesociety.Theyallwork forandsupport theorganisation;andareaffectedbythebusinessperformanceoftheorganisation.“Stakeholders are the individuals and groups who can affect and are affected by the strategyoutcomes;andwhohaveenforceableclaimsonthefirm’sperformance.”Theysupportthebusinessoperations of the organisation. The firm has accountability towards its stakeholders and shouldattempttofulfiltheirexpectations.

Figure:TheOrganisation–StakeholderRelationship

ExternalStakeholders

Customers,Suppliers,Unions(s),

MassMedia,Bankers,andCreditors

Contribution/Support

Expectations/Claims

InternalStakeholders

Shareholders,Employees,Managers,Directors

BusinessFirm


The association of the stakeholderswith the organisation is a two-way relationship. Stakeholdersprovide support to the organisation and contribute in different ways for achievement of theobjectivesoftheorganisation.Inreturn,theorganisationisaccountabletosatisfytheirexpectationsandclaims.Theexternalaswellas internalstakeholdersservetheorganisations inmanyways.Thecustomersbuyandpay for theproducts& services; the suppliers supply thematerials, the creditorsprovidefinanceandsoon.Similarly,theshareholdersbuytheshares,theemployeesprovideskills&labour;the managers undertake decision-making; and the Directors guide & supervise the managers. Inreturn, the stakeholders have certain expectations and claims. The shareholders expect goodperformanceandreturnsontheirinvestment.Theemployeesandmanagersexpectfairdealingfromorganisationandclaimcompensationintermsofsalary&wages.14.2.1 ControlIssuesControl issues in termsof accountability refer to the specific actionsexpected tobe takenby themanagement of the business organisation to fulfil the expectations of the stakeholders from thebusiness.Thesearepresentedinthefiguregivenbelow.

AccountabilityActions

‘A’ GivingExpectedBusiness-Performance;HonestyinUseofResources;AnswerabilityforPerformance&Results;ProvideRequiredInformation.

Business StakeholderOperation Interest

RightfulnessinBehaviour;‘B’ TrustworthinessofBusiness;

TransparencyinStakeholderRelationship

‘C’ HonourStakeholder-Relationship;TakeCareofStakeholder-Interest

Fig:AccountabilityActionsbyBusinessOrganisationstowardsStakeholdersTheaccountabilitycontrolissuesmaybedividedintothreebroadcategories:

• ‘A’:Accountability/answerabilityfor‘business-performanceresults’;• ‘B’:Rightfulnessandtrustworthinessindealingsandproviding‘information’;and• ‘C’:Commitmentto‘stakeholder-relationship’.

Theaboveactions shouldbeoriented towardsmeeting theexpectationsof the stakeholders fromthebusiness.Itmaybenotedthatdifferentsegmentsofstakeholdersmayhavesomedifferentsetof expectations. For example, the shareholders expect good level of dividends. Employees expectgood levelofsalaryandwages,Suppliersandcreditorsexpecttimelypayments.Customersexpecthighqualitygoods&servicesmeetingtheirexpectedlevelofsatisfaction.


14.3 ShareholderversusSoleTraderBoththeshareholdersandthesoletradersaretheownersof theirbusiness.Thedifference lies intheir day-to-day involvement in decision-making for the business and their liability towards thebusiness.Asoletraderisanindividualinbusinesswhohasset-upthebusinesswithsoleownershipstatus.Heis personally responsible for the debts and liabilities of his business. He has no protection for hispersonalassets,ifthebusinesssuffersheavylosses.Ashareholder’spersonal liabilitiesare limitedtotheamounthehas invested inthecompany.Theshareholdersareresponsibleforthedebtsandliabilitiesofthecompanyonlytotheextentoftheirunpaidsharecapital(ifanystillleftforpayment,otherwisenot).ThepersonalassetsofDirectorsorshareholderscannotbeseizedtopayoffcompanydebts.Thesignificantdifferencesbetweenlegalstatusof‘shareholder’and‘soletrader’areasunder:

• Bothareownersorshareholders.SoleTraderisthesingleshareholderinhisbusiness.• Shareholderdoesnotparticipateinbusinessactivitiesanddecision-makingforthecompany.

Sole trader is actively involved in business activities andmanagement activities includingdecision-makingforthebusiness.

• SoleTraderhasfull informationregardingconductofbusinessand its finalresults.Buttheshareholders have to depend on the management (Directors) of the business to getinformationregardingbusinessperformancereport.

Being thesoleowneraswellas themanagerofhisbusiness, the ‘aspectofaccountability’ for thesole 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 notinvolvedinday-to-dayoperationsanddecision-makingforthebusiness.Therefore,theyexpectthemanagementofthecompanytobeaccountabletothem. 14.4 ManagerandOwnerInasoletraderorganisation,thetraderistheowneraswellasthemanagerofhisbusiness.Hehasall information regarding his business and takes all decisions himself. Thus, he is accountable tohimself,hisbusinessandhisstakeholders.Butthesituationisdifferentforotherstructuresofbusiness,whereamanagerisnottheownerofthebusiness.Hetakesdecisionsforthebusinessorganisation,whichmayaffecttheownerseitherfavourablyoradversely,dependingonthequalityofhisdecisionsandactions.The managers have accountability towards the Owners for the purpose of maximisation of theirwealth.Theyareaccountableandliabletofollowthecorporateandbusinessrulesandregulations.Theyarealsoaccountabletofollowethicalandlegalrequirements&practices.Theowners(unlessthesoletraderorpartnersinapartnershipbasedbusiness)arenotaccountableforfirms’activities.TheydonothaveanyliabilitytowardssuchpracticesandactionsbytheDirectorsandmanagementofthecompany.ManagersincludingtheDirectorsareaccountablefortheactionsbythebusinessCompanyandareliabletofulfiltheexpectationsofvarioussegmentsofstakeholders.Theyareaccountableforethicalexpectationsandlegalregulationsstipulatedforthebusiness.


14.5 Decision-MakingInterestsThe Directors and managers of a business company take variety of decisions to ensure smoothoperationandgrowthofthebusiness.Theyarealsoresponsibleforensuringcompliancetovariousregulationsandlawsofthecountry.Therefore,theinterestsofmanagementindecision-makingareasunder:-

• Properconductofbusiness;• Protectingtheinvestedcapital;• Profitabilitymaximisation;• Timelypaymentsofwagesandbenefitstotheemployees;• Ensuringgrowthofbusiness;• MeetingtheexpectationsoftheStakeholders;and• Meetingthecompetitivepressurewithreasonablesuccess.

14.6 OrganisationalStrategiesThebusinessorganisationshaveaccountabilitytowardsitsstakeholdersandtothesociety.Leadingandreputed organisations have well established strategies and action plans to meet stakeholders’expectations,andtoensurecompliancetothevariousregulationsandlegalstipulations.Successful companies consider the need to provide information to their stakeholders as animportant part of corporate governance. They provide relevant information to their stakeholdersregardingbusinessperformance,andnew investments.Theytakeperiodicalactions in this regard,suchas:

• MakingpresentationstoShareholdersintheAnnualGeneralMeeting;• MeetingswiththeMediaregardingbusinessresults;• Presentationsonbusinessperformancetoinstitutionalinvestors;• Individualmeetingsforoverseasinstitutionalinvestors;and• Puttinggeneralinformationmaterialonthecompany’swebsite.

14.7 CorporateSocialResponsibility(CSR)Corporatesocialresponsibility(CSR)referstotheobligationsofthebusinessorganisationtoacceptaccountabilityforitsactionsandtomakebesteffortstomake‘positiveimpact’ontheenvironment,consumers,employees,andotherstakeholders.TheCSRconceptisgaininggroundinpost2000era.The leading business firms are making all-out efforts to avoid any kind of unethical or sociallyadversebehaviour.Somebusinessorganisationsundertakephilanthropicactivitiesforbenefitofitsemployeesandthelocal population living around its business site. Some firms are providing scholarships for highereducation for the children of their employees. Many organizations are taking positive actions tointegrate ‘social values’ in their business strategies. There is now rising trend of reporting CSRrelatedpoliciesandactivitiesintheannualreportofthecompany.CompaniesarepayingmoreattentionandeffortsonCSRrelatedactivities.Greatereffortsarenowbeingdevotedforensuringenvironment-friendliness,higherproductsafety,andfairtradepractices.Manufacturingcompaniesareusingnewenvironmental friendlytechnologies,andareundertakingsociallybeneficialactivities.

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