BALAJI INSTITUTE OF I.T AND MANAGEMENT KADAPA 2.5 UNITS-(FROM LAST HAL… · Financial Management,...

BALAJI INSTITUTE OF

I.T AND MANAGEMENT

KADAPA

FINANCIAL MANAGEMENT (17E00204)

ICET CODE: BIMK SECOND INTERNAL

ALSO DOWLOAD AT http://www.bimkadapa.in/materials.html

Name of the Faculty: S.RIYAZ BASHA

Units covered: Last half of 3rd Unit, 4th & 5th Units

E-Mail:[email protected]

FINANCIAL MANAGEMENT M.B.A -II –SEMESTER- R17

UNIT-3 The Financing Decision |BALAJI INST OF I.T AND MANAGEMENT 1

(17E00204)FINANCIAL MANAGEMENT

SYLLABUS * Standard Discounting Table and Annuity tables shall be allowed in the examination

1. The Finance function: Nature and Scope. Importance of Finance function – The role in

the contemporary scenario – Goals of Finance function; Profit Vs Wealth maximization .

2. The Investment Decision: Investment decision process – Project generation, Project

evaluation, Project selection and Project implementation. Capital Budgeting methods–

Traditional and DCF methods. The NPV Vs IRR Debate.

3. The Financing Decision: Sources of Finance – A brief survey of financial instruments.

The Capital Structure Decision in practice: EBIT-EPS analysis. Cost of Capital: The

concept, Measurement of cost of capital – Component Costs and Weighted Average Cost.

The Dividend Decision: Major forms of Dividends

4. Introduction to Working Capital: Concepts and Characteristics of Working Capital,

Factors determining the Working Capital, Working Capital cycle-Management of Current

Assets – Cash, Receivables and Inventory, Financing Current Assets

5. Corporate Restructures: Corporate Mergers and Acquisitions and Take-overs-Types of

Mergers, Motives for mergers, Principles of Corporate Governance.

Textbooks:

Financial management –V.K.Bhalla ,S.Chand

Financial Management, I.M. Pandey, Vikas Publishers.

Financial Management--Text and Problems, MY Khan and PK Jain, Tata McGraw- Hill

References

Financial Management , Dr.V.R.Palanivelu ,S.Chand

Principles of Corporate Finance, Richard A Brealeyetal., Tata McGraw Hill.

Fundamentals of Financial Management, Chandra Bose D, PHI

Financial Managemen , William R.Lasheir ,Cengage.

Financial Management – Text and cases, Bringham&Ehrhardt, Cengage.

Case Studies in Finance, Bruner.R.F, Tata McGraw Hill, New Delhi.

Financial management , Dr.M.K.Rastogi ,Laxmi Publications



UNIT-3

THE FINANCING DECISION

1.5 COST OF CAPITAL

The cost of capital is the rate of return the company has to pay to various suppliers of funds.

There is a variation in the cost of capital due to the fact that different levels of investment

carry different levels of risk, which is compensated for, by different levels of return on

investment.

There are two main sources of capital for a company viz. shareholders and lenders. The cost

of equity and cost of debt are the rates of return that need to be offered to the shareholders

and lenders for supplying capital.

“The cost of capital is the minimum required rate of earnings of the cut-off rate for

capitalexpenditures”.

“The cost of capital is the minimum required of return the hurdle or target rate the cut-off

rateor the financial standard of performance of a project.”

“The project cost of capital is the minimum required rate of return on funds committed to

theproject which depends on the friskiness of its cash flows.”

“The firms cost of capital means overall or average required rate of return on the aggregate

ofinvestment projects”.

1.5.1 SIGNIFICANCE OF THE COST OF CAPITAL:

The determination of the firm’s cost of capital is important from the point of view of both

capital budgeting as well as capital structure planning decisions.Cost of capital is a concept of

vital importance in the financial decision making. It is useful as astandard for

1. Evaluating investment decisions: The primary purpose of measuring the cost of capital is

its use as a financialstandard for evaluating the investment projects.

a. In NPV method the investment project is accepted it has positive NPV. The projects

NPV are calculated by discounting its cash flows by the cost of capital. Positive NPV

makes a net contributing to the wealth of shareholders.



b. If the project has zero NPV it means that its cash flows have yielded a return just equal

to the cost of capital and acceptance or rejecting of the project does not affect the

wealth of shareholders.

c. In the I.R.R. method the investment project is accepted if it has an internal rate of return

greater than the cost of capital.

d. The cost of capital is the minimum required rate of return on the investment project that

keeps the present wealth of shareholders unchanged cost of capital represent a financial

standard for allocation the firm funds supplied by owners and creditors in the most

efficient manner.

2. Designing Debt Policy: The debt policy of a firm is significantly influenced by the cost

considerationdebt helps to save taxes as interest on debt is a tax deductible expense. The

interest tax should reducethe overall cost of capital though it also increase the financial risk

of the firm.

In designing the financing policy the proportioned debt and equity in the capital structure

thefirms aims at maximizing the firm value by minimizing the overall cost of capital.

The cost of capital can also useful in deciding about the methods of financing at a point of

time.

Ex. Cost may be compared in choosing between leasing and borrowing.

3. Appraising the financial performance of top management: The cost of capital

framework can be used to evaluate the financialperformance of top management. It involves a

comparison of actual profitability of the investmentprojects undertaken by the firm with the

project overall cost of capital and the appraisal of the actualcost incurred by management in

rising the required funds.The cost of capital also plays a useful role in a dividend decision

and investment in current assets.

1.6 ELEMENTS OF COST OF CAPITAL (OR) MEASUREMENT OF COST OF

CAPITAL:

The cost of capital consists of the following elements:

1. cost of equity

2. cost of retained earnings

3. cost of preference shares

4. cost of debt



5. weighted average cost of capital

I.)Cost of equity: the funds required for the project are raised from equity shareholders. These

funds need not be repayable during the lifetime of the company. Hence it is a permanent

source of fund. If the business is doing well the ultimate beneficiaries are the equity

shareholders (ESH). On other hand, if the company comes for liquidation due to losses, the

ultimate sufferers are also equity shareholders. Sometimes they may not get their investment

back during the liquidation process. That’s why equity share capital is also known as ‘risk

capital’.

Profits after tax less dividends paid to preference shareholders are the funds available

to ESH. These funds have been re-invested in the company and therefore, these retained

funds should be included in the cost of equity.

Cost of equity may be defined as the minimum rate of return that a company that must

earn on its equity financed portion so that the market value of share remain unchanged.

Methods of valuation:

The following methods are used in calculation of cost of equity.

a) Dividend yield method: This method is based on the assumption that the market value of

share is directly related to the future dividends on the shares. Another assumption is that

the future dividend per share is expected to be constant. It does not allow for any growth

in future dividends. But in reality the shareholders expects the return from his equity

investment to grow over time.

D1

Thus Ke = -------

PE

Where Ke= Cost of equity

D1 = annual dividend per share

PE = Market price per share



b) Dividends Growth Model: In this method an allowance for future growth in dividend is

added to the current year dividend. It is recognized that the current market price of a

share reflects expected future dividends. This model is also known as Gordon dividend

growth model.

D1 + g

Ke = ------------

PE

(OR)

Do (1+g)+g

Ke= -----------------

NP

Where Ke= cost of equity

D1 = current dividends per ES

G=growth in expected dividend

PE = Market price per ES

c) Price earning model: It takes into consideration the earnings per share (EPS) and

market price of share (MPS). It is based on the assumption that it the earnings are not

disbursed as dividends and kept as retained earnings are not disbursed earnings will causes

future growth in the earnings of the company as well as an increase in the market price of

the share. In calculation of equity share capital the EPS is divided by the current market

price.

E

Thus Ke= ------

M

Where Ke = cost of equity

E = current EPS

M=MPS



d) Capital Asset Pricing Model (CAPM): William F.Sharpe developed the CAPM. He

emphasized the risk factor in portfolio theory.

Risk refers to possibility of variation in the expected returns of the investor’s portfolio risk

consists of both systematic risk and unsystematic risk. Systematic risk affects the entire stock

market. For example wars, political situation influence the downward of upward movement

of stock exchange. On the other hand, the unsystematic risk happens to a company or any

industry due to shortage of raw-materials, technological changes, change in the preference of

customers etc.,

The CAPM divides the cost of equity into two components, the near risk-free return available

on investing in govt. bonds and an additional risk premium for investing in a particular share

or investment. This a additional risk premium comprises the average return on the overall

market portfolio and the beta (or risk) factor of particular investment. Putting this all together

the CAPM assess the cost of equity for an investment as follows:

Ke=Rf + Bi(Rm-Rf)

Where Ke = cost of equity

Rf = risk – free rate of return

Rm = average market return

Bi= risk of the investment.

II) Cost of retained earnings: These are the funds accumulated over the years. These

retained profits are now distributed to the shareholders, become the company can use these

funds for further profitable investment opportunities. The cost of retained earnings is an equal

to the income that they would otherwise obtain by placing these funds in alternative

investment. It the retained earnings are distributed to the equity shareholders will attract

personal taxation and therefore, the cost of retained earnings is calculated as follows:

Kr = Ke (1-T)



Where Kr = cost of retained earnings

Ke = cost of equity

T= tax rate of individuals

III. Cost of preference shares: the cost of preference share is the cost of return that must be

earned on preference capital financed investments, to keep unchanged the earnings available

to equity share holders.

A. Cost of irredeemable preference shares: the cost of irredeemable preference

share capital is the rate of preference dividend, also called the coupon rate

dividend by net issue proceeds.

I (1-T)

Kd = -----------

Np

Where Kd= cost of debt

I = annual interest payment

T = tax rate

Np = net proceeds from the issue of debentures, bonds, term loans etc.

1.7 THE CONCEPT OF AVERAGE VS MARGINAL COST OF CAPITAL

1. Marginal cost of capital:-Current rate of interest on long term debt or normal rate of

return is treated as firms marginalcost of capital. It is also termed as explicit cost.

Marginal cost of capital The weighted average cost of capital is computed for the sources of

finance already employedby the firm. If the company undertakes new projects or expansion

schemes. It may be required tocompute the cost of raising new funds and not the historical



costs incurred in the past. The weightedaverage cost of capital of the expansion programmes

or new projects is called the marginal cost ofcapital. Thus, the weighted average cost of new

or incremental capital is known as marginal cost ofcapital.

To finance its new projectors, a company should raise funds proportionally in accordance

withthe optimum capital structure. When a company raises funds to finance its new projects

in the sameproportion as it has for the company as a whole, and the component costs remain

unchanged, there willbe no difference between the average cost of capital (of the total funds)

and the marginal cost a capital(new funds). But the marginal cost of capital would rise

whenever any component cost increases. Therationale for using the marginal cost of capital

as an investment criterion is to maximize the value ofequity shares of the company.

2. Average Cost of Capital:-Average cost of capital is the weighted average of the costs of

each component of funds used bythe firm. The composite cost of capital is the weights being

the proportion of each source of funds in thecapital Structure. In financial decision making

the term cost of capital is used in this sense. Thisapproach enables the corporate management

to maximize the profits and wealth of the equityshareholders by investing funds in projects

earning in excess of the cost of its capital mix.

The following steps are involved in the computation of weighted average cost of capital:

Calculate the specific costs of various sources of finance, viz debt, preference equity etc.

Multiply the cost of each source by its proportion in the capital structure.

Add the weighted costs of all sources of funds to arrive at the weighted or composite cost of

capital.

1.7.1 WEIGHTED AVERAGE COST OF CAPITAL:

What is weighted average cost of capital? Illustrate your answer with imaginary figures.

a) Meaning of Weighted Average Cost of Capital: A company has to employ owner’s funds

as well as creditors funds to finance its projects so as to make the capital structure of the

company balanced and to increase the return to the shareholders. The total cost of capital is

the aggregate of costs of specific sources. In financial decision making, the concept of

composite cost is relevant. The composite cost of capital is the weighted average of the costs

of various sources of funds, weights being the proportion of each source of funds in the

capital structure. It should be remembered, that it is weighted average, and not the simple

average, which is relevant in calculating the overall cost of capital. The composite cost of all



capital lies between the least and the most expansive funds. This approach enables the

maximization of corporate profits and the wealth of the equity shareholders by investing the

funds in a projects earning in excess of the cost of its capital- mix.

Weighted average, as the name implies, is an average of the costs of specific source of capital

employed in a business, properly weighted by the proportion, they hold in the firm’s capital

structure.

Weighted Average, How to calculate? Though the concept of weighted average cost of

capital is very simple, yet there are so many problems in the way of its calculations. Its

computation requires:

i) computation of weights to be assigned to each type funds; and

ii) assignment of costs to various sources of capital

once these values are known, the calculation of weighted average cost becomes very simple.

It may be obtained by adding up the products of specific cost of all types of capital multiplied

by their appropriate weights.

In financial decision making, the cost of capital should be calculated on after tax basis.

Therefore, the component costs to be used to measure the weighted cost of capital should be

after tax costs.

Computation of weights: the assignment of weights to specific sources of funds is a difficult

task. Several approaches are followed in this regard but two of them are commonly used i.e.,

book-value approach and market value approach. As the cost of capital is used as a cut- off

rate of investment projects, the market value approach is considered better because of the

following reasons:

i) it evaluates the profitability as well as the long term financial position of the firm.

ii) The investors always consider the committing of his funds to an enterprise and an

adequate return on his investment. In such cases, book values are of little

significance.

iii) It does not indicate the true economic value of concern.

iv) It considers price level changes. But as the market value fluctuates widely and

frequently, the use of book value weights is preferred in practice because,

v) The firm sets its targets in terms of book value.

vi) It can easily be derived from published accounts and

vii) The investors generally use the debt-equity ratio on the basis of published figures

to analyze the riskiness of the firms.



Determining the type of capital structure: the next problem in calculating the weighted

average cost is the selection of capital structure from which the weights are obtained. There

may be several possibilities i.e,.,

a) current capital structure either before or after the projected new financing

b) marginal capital structure i.e, proportion of various types of capital in total of

additional funds to be raised at certain time and

c) optimal capital structure. All may agree that firms do seek optimum capital structure

i.e., the capital structure that minimizes the average cost of capital .



1.8 DIVIDEND DECISION

The term dividend refers to that part of profits of a company which is distributed by the

company among its shareholders after execution of retained earnings. It is the reward of the

shareholders for investments made by them in the shares for the company. And In other

words, it is the return that a shareholder gets from the company out of profit on his

shareholding.

According to the Institute of Chartered Accountant of India, “A dividend is distribution to

shareholders out of profit or reserves available for this purpose”.

1.9 MAJOR FORMS OF DIVIDEND/TYPES OF DIVIDEND

Dividends can be classified in various forms. Dividends paid in the ordinary course of

business are known as profit dividends. While dividends paid out of capital are known

Liquidation dividends.

Dividends may also be classified on the basis of medium in which they are paid:



1. ON THE BASIS OF TYPES OF SHARES:-

i. Equity Dividend: Dividend paid on equity shares called as equity dividend. Generally

dividend on equity shares is recommended by the Board of Directors depending upon profit

of the company. Rate of dividend is not fixed. It depends upon the recommendation of

directors which in turn depends upon the profit and future requirement of funds of the

company. Because the Directors has freedom regarding quantum and time of payment of

dividend.

ii. Preference Dividend: Preference dividend is the dividend paid to preference shareholders.

The preference dividend is paid at pre-determined rate and like equity shares, dividend on

preference shares is also recommended by the Board of Directors. As the name suggest

preference dividend gets priority over equity dividend. Equity dividend is paid only after

payment of shares on preference dividend. The board does not have power to reduce the rate

of dividend, however they can recommend higher dividend on preference shares.

2.ON THE BASIS OF MODES OF PAYMENT:-

i. Cash Dividend: A cash dividend is a usual method of paying dividends. Payment of

dividend in cash results in outflow of funds and reduces the company’s net worth, though the

shareholders get an opportunity to invest the cash in any manner they desire. This is why the

ordinary shareholders prefer to receive dividends in cash. But the firm must have adequate

liquid resources at its disposal or provide for such resources so that its liquidity position is not

adversely affected on account of cash dividends.

ii. Bonus Share/Stock Dividend: Stock dividend means the issue of bonus shares to the

existing shareholders. If a company does not have liquid resources it is better to declare stock

dividend. Stock dividend amounts to capitalization of earnings and distribution of profits

among the existing. Shareholders without affecting the cash position of the firm.

iii. Bond Dividend: A Bond dividend promise to pay the shareholders at a future specific

date. In case a company does not have sufficient funds to pay dividends in cash, it may issue

notes or bonds for amounts due to the shareholders. The objective Bond dividend bears

interest and is accepted as collateral security.



iv. Property Dividend: Property dividends are paid in the form of some assets other than

cash. They are distributed under exceptional circumstances and are not popular in India.

v. Composite Dividend: When dividend is paid partly in the form of cash and partly in other

form, it is called as composite dividend. This is not a new technique for payment of dividend

it is a combination of earlier discussed techniques.

3. ON THE BASIS OF TIME OF PAYMENT:-

i. Interim Dividend: Generally dividend is declared at the end of financial year, but

sometime company pays dividend before it declares dividend in its annual general meeting.

In other words, we can say that it is dividend paid between two annual general meetings.

Generally it is paid when company’s Board thinks that company has earned sufficient/huge

profit. In such a case Directors should be very careful because at the end of year profit may

fall short than what was expected by them.

ii. Regular Dividend: Dividend declared in Annual General Meeting is called as Regular

dividend. Every year company declares dividend in its Annual General Meeting.

iii. Special Dividend: A sound dividend policy should be formed in such a way that rate of

dividend should not be changed frequently year to year. Rate of dividend should be static.

However, wherever there is any huge/abnormal/extra profit, company should declare it as

special dividend. So that the shareholders do not expect for the same in each year, the basic

purpose of this special dividend is to convey the shareholders that this is a special dividend

and will not be paid every year.

1.9.1 TYPES OF DIVIDEND POLICY

1. Regular Dividend Policy:Payment of dividend at the usual rate is termed as regular

dividend. The investors such as retired persons, widows and other economically weaker

person prefer to get regular dividends.

Advantages of Regular Dividend Policy:-

A regular dividend policy offers the following advantages:

i) It establishes a profitable record of the company.

ii) It creates confidence among the shareholders.

iii) It aids in long-term financing and renders financing easier.



iv) It stabilizes the market value of shares.

v) The ordinary shareholders view dividends as a source of funds to meet their day-to-day

living expenses.

vi) If profits are not distributed regularly and are retained, the shareholders may have to

pay a higher rate of tax in the year when accumulated profits are distributed.

However, it must be remembered that regular dividends can be maintained only be

companies of long standing and stable earnings. A company should establish the regular

dividend at a lower rate as compared to the average earnings of the company.

2. Stable Dividend Policy:The term ‘stability of dividends’ means consistency or lack of

variability in the stream of dividend payments. In more precise terms, it means payment of

certain minimum amount of dividend regularly. A stable dividend policy may be established

in any of the following three forms:

i) Constant Dividend per Share: Some companies follow a policy of paying fixed

dividend per share irrespective of the level of earnings year after year. Such firms, usually,

create a ‘Reserve for Dividend Equalization’ to enable them pay the fixed dividend even in

the year when the earnings are not sufficient or when there are losses. A policy of constant

dividend per share is most suitable to concerns whose earnings are expected to remain

stable over a number of years.

ii) Constant Pay-out Ratio: Constant pay-out ratio means payment of a fixed percentage

of net earnings as dividend every year. The amount of dividend in such a policy fluctuates

in direct proportion to the earnings of the company. The policy of constant pay-out is

preferred by the firms because it is related to their ability to pay dividends.

iii) Stable Rupee Dividend plus Extra Dividend: Some companies follow a policy of

paying constant low dividend per share plus an extra dividend in the years of high profits.

Such a policy is most suitable to the firm having fluctuating Earnings from year to year.

Advantages of Stable Dividend Policy:-

A stable dividend policy is advantageous to both the investors and the company on

account of

the following:

i. It is sign of continued normal operations of the company.

ii. It stabilizes the market value of shares.



iii. It creates confidence among the investors

Iv. It meets the requirements of institutional investors who prefer companies with stable

dividends.

3. Irregular Dividend Policy:Some companies follow regular dividend payments on account

of the following:

i. Uncertainty of earnings

ii. Unsuccessful business operations

iii. Lack of liquid resources

iv. Fear of adverse effects of regular dividends on the financial standing of the company

4. No Dividend Policy:A company may follow a policy of paying no dividends presently

because of its unfavorable working capital position of on account of requirements of funds of

future expansion and growth.

UNIT-3-AFTER 2.5 UNITS-IMPORTANT QUESTIONS

Briefly explain about Measurement of cost of capital of cost of capital?

What is Dividend? Elucidate major forms of dividend?

Cost of capital, weighted average cost of capital related Problems?



CASE STUDY

Financial Management M.B.A -II –SEMESTER-R17

UNIT-4 Introduction to Working Capital |BALAJI INST OF I.T AND MANAGEMENT 1


Syllabus

* Standard Discounting Table and Annuity tables shall be allowed in the examination

1. The Finance function: Nature and Scope. Importance of Finance function – The role in the

contemporary scenario – Goals of Finance function; Profit Vs Wealth maximization .




3. The Financing Decision: Sources of Finance – A brief survey of financial instruments. The

Capital Structure Decision in practice: EBIT-EPS analysis. Cost of Capital: The concept,

Measurement of cost of capital – Component Costs and Weighted Average Cost. The Dividend

Decision: Major forms of Dividends

4. Introduction to Working Capital: Concepts and Characteristics of Working Capital, Factors

determining the Working Capital, Working Capital cycle-Management of Current Assets –

Cash, Receivables and Inventory, Financing Current Assets



Textbooks:




References

Financial Management , Dr.V.R.Palanivelu , S.Chand

Principles of Corporate Finance, Richard A Brealey etal., Tata McGraw Hill.



Financial Management – Text and cases, Bringham & Ehrhardt, Cengage.





UNIT-4

INTRODUCTION TO WORKING CAPITAL

1.INTRODUCTION TO WORKING CAPITAL MANAGEMENT:

Working capital is the life blood and nerve centre of a business. Just as circulation of blood is

essential in the human body for maintaining life, working capital is very essential to maintain

the smooth running of a business. No business can run successfully without an adequate amount

of working capital.

Working capital refers to that part of firm’s capital which is required for financing short term or

current assets such as cash, marketable securities, debtors, and inventories. In other words

working capital is the amount of funds necessary to cover the cost of operating the enterprise.

Meaning: Working capital means the funds (i.e.; capital) available and used for day to day

operations (i.e.; working) of an enterprise. It consists broadly of that portion of assets of a

business which are used in or related to its current operations. It refers to funds which are used

during an accounting period to generate a current income of a type which is consistent with

major purpose of a firm existence.

Definition:

The following are the some of the definitions given for working capital by experts in the areas of

finance.

“ the sum of current assets is the working capital of a business”.-J.S.Mill.

“working capital has ordinarily been defined as the excess of current assets over current

liabilities”. – C.W.Gerstenberg.

Definition of Working Capital:“Working Capital sometimes called as Net Working Capital is

represented by the excess of current assets over the current liabilities and identified the relatively

liquid portion to total enterprise capital which constitutes a margin of buffer for maturing

obligations within the ordinary operating cycle of the business”.

‘Working Capital is a excess of current assets over current liabilities’.



1.1 OBJECTIVES & NEED OF WORKING CAPITAL:

To ensure optimum investment in current assets.

To strike balance between the twin objectives of liquidity and profitability in the use of

funds.

To ensure adequate flow of funds of current operations.

To speed up flow of funds or to minimize the stagnation of funds.

Businesses with a lot of cash sales and few credit sales should have minimal trade

debtors. Supermarkets are good examples of such businesses;

Businesses that exist to trade in completed products will only have finished goods in

stock. Compare this with manufacturers who will also have to maintain stocks of raw

materials and work-in-progress.

Some finished goods, notably foodstuffs, have to be sold within a limited period because

of their perishable nature.

Larger companies may be able to use their bargaining strength as customers to obtain

more favorable, extended credit terms from suppliers. By contrast, smaller companies,

particularly those that have recently started trading (and do not have a track record of

credit worthiness) may be required to pay their suppliers immediately.

Some businesses will receive their monies at certain times of the year, although they may

incur expenses throughout the year at a fairly consistent level. This is often known as

“seasonality” of cash flow. For example, travel agents have peak sales in the weeks

immediately following Christmas.

Working capital needs also fluctuate during the year. The amount of funds tied up in

working capital would not typically be a constant figure throughout the year.

Only in the most unusual of businesses would there be a constant need for working

capital funding. For most businesses there would be weekly fluctuations.



1.2 CONCEPTS/TYPES OF WORKING CAPITAL

A)On The Basis of Concept:-On the basis of concept, working capital is classified as

gross working capital and net working capital. This classification is important form the point of

view of the financial manager.

i) Gross Working Capital:- The term working capital refers to the gross working capital and

represents the amount of funds invested in current assets.

GROSS WORKING CAPITAL = TOTAL OF CURRENT ASSETS

ii) Net working Capital:- The term working capital refers to the net working capital. Net

working capital is the excess of current assets over current liabilities.

NET WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITEIS

Kinds of Working Capital

On The Basis of Concept On The Basis of time

Gross Working

Capital

Net

Working Capital

Permanent or

Fixed working

Capital

Temporary or

Variable Working

Capital

Regular Working

Capital

Reserve

Working Capital

Seasonal Working

Capital

Special Working

Capital



B)On The Basis of Time:-On the basis of time, working capital may be classified as

permanent of fixed working capital and temporary or variable working capital.

i) Permanent or Fixed Working Capital:-Permanent of fixed working capital is the

minimum amount which is required to ensure effective utilization of fixed facilities and

for maintaining the circulation of current assets. There is always a minimum level of

current assets, which is continuously required by the enterprise to carry out its normal

business operations. For example, every firm has to maintain a minimum level of raw

materials, work-in-process, finished goods and cash balance. This minimum level of

current assets is called permanent or fixed working capital as this part of capital is

permanently blocked in current assets. As the business grows the requirements of

permanent working capital also increase due to the increase in current assets. The

permanent working capital can further be classified as regular working capital and

reserve working capital required ensuring circulation of current assets from cash to

inventories, from inventories to receivables and form receivables to cash and so on

a) Regular Working Capital:- this is the amount of working capital required for

the continuous operations of an enterprise. It refers to the excess of current assets

over current liabilities. Any organization has to maintain a minimum stock of

materials. Finished goods and cash to ensure its smooth working and to meet its

immediate obligations.

b) Reserve Worki8ng Capital:- Reserve working capital is the excess amount over

the requirement for regular working capital which may be provided for

contingencies that may arise at unstated period such as strikes, rise in prices,

depression, etc.,

ii) Temporary or variable Working Capital:-Temporary or variable working capital is the

amount of working capital which is required to meet the seasonal demands and some special

exigencies. Variable working capital can be further classified as seasonal working capital and

special working capital.

a) Seasonal Working Capital:- Seasonal working capital is required to meet the

seasonal needs of the enterprise such as, a textile dealer would require large

amount of funds a few months before Diwall.



b) Special Working Capital:- Special working capital is that part of working

capital which is required to meet special emergency such as launching or

extensive marketing campaigns for conducting research, etc

c)

Differences between Temporary and Permanent Working Capital:- In the following figure

we can see the differences between the Temporary and Permanent Working capital in case of

two firms like Constant Firm and growing firm.

1.3 COMPONENTS OF WORKING CAPITAL:-

Working Capital will be defined as that Excess of current assets over current liabilities of a firm.

The following are components of working capital which comprise of current assets and current

liabilities. Examples of current assets are:

CONSTITUENT OF CURRENT

LIABILITIES

CONSTITUENT OF CURRENT

ASSETS

1. Bills Payable.

2. Sundry Creditor or Accounts Payable.

3. Accrued or Outstanding Expenses.

4. Short term loans and advances.

5. Dividends Payable.

6. Bank over Draft.

1. Cash in hand and bank balances.

2. Bills Receivables.

3. Sundry Debtors.

4. Short term loans and advances.

5. Inventories of Stock:

Raw Materials.

Temporary

Permanent

Time

Constant Permanent Capital

Time

Increasing Permanent Capital

Wo

rkin

g C

ap

ita

l (R

s.)

Wo

rkin

g C

ap

ita

l (R

s.)



7. Provision for Taxation. Work – in – Process.

Stores and Spares

Finished Goods.

6. Temporary Investment of Surplus funds.

7. Prepaid Expenses, Accrued Income.

1.4 GROSS CAPITAL VS. NET WORKING CAPITAL:

The distinction between gross working capital and net working capital does not in any

way undermine the relevance of the concepts of either gross or net working capital. A financial

manager must consider both of them because they provide different interpretations. The gross

working capital denotes the total working capital or the total investment in current assets. A

firm should maintain an optimum level of gross working capital. On the other hand Net working

capital means the excess of current assets over current liabilities.

Gross Working Capital = Total of Current Assets

Net Working Capital = Current Assets – Current Liabilities

2. CHARACTERISTICS OF WORKING CAPITAL

The features of working capital distinguishing it from the fixed capital are as follows:

(1)Short term Needs: Working capital is used to acquire current assets which get converted into

cash in a short period. In this respect it differs from fixed capital which represents funds locked

in long term assets. The duration of the working capital depends on the length of production

process, the time that elapses in the sale and the waiting period of the cash receipt.

(2) Circular Movement: Working capital is constantly converted into cash which again turns

into working capital. This process of conversion goes on continuously. The cash is used to

purchase current assets and when the goods are produced and sold out; those current assets are

transformed into cash. Thus it moves in a circular away. That is why working capital is also

described as circulating capital.

(3) An Element of Permanency:Though working capital is a short term capital, it is required

always and forever. As stated before, working capital is necessary to continue the productive



activity of the enterprise. Hence so long as production continues, the enterprise will constantly

remain in need of working capital. The working capital that is required permanently is called

permanent or regular working capital.

(4) An Element of Fluctuation: Though the requirement of working capital is felt permanently,

its requirement fluctuates more widely than that of fixed capital. The requirement of working

capital varies directly with the level of production. It varies with the variation of the purchase

and sale policy; price level and the level of demand also. The portion of working capital that

changes with production, sale, price etc. is called variable working capital.

(5) Liquidity: Working capital is more liquid than fixed capital. If need arises, working capital

can be converted into cash within a short period and without much loss. A company in need of

cash can get it through the conversion of its working capital by insisting on quick recovery of its

bills receivable and by expediting sales of its product. It is due to this trait of working capital

that the companies with a larger amount of working capital feel more secure.'

(6) Less Risky: Funds invested in fixed assets get locked up for a long period of time and

cannot be recovered easily. There is also a danger of fixed assets like machinery getting obsolete

due to technological innovations. Hence investment in fixed capital is comparatively more risky.

As against this, investment in current assets is less risky as it is a short term investment.

Working capital involves more of physical risk only, and that too is limited. Working capital

involves financial or economic risk to a much less extent because the variations of product

prices are less severe generally. Moreover, working capital gets converted into cash again and

again; therefore, it is free from the risk arising out of technological changes.

(7) Special Accounting System not needed: Since fixed capital is invested in long term assets,

it becomes necessary to adopt various systems of estimating depreciation. On the other hand

working capital is invested in short term assets which last for one year only. Hence it is not

necessary to adopt special accounting system for them.

3. FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS:

1)Nature of Business:- the working capital requirements of a firm basically depend upon the

nature of its business. Public utility undertakings like Electricity, Water Supply and Railways

need very limited working capital because they offer cash sales only and supply services, not

products and as such no funds are tied up in inventories and receivables. On the other hand

trading and financial firms require less investment in fixed assets but have to invest large



amount sin current assets like inventories, receivables and cash; as such they need large amount

of working capital.

2)Size of Business / Scale of Operations:- the working capital requirements of a concern are

directly influenced by the size of its business which may be measured in terms of scale of

operations Greater the size of a business unit, generally larger will be the requirements of

working capital.

3)Production Policy:- In certain industries the demand is subject to wide fluctuations due to

seasonal variations. The requirements of working capital, in such cases, depend upon the

production policy.

4)Manufacturing Process / Length of Production Cycle:- In manufacturing business, the

requirements of working capital increase in direct proportion to length of manufacturing process.

Longer the process period of manufacturing, larger is the amount of working capital required.

5)Seasonal Variations:- In certain industries raw material is not available throughout the year.

They have to buy raw materials in bulk during the season to ensure an uninterrupted flow and

process then during the entire year.

6)Working Capital Cycle:- In a manufacturing concern, the working capital cycle starts with

the purchase of raw material and ends with the realization of cash from the sale of finished

products. This cycle involves purchase of raw materials and stores, its conversion into stocks of

finished goods through work-in-progress with progressive increment of labour and service costs,

conversion of finished stock to sales, debtors and receivables and ultimately realization or cash

and this cycle continues again from cash to purchase of raw material and so on. The speed with

which the working capital completes once cycle determines the requirement of working capital

longer the period of the cycle larger is the requirement of working capital.

7)Rate of Stock Turnover:- There is a high degree of inverse co-relationship between the

quantum of working capital and the velocity or speed with which the sales are affected. A firm

having a high rate of stock turnover will need lower amount of working capital as compared to a

firm having a low rate of turnover.

8)Credit Policy:- The Credit Policy of a concern in its dealings with debtors and creditors

influence considerably the requirement6s of working capital a Concern that purchases its

requirements on credit and sells its products /services on cash requires lesser amount of working

capital. On the other hand a concern buying its requirements for cash and allowing credit to its



customers, shall need larger amount of working capital as very huge amount of funds are bound

to be blocked up in debtors or bills receivables.

9)Business Cycles:- Business cycle refers to alternate expansion and contraction in general

business activity. In a period of boom i.e., when the business is prosperous, there is a need for

larger amount of working capital due to increase in sales, rise in prices, optimistic expansion of

business, etc. on the contrary in the times of depression i.e., when there is a down swing of the

cycle, the business contracts sales decline, difficulties are faced in collections from debtors and

firms may have a large amount of working capital lying idle.

10)Rate of Growth of Business :- the working capital requirements of a concern increase with

the growth and expansion of its business activities. Although, it is difficult to determine the

relationship between the growth in the volume of business and the growth in the working capital

of a business. Yet it may be concluded that for normal rate of expansion in the volume of

business, we may have retained profits to provide for more working capital but in fast growing

concerns, we shall require larger amount of working capital.

11)Earning Capacity and Dividend Policy:- Some firms have more earning capacity than

others due to quality of their products, monopoly conditions, etc. such firms with high earning

capacity may generate cash profits form operations and contribute to their working capital. The

dividend policy of a concern also influences the requirements of its working capital.

12)Price Level Changes:- Changes in the price level also affect the working capital

requirements. Some firms may be affected much while some others may not be affected at all

by the rise in prices.

13)Tax Level:- The first appropriation out of profits is payment or provision for tax. Taxes

have to be paid in advance on the basis of the profit of the preceding year. Tax liability is, in a

sense, short term liability payable in cash. An adequate provision for tax payments is, therefore,

an important aspect of working capital planning. If tax liability increases, it leads to an increase

in the requirement of working capital and vice versa.

14)Other Factors;-Certain other factors such as operating efficiency, management ability,

irregularities to supply, import policy, asset structure, importance of labour, banking facilities,

etc., influence the requirements of working capital.



4. WORKING CAPITAL CYCLE / OPERATING CYCLE

The working capital requirement of a firm depends, to a great extent upon the operating cycle of

the firm. The duration of time required to complete the sequence of events right from purchase

of raw material goods for cash to the realization of sales in cash is called the operating cycle or

working capital cycle. It can be determined by adding the number of days required for each

stage in the cycle. In case of manufacturing concerns, working capital is required to cater to the

following needs of business in order:

a)Operating Cycle Manufacturing Firm:-

1. Raw materials are to be purchased for cash.

2. Production process converts raw materials into work-in-process.

3. Work-in-process in converted into finished goods, during course of time through

production process.

4. Finished goods are converted into accounts receivable (debtors and bills receivable)

through sale.

5. Accounting receivable are realized into cash in due course of time.



Operating Cycle of a Manufacturing concern

The above operating cycle is repeated –again and again over the period depending upon

the nature of the business and type of product etc. the duration of the operating cycle for the

purpose of estimating working capital is equal to the sum of the duration allowed by the

suppliers.

b) Operating Cycle of Non-Manufacturing Firm:- Non-Manufacturing firms are wholesalers,

retailers, service firms which do not have manufacturing process. They will have direct

conversion of cash into finished goods and then into cash. In other words, they purchase

finished goods from manufacturing firm and sell them either cash or credit if they sell goods on

credit the process will like in the following figure.

Operating Cycle of a Trading Concern

Finished Goods (1)

Sa

les (2

)

Debtors (3)

Cas

h



c) Operating Cycle of Service and Finance Firm

Working capital cycle can be expressed as: =R+W+F+D-C where

R = Raw material storage period = Average Stock of raw materials

Average cost of production per day

W = Work in progress holding period = Average work in progress inventory

Average cost of production per day.

F = Finished goods storage period =Average stock of finished goods

Average cost of goods sold per day

D = Debtor collection period = Average Book Debts

Average credit sales per day

C = Credit period availed = Average trade creditors

Average credit purchase per day

Debtors Cash

Operating Cycle of Service and Finance Firm



5. MANAGEMENT OF CURRENT ASSETS

Working capital management involves the management and control of the gross current assets.

And the current assets mainly comprise cash, sundry debtors (also known as accounts receivable

(ARs) and bills receivable (BRs)) and inventories. Thus the working capital management

comprises the management of all those components individuals and collectively too.

Working capital refers to the excess of current assets over current liabilities.



A. CASH MANAGEMENT: identify the cash balance which allows for the business to

meet day to day expenses but reduces cash holding costs.

B. RECEIVABLES MANAGEMENT: identify the appropriate credit policy i.e., credit

terms which all attract customers such that any impact on cash flows and the cash

conversion cycle will be offset by increased revenue and hence return on capital.

C. INVENTORY MANAGEMENT: identify the level of inventory which allows for

uninterrupted production but reduces the investment in raw materials and minimizes re-

ordering costs and hence increases cash flow.

A.CASH MANAGEMENT: Cash is one of the current assets of a business. It is needed at all

times to keep the business going. A business concern should always keep sufficient cash for

meeting its obligations. Any shortage of cash will hamper the operation of a concern and any

excess of it will be unproductive. Cash is the most unproductive of all the assets. While fixed

assets like capacity cash in hand will not add anything to the coercer. Cash in a broader sense

includes coins currency notes cheques bank drafts and also marketable securities and time

deposits with banks.

5.1 FACTORS DETERMINING CASH NEEDS

The amount of cash for transaction requirements is predictable and depends upon a variety of

factors which are as follows.

1. Credit Position Of The Firms: the credit position influences the amount of cash required in

two distinct ways.

If a firms credit position is sound it is not necessary to carry a large cash reserve for

emergencies.

Components of working capital management

Management of cash Management of receivables

Management of inventory



If a firm finance its inventory requirements with trade credit its cash requirements are

considerably smaller since the firm can synchronize the credit terms it gives to its

customers with eh terms it receives.

2. Status Of Firm’s Receivable: the amount of time required for a firm to convert its

receivable into cash also affects the amount of cash needed and of course, reduces total

working capital employed. In other words the longer the credit terms the slower the turn

over. When flow out is not synchronized with turn over a firm must carry amounts of cash

relatively larger than would otherwise be required.

3. Status of Firms Inventory Account: the status of a firms inventory account also affects the

amount of cash tied up at any one time. For example, if one business firm carries two

months inventory on hand and another firm carries only one month’s supply the former has

twice as much investment in inventory and will normally be called up on to maintain a

larger investment in cash in order to finance its acquisition.

4. Nature of Business Enterprise: the nature of firms demand definitely affects the volume of

cash required. For example, a firm whose demand is volatile needs a relatively larger cash

reserve than one whose demand is stable.

5. Management’s Attitude towards Risk: a more conservative management will hold a larger

cash reserve than one that is less conservative. The former usually demands more liquidity

than the latter and consequently does not experience the same degree of efficiency.

6. Amount of Sales In Relation To Assets: another characteristic affecting the level of cash is

the amount of sales in relation to assets. Firms with large sales relative to fixed assets are

required to carry larger cash reserves. This is the result of having larger sums invested in

inventories and receivable.

7. Cash Inflows and Cash Outflows: every firm has to maintain cash balance because its

expected inflows and outflows are not always synchronized. The timings of the cash inflows

may not always match with the timing of the outflows. Therefore a cash balance is required

to fill up the gap arising out of difference in timings and quantum of inflows and outflows.

8. Cost of Cash Balance: another factor to be considered while determining the minimum

cash balance is the cost of maintaining excess cash or of meeting shortage of cash. There is

always an opportunity cost of maintaining excessive cash balance. If a firm is maintaining

excess cash then it is missing the opportunities of investing these funds in a profitable way.



5.2 OBJECTIVES OF CASH MANAGEMENT

Cash management refers to management of cash balance and the bank balance including the

short terms deposits. For cash management purposes the term cash is used in this broader sense,

i.e., it covers cash equivalents and those assets which are immediately convertible into cash.

Even if a firm is highly profitable its cash inflows may not exactly match the cash outflows. He

has to manipulate and synchronize the two for the advantage of the firm by investing excess

cash if any as well as arrangement funds to cover the deficiency.

1. Meeting the Payment Schedule: in the normal course of business firms to make

payments of cash on a continuous and regular basis to suppliers of goods, employees and

so on. At the same time there is a constant inflow of cash through collections from

debtors. The importance of sufficient cash to meet the payment schedule can hardly be

over emphasized.

2. Minimizing Funds Committed To Cash Balance: the second objectives of cash

management are to minimize cash balances. In minimizing the cash balances two

conflicting aspects have to be reconciled. A high level of cash balances ensures prompt

payment together with all the advantages. But it also implies that large funds will remain

idle as cash is a non earning asset and the firm will have to forego profits. A low level of

cash balances on the other hand may mean failure to meet the payment schedule. The

aim of cash management should be to have an optimal amount of cash balances.

5.3 CASH BUDGET

It is an estimate of cash receipts from all sources and cash payments for all purposes and the net

cash balances during the budget period. It ensures that the business has adequate cash to meet its

requirements as and when these arise. It indicates cash excesses and shortfalls so that action may

be taken in advance to invest any surplus cash or to borrow funds to meet any shortfalls.

According to GUTHMEN AND DOUGAL cash budget is an estimate of cash receipts and

disbursements for a future period of time.

5.3.1 PURPOSE OF CASH BUDGET

1. Helps in Determining Future Cash Requirements: cash budget helps in estimating the

future cash requirements. It is estimated how much cash will be needed for different activities in

a period.

2. Help In Making Plans: cash budget helps in making plans. It gives reality and possibility on

plans.



3. Planning Suitable Investment Of Surplus Cash: in cash budget declared as surplus as per

the cash budget the financial manager will study the amount of surplus future requirements of

cash and also take into consideration the chance factor.

4. Helps In Cash Control And Liquidity Of The Enterprises: by preparing cash budget one

can controlled over cash misuse of cash be stopped by preparing cash budget. It also helps the

liquidity of cash.

PARTICULARS JAN FEB MAR

1. opening cash balance

2. estimated cash receipts

Cash sales

Cash collection from debtors

Interest received from investments

Cash inflow on issue of new securities

Raising of loans

Sales of assets

divided

XXX XXX XXX

3. total receipts available during the month (1+2)

4. estimated cash payments

payment for cash purchases

payment to Sunday creditors for credit purchases

payment for wages and salaries

payments for other administrative expenses

payment in the nature of capital expenditure

loan repayment

dividend payment

payment of interest on loan

5. total cash payments

6. closing cash balance (3-4)

XXX XXX XXX

XXX XXX XXX

XXX XXX XXX

XXX XXX XXX



EXAMPLES: Prepare a cash budget for the months of June, July, and august 2014 from the

following information:

opening cash balance in June 7,000

cash sales for June 20,000 July 30,000 and august 40,000

wages payable 6,000 every month

interest receivable 500 n the month of august

Purchase of furniture for 16,000 in July.

Cash purchases for June 10,000 July 9,000 and august 14,000.

Cash budget

(For the period June to August 2014)

Particulars June July August

opening cash balance

add: cash receipts (estimated)

cash sales

interest

7,000

20,000

11,000

30,000

10,000

40,000

500

Total receipts 27,000 41,000 50,500

Less: cash payments (estimated)

Cash purchases

Payment of wages

Purchases of furniture

10,000

6,000

9,000

6,000

16,000

14,000

6,000

Total payment 16,000 31,000 20,000

Closing balance (surplus/deficit)

(total receipts – total payments)

11,000

10,000

30,500

Note: the closing cash balance in June will be the opening cash balance in July

6. RECEIVABLES MANAGEMENT

Accounts receivables are simply extensions of credit to the firm’s customers allowing

them a reasonable period of time in which to pay for the goods. Most firm treat account

receivables as a marketing tool to promote sales and profits. The receivables constitute a

significant portion of the working capital and are important elements of it.

The receivables emerge whenever goods are sold on credit and payments are deferred by

customers. Receivables are a type of loan extended by a seller to the buyer to facilitate

the purchase process. As against the ordinary type of loan the trade credit in the form of



receivable is not a profit making service but an inducement or facility to the buyer

customer of the firm.

According to HAMPTON receivables are asset accounts representing amount owned to

firm as a result of sale of goods or service in ordinary course of business.

According to Bobert N. Anthony accounts receivables are amounts owed to the business

enterprise, usually by its customers. Sometimes it is broken down into trade accounts

receivables; the former refers to amounts owed by customers and the latter refers to

amounts owed by employees and others.

Thus receivables are forms of investment in any enterprise manufacturing and selling

goods on credit basis large sums of funds are tied up in trade debtors. Hence a great deal

of careful analysis and proper management is exercised for effective and efficient

management of receivables to ensure a positive contribution towards increase in turnover

and profits.

Receivables management is the process of making decisions relating to investment in

trade debtors. Certain investment in receivables is necessary to increase the sales and the

profits of a firm. But at the same time investment in this asset involves cost

considerations also. Further there is always a risk of bad debts too.

6.1 OBJECTIVES OF RECEIVABLES MANAGEMENT

The objectives of receivables management are to improve sales eliminate bad debts and reduce

transaction costs incidental to maintenance of accounts and collection of sale proceeds and

finally enhance profits of the firm. Credit sales help the organization to make extra profit. It is a

known fact firms charge a higher price when sold on credit compared to normal price.

1. Book Debts Are Used As A Marketing Tool For Improvement Of Business: if the firm

wants to expand business it has to necessarily sell on credit. After a certain level additional sales

do not create additional production costs duet o the presence of fixed costs. So the additional

contribution totally goes towards profit improving the profitability of the firm.

2. Optimum Level of Investment In Receivables: to support sales it is necessary for the firm to

make investment in receivables. Investment in receivables involves costs as funds are tied up in

debtors. Further there is also risk in respect of bad debts too. On the other hand receivables bring

returns. If so till what level investment is to be made in receivables? Investment in receivables is

to be made till the incremental costs are less than the incremental return.



In the other words the objectives of receivables management is to promote sales and profits until

that point is reached where the return on investment in further funding receivables is less than

the cost of funds raised to finance that additional credit.

6.2 FACTORS AFFECTING THE SIZE OF RECEIVABLES

The following factors directly and indirectly affect the size of receivables.

1. Stability of Sales: in the business of seasonal character total sales and the credit sales will go

up in the season and therefore volume of receivable will also be large. On the other hand if a

firm supplies goods on installment basis its balance in receivables will be high.

2. Size and Policy of Cash Discount: it is also important variable in deciding the level of

investment in receivables. Cash discount affects the cost of capital and the investment in

receivables. If cost of capital of the firm is lower in comparison to the discount to be allowed

investment in receivables will be less. If both are equal it will not affect the investment at all. If

cost capital is higher than cash discount the investment in receivables will be larger.

3. Bill Discounting and Endorsement: if firm has any arrangement with the banks to get the

bills discounted or if they re-endorsed to third parties, the level of investment in assets will be

automatically low. If bills are honored on due dates the investment will be larger.

4. Terms Of Sale: a firm may affect its sales either on cash basis or on credit basis. As a matter

of fact credit is the soul of a business. It also leads to higher profit level through expansion of

sales. The higher the volume of sales made on credit the higher will be the volume of receivables

and vice-versa.

5. Volume of Credit Sales: it plays the most important role in determination of the level of

receivables. As the terms of trade remains more or less similar to most of the industries. So a

firm dealing with a high level of sales will have large volume of receivable.

6. Collection Policy: the policy practice and procedure adopted by a business enterprise in

granting credit deciding as to the amount of credit and the procedure selected for the collection

of the same also greatly influence the level of receivables of a concern. The more lenient or

liberal to credit and collection policies the more receivables are required for the purpose of

investment.

7. Collection Collected: if an enterprise is efficient enough in encasing the payment attached to

the receivables within the stipulated period granted to the customer. Then it will opt for keeping

the level of receivable low. Whereas enterprise experiencing undue delay in collection of

payments will always have to maintain large receivables.

8. Quality of Customer: if a company deals specifically with financially sound and credit

worthy customers then it would definitely receive all the payments in due time. As a result the



firm can comfortably do with a lesser amount of receivables than in case where a company deals

with customers having financially weaker position.

7. INVENTORY MANAGEMENT

The dictionary meaning of inventory is stock of goods. The word inventory is understood

differently by various authors. In accounting language it may mean stock of finished goods only.

In a manufacturing concern it may include raw materials work in process and stores etc.

INTERNATIONAL ACCOUNTING STANDARD COMMITTEE (I.A.S.C): defines

inventories as tangible property,

Held for sale in the ordinary course of business

In the process of production for such sale or

To be consumed in the process of production of goods or services for sale.

According to Bolten S.E., inventory refers to stock pile of product a firm is offering for sale and

components that make up the product.

7.1 NATURE/ELEMENTS OF INVENTORY

1. Raw Material: It includes direct material used in manufacture of a product. The purpose of

holding raw material is to ensure uninterrupted production in the event of delaying delivery. The

amount of raw materials to be kept by a firm depends on various factors such as speed with

which raw materials are to be ordered and procured and uncertainty in the supply of these raw

materials.

a. Direct Material: direct material is the primary classification for raw materials in

manufacturing operations. It is directly related to the final product. It is only the material

that after manufacturing processes are applied ships out to a distributor or the final

customer. If e.g., company manufacture hammers then steel would be its primary direct

material.

b. Indirect Material: indirect material is the class of material in the manufacturing process

that does not actually ship to the customer as part of the final product.

For Example, The gas used to heat the furnaces that melt the steel in the manufacture of

hammers is an indirect material. Similarly the water that cools the metal is also an indirect

material

2. Work In Progress: in includes partly finished goods and materials held between

manufacturing stages. It can also be stated that those raw materials which are used in production

process but are not finally converted into final product are work in progress.



3. Consumable: consumables are products that consumers buy recurrently i.e., items which get

used up or discarded. For example, consumable office supplies are such products as paper pens,

file folders post it notes computer disks and toner or ink cartridges.

4. Finished Goods: the goods ready for sale or distribution comes under this class. It helps to

reduce the risk associated with stoppage in output on account of strikes breakdowns shortage of

material etc.

5. Stores And Spares: this category includes those products which are accessories to the main

products produced for the purpose of sale. For example, stores and spares items are bolt nuts

clamps, screws, etc.

7.2 FACTORS AFFECTING INVETNORY MANAGEMENT

1. Characteristics of the Manufacturing System: the natures of the production process the

product design and production planning and plant layout have significant affect on inventory

policy.

a. Degree Of Specialization And Differentiation Of The Products At Various Stages: the

degree of changes in the nature of the product from raw material to final product at various

stages of transformation viz. final assembly and packaging determines the nature of

inventory control operation, for example, if nature of product remains more or less same at

various stages of production then economics can be achieved by keeping the right balance

of stock of semi finished product.

b. Process Capability and Flexibility: process capability is characterized by processing

time of various operations example; the replenishment lead time directly influences the

size of inventory. Inventory policy should aim towards balancing the production flexibility

capability inventory levels and customer service needs.

c. Production Capacity and Storage Facility: the capacity of production system as well as

the nature of storage facilities considerably affects the inventory policy of an organization

e.g., capacity for heating oil production in an oil refinery is governed in part by its

distribution system. Similarly production the cost of facility is high then it sets a limit on

the storage capacity.

d. Quality Requirements: quality is the performance of the product as per the commitment

made by producer to the customer. The qualities required for various factors are quality of

material manpower machine and management. The quality requirements of material

directly affect the inventory decision.



e. Nature of the Production System: it is characterized by the number of manufacturing

stages and the inter relationship between various production operations e.g, in product line

system inventory control is simpler than in job type system.

2. Amount of Protection against Storages: there is always variation in demand and supply of

product. The protection against such unpredictable variations can be done by means of buffer

stocks.

a. Changes In Size And Frequency Of Orders: The amount of product sold in large number

of orders of small size can be operated with fewer inventories.

b. Unpredictability Of Sales: if there are too many fluctuations in demand of product then

these can be held only by flexible and large capacity of inventory operations.

c. Costs Associated With Failure To Meet Demands: When there is heavy penalty on any

delay in fulfillment of any order then inventory should be large.

d. Accuracy Frequency And Detail Of Demand Forecasts: fluctuations in stock exist when

forecasts are not exact. The responsibility of forecast errors for inventory needs should be

clearly recognized.

e. Breakdown: protection against breakdown or other interruptions in production

3. Organizational Factors: there are certain factors which are related to the policies traditions

and environment of any enterprise.

Labor relation policies of the organization

Amount of capital available for stock

Rate of return on capital available if invested elsewhere.

4. Other Factors: these are related to the overall business environment of the region viz,

Inflation

Strike situation in communication facilities

Wars or some other natural calamities like famines floods etc.

7.3 INVENTORY MANAGEMENT TECHNIQUES

Several techniques of inventory management are in use and it depends on the convenience of the

firm to adopt any of the techniques. What should be stressed however is the need to cover all

items of inventory and all stages i.e, from the stage of receipt from suppliers to the stage of their

use. The techniques most commonly used are the following.



1. ECONOMIC ORDER QUANITY (EOQ): EOQ is a quantity of inventory which can

reasonably be ordered economically at a time. It is also known as standard order quantity,

economic lot size, or economical ordering quantity. In determining this point ordering costs and

carrying costs are taken into consideration. Ordering costs are basically the cost of getting an

item of inventory and it includes cost of placing an order. Either of these two costs affects the

profits of the firm adversely and management tries to balance these two costs.

The balancing or reconciliation point is known as economic order quantity. The economic order

quantity can also be determined with the help of a graph. Assuming that inventory is allowed to

fall to zero and then immediately replenished the average inventory becomes EOQ/2. EOQ

model can be presented as in. it can be seen that ordering cost of an item is decreasing as the size

the order is increasing. This happens because total number of orders for a particular item will

decrease resulting in decrease in total order cost. As a result carrying cost is increasing because

firm keeps more items in stock. The trade off of these two costs is attained at a level at which

total annual cost is least. At this level order size is designated as economic order quantity.

Inventory management techniques

Economic order quantity

ABC analysis

Just in time

Reorder levels

VED analysis

Inventory turnover

Inventory control of spares and slow moving items



The quantity may be calculated with the help of the following formula

2DA

EOQ =

h

Where, D = annual quantity used (in limits)

A = cost of placing an order (fixed cost)

H = cost of holding one unit

ASSUMING OF EOQ

While calculating EOQ the following assumptions are made,

Supply of goods is satisfactory. The goods can be purchased whenever these are needed.

The quantity to be purchased by the concern is certain

The prices of goods are stable. It results to establish carrying costs.

EXAMPLE 6, a company uses annually 12,000 units of raw material costing 1.25 pr unit.

Placing each order costs 15 and the carrying costs are 15% per year per unit of the average

inventory. Find the economic order quantity.

SOLUTION: Here

D = 12,000 units

A = 15 per unit

C = 1.25 per unit

Now h = ic = 15% per year per unit of average inventory

= 0.15 x 1.25 = 0.1875

2DA

EOQ =

H

2x12000x15

EOQ = = 1,385 units

0.1875

2. RE-ORDERED LEVEL: this is that level of materials at which a new order for supply of

materials is to be placed. The concept of re-order point is basically related with lead time

demand. The problem is that demand can never be accurately projected over the lead time. This



point is fixed somewhere in between the maximum and minimum inventory levels in such a way

that the quantity of materials available between the minimum and this point may be sufficient to

meet the production requirement upon the time fresh suppliers are received. This point can be

determined by taking into account the following.

Rate of usage, i.e, average quantity consumed in one unit of time, i.e, day week etc.

Safety or buffer stock level.

There are a number of methods for demand forecasting. Once we know the demand in lead time

re-order level can be easily determined mathematically.

3.ABC ANALYSIS:

4. VED analysis: in VED analysis the items are classified on the basis of their critically to the

production process or other services. In the VED classification of materials V stands for vital



items without which the production process would come to a standstill. The VED analysis is

done mainly in respect of spare parts.

5. JUST IN TIME: just in time production is defined as a philosophy that focuses attention on

eliminating waste by purchasing or manufacturing just enough of the right items just in time. It

is a Japanese management philosophy applied in manufacturing which involves having the right

items of the right quality and quantity in the right place and at the right time.

6. INVENTORY TURNOVER: this ratio is computed by dividing the cost of goods sold by the

average inventory. This ratio is usually expressed as x number of times. In the form of a formula

this ratio may be expressed as under.

Cost of goods sold

Stock turnover ratio =

Average inventory

It may also be of interest to see average time taken for cleaning the stocks. This can be possible

by calculating inventory conversion period. This period is calculated by dividing the number of

days by inventory turnover. The formula may be as

12 months/52weeks/365 days

Inventory conversion period =

Stock turnover ratio

7. INVENTORY CONTROL OF SPARES AND SLOW MOVING ITEMS: stores and

spares is a term which commonly covers all kinds of supplies necessary to keep production

equipment operating to turn out production to the desired quantity and quality at the desired

time. Indiscriminate stocking of each and every item of stores and spares is not wise because a

huge amount of funds may unnecessarily be locked up in this component of stores and spares.

Thus a firm should keep each and every component of stores and spares to reasonable level

Annual consumption of stores and spares

Stores and spares inventory turnover =

Stores and spares inventory

365

Stores spars holding period =

Turnover of stores and spares



8. FINANCING CURRENT ASSTS/WORKING CAPITAL

The level of working capital requirements varies from industry to industry within one industry

and from one company to another. Similarly working capital requirements are generally at a

higher level in the case of manufacturing units than the level of the units engaged in trading

business.

1. Trade Credit: Trade credit is an arrangement between two consenting parties under which

gods and services are provided by the seller/supplier without making prompt cash payment by

the buyer on a condition to make payment within an agreed time period.

2. Accrued Expenses and Deferred Income: The accrued expenses as well as the deferred

income are liabilities of a company and acts a short term source of finance.

Accrued expenses are the expenses which a business organization owes to others but have not

been paid as they have not yet become due. They are liability for a company as they arise due to

the goods or services, which are already availed by the company. These expenses become due

for payments on monthly quarterly half yearly or yearly basis. All such items of expenses act as

a short term source of finance for a company.

3.Commercial Paper (CP): commercial paper is a money market financial instrument issued by

large sized corporate bodies to raise short term funds to meet their temporary requirement. This

is an unsecured instrument supported by the promise of the issuer or his banker for the payment

of the face value on the due date specified on the paper. Since CP is not supported by any

collateral only big companies enjoying high level of god will and credit rating are capable of

raising funds through this route at reasonable rates.

Financing current assets/working

capital

Trade credit Accrued expenses and

deferred income Commercial paper Certificate of deposit

Letter of credit Installment credit

Bank finance



4. Certificate of Deposited (CD): certificate of deposit is a document/financial instrument

which certify that there is a bank deposit to support it. CD is also a tradable money market

instrument. Thus basically CD is nothing but a tradable bank deposit and transferable from one

holder to another till the maturity of the underlying bank deposit. Interest is paid in the normal

course to the holder of the instrument. However the market value of the CD depends on the

difference between the rate of interest on that bank deposit and the general rate of interest

prevailing in the market. CDs are issued by banks with a view to encouraging the short term

deposit mobilization.

5. Letter Of Credit (LC): letter of credit is a facility extended by a buyer bank under which the

latter helps the former in obtaining credit from the suppliers. It is a form of a guarantee given by

the bank on behalf of its customer for certain purchase made by it. In case of customers failure

to make the timely payment it becomes the responsibility of letter of credit opening bank to

honor the commitment of its customer. For example a bank opens a LC in favor of its customer

A for some purchases, A plans to make from the supplier B. in the event of failure on the part of

A to make payment to B in terms of the agreement of the credit period offered by B it becomes

the bank’s responsibility to make the payment on behalf of A for the purchases covered under

the LC arrangements. In such cases the supplier draws a lot of comfort regarding payment of its

dues and as such there is no problem to extend credit to a buyer in favor of whom a bank opens a

LC.

6. Instalment Credit: Installment credit is a financial arrangement under which the payment of

goods and services are made over a period of time in regular installments. Installment credit is

popular between the buyers and sellers of consumer goods. Cars, houses, etc. for a better

understanding of the concept an example, of car loan may be taken. If a buyer A borrow

3,00,000 to buy a new car the lender may like to set his payments at 6,000 per month for 60

months. Over the next 60 months A would make payments of 3,60,000. The 3,00,000 amount is

the principal and 60,000 represents the interest accrued on the borrowed amount of 3,00,000.

7.Bank Finance: Bank borrowing is one of the important sources of finance for the companies

in the need of funds especially working capital requirements. Bank borrowing as a source of

short term finance ranks just next to trade finance, which is the most popular mode of short term

finance in India. For seasonal industries banks are expected to prescribe separate credit limits for

peak season and non peak season indicating the period during which such limits would be

utilized by the borrower.



8.Others: Generally banks do not extend 100% of the credit limit sanctioned by them. An

amount known as margin money is deducted from the credit limit. The concept of margin money

is based on the principal of conservatism and is basically in place to ensure security. If the

margin money requirements are 20% the lending bank would extend borrowing facilities only up

to 80% of the value of asset. This implies that the security of bank’s lending should be

maintained even if the asset’s value falls by 20%.

CASE STUDY



UNIT-4-IMPORTANT QUESTIONS

Factors influencing or determine working capital management?

Advantages & classifications of working capital?

Concepts & characteristics of working capital?

Briefly explain about current assets management?

Estimation of working capital requirements (problems)


UNIT-5 Corporate Restructures |BALAJI INST OF I.T AND MANAGEMENT 1


Syllabus

* Standard Discounting Table and Annuity tables shall be allowed in the examination

1. The Finance function: Nature and Scope. Importance of Finance function – The role in

the contemporary scenario – Goals of Finance function; Profit Vs Wealth maximization .




3. The Financing Decision: Sources of Finance – A brief survey of financial instruments.

The Capital Structure Decision in practice: EBIT-EPS analysis. Cost of Capital: The

concept, Measurement of cost of capital – Component Costs and Weighted Average Cost.

The Dividend Decision: Major forms of Dividends

4. Introduction to Working Capital: Concepts and Characteristics of Working Capital,

Factors determining the Working Capital, Working Capital cycle-Management of Current

Assets – Cash, Receivables and Inventory, Financing Current Assets



Textbooks:




References

Financial Management , Dr.V.R.Palanivelu ,S.Chand

Principles of Corporate Finance, Richard A Brealeyetal., Tata McGraw Hill.



Financial Management – Text and cases, Bringham&Ehrhardt, Cengage.





UNIT- V

CORPORATE RESTRUCTURES

1.1 CORPORATE RESTRUCITNG:

Corporate restructuring refers to the changes in ownership, business mix, assets mix and

alliances with a view to enhance the shareholder value, Hence , corporate restricting may

involve ownership restricting, business restructuring and assets restructuring,. A company

may affect ownership restructuring through mergers and acquisitions, leveraged buy-outs,

buyback of share, spin-offs. Joint ventures and strategic alliance, business restructuring

involves the reorganization of business units or divisions, it includes diversification into new

businesses, out-sourcing, divestments, and brand acquisitions etc. asset restructuring involves

the acquisition or sale of assets and their ownership structure. The examples of asset

restructuring are sale and lease back of assets, securitization of debt, receivable factoring etc.

The basic purpose of corporate restructuring is to enhance the shareholder value. A

company should continuously evaluate its portfolio of business, capital mix and ownership

and assets arrangements to find opportunities for increasing the shareholder value. It should

focus on assets utilization and profitable investment opportunities and reorganize or divest

less profitable or loss making business/products. The company can also enhance value

through capital restructuring; it can design innovative securities that help to reduce cost of

capital.

1.2 TYPES OF BUSINESS COMBINATION:

The different types of business combination are merger, acquisition, takeover,

amalgamation and consolidation..

a) Merger or amalgamation: A merger is said to occur when two or more companies

combine into one company. One or more companies may merge with an existing

company or they may merge to form a new company. In merger, there is complete

amalgamation of the assets and liabilities as well as shareholders interests and business

of the merging companies. There is another mode of merger called amalgamation, in

this , one company may purchase another company without giving proportionate



ownership to the shareholders of the acquired company or without continuing the

business of the acquired company

b) Acquisition: A fundamental characteristic of merger is that the acquiring or

amalgamated company (Existing or new) takes over the ownership of other company

and combines its own operations.

Acquisition may be designed as an act of acquiring effective control over assets or

management of a company by another company without any combination of

businesses or companies.

c) Takeover’s: takeover occurs when the acquiring firm takes over the control of the

target firm. An acquisition or takeover does not necessary entail full, legal control. A

company can have effective control over another company by holding minority

ownership under the monopolies and Restrictive Trade Practices Act, takeover means

acquisition of not less than 25 % of the voting power of a company.

1. 3. TAKEOVER VS ACQUISITIONS:

The term takeover is understood to connote hostility. When an acquisition is a forced or

unwilling acquisition, it is called a takeover. In an unwilling acquisition, the management of

Target Company would oppose a move of being taken over. When managements of acquiring

and target companies mutually and willingly agree for the takeover, it is called acquisition or

friendly takeover. An example of acquisition is the acquisition is the acquisition of

controlling interest of Universal Luggage Manufacturing Company Ltd. By blow plats Ltd.

Similarly, Mahindra and Mahindra Ltd. A leading manufacturer of jeeps and tractors acquired

of a 26 % equity stake in Ally win Nissan Ltd. Yet.

Another example is the acquisition of 28% equity of international Data Management (IDM)

by HCL ltd., in recent years, due to the liberalization of

Financial sector as well as opening up of the economy for foreign investors, a number of

hostile takeovers could be witnessed in India. Examples include takeover of shawwallace,

Dunlop, Mather and plant and Hindustan Dorr Oliver by chhabrias, Ashok Leyland by

Hindujas and ICIM, Harrison Malayalam and Spencer’s by Goenkas. Both Ghindujas and

Chhabrias are non-resident Indian ( NRIs )



2. TWO FORMS A MERGER CAN TAKE

Mergers: A merger is said to occur when two or more companies combine into one

company. One or more companies may merge with an existing company or they may

merge to form a new company. In merger, there is complete amalgamation of the assets

and liabilities as well as shareholders, interests and business of the merging companies.

There is another mode of merger called amalgamation. In this, one company may

purchase another company without giving proportionate ownership to the shareholders

of the acquired company or without continuing the business of the acquired company.

Forms /types of mergers:

The two forms of mergers are

a. Merger through absorption

b. Merger through consolidation

a) Absorption: absorption is a combination of two or more companies into an existing

company. All companies except one lose their identify in a merger through absorption.

E.g., The absorption of Tata Fertilizers Ltd., ( TFL ) by Tata Chemicals Ltd. (TCL).

TCL is an acquiring company (buyer), survived after merger while TFL.an acquired company

(seller) ceased to exist. TFL transferred the assets, liabilities and shares to TCL. Under the

scheme of merger, TFL shareholders were offered 17 shares of TCL for every 100 shares of

TFL held by them.

b) Consolidation: Consolidation is a combination of two or more companies in to a new

company. In this form of merger, all companies are legally dissolved and a new entity is

created. in a consolidation, the acquired company transfers its assets, liabilities and shares to

the new company for cash or exchange of shares . in a narrow sense, terms amalgamation

and consolidation are sometimes used interchangeably.

E.g., consolidation is the merger or amalgamation of Hindustan computers Ltd., Hindustan

Instruments Ltd., Indian Software Company Ltd. And Indian Reprographics Ltd. In 1986 to

an entirely new company called HCL.Ltd.



2.1 TYPES OF MERGERS:

a) Horizontal Mergers: This is a combination of two or more firms in similar type of

production, distribution or area of business. Example can be combining of two book

publishers or two luggage manufacturing companies to gain dominant market share.

b) Vertical Merger: This is a combination of two or more firms involved in different

stages of production or distribution.

For example, joining of a TV manufacturing company and TV marketing company or

the joining of a spinning company and a weaving company. Vertical merger may take

the form of forward or backward merger. When a company combines with the

supplier of material, it is called backward merger and when it combines with the

customer, it is called forward merger.

c) Conglomerate Merger: This is a combination of firms engaged in unrelated lines of

business activity. A typical example is merging of different business like

manufacturing of cement products, fertilizers products, electronic products, insurance

investment and advertising agencies. Voltas Ltd. Is an example of a conglomerate

company

3. MOTIVES AND BENEFITS OF MERGERS AND ACQUISITIONS

Mergers and acquisitions are strategic decisions leading to the maximizations of a company’s

growth by enhancing its production and marketing operations. They have become popular in

the recent times because of the enhanced competition, breaking of trade barriers, free flow of

capital across countries and globalization of business as a number of economies are being

deregulated and integrated with other economies.. a number of reasons are attributed for the

occurrence of mergers and acquisitions . it is suggested that mergers and acquisition intended

to :

i) Limit competition

ii) Utilize under-utilized market power

iii) Overcome the problem of slow growth and profitability in one’s own industry

iv)Achieve diversification



v) Gain economies of scale and increase income with proportionately less investment

vi)Establish transactional bridgehead without excessive start-up costs to gain access to a

foreign market.

vii) Displace existing management

viii) Circumvent government regulations

ix)Reap speculative gains attendant upon new security issue or change in P/E ratio

x) Create an image of aggressiveness and strategic opportunism, empire building and to

amass vast economic power of the company

3.1 THE ADVANTAGES OF MERGERS AND ACQUISITIONS ARE AS FOLLOWS:

i) Maintain or accelerating a company’s growth, particularly when the internal growth is

constrained due to paucity of resources.

ii) Enhancing profitability, through cost reduction resulting from economies of scale,

operating efficiency and synergy;

iii) Diversifying the risk of the company, particularly when it acquires those businesses

whose income streams are not correlated

iv)Reducing tax liability because of the provision of setting-off accumulated losses and

unabsorbed depreciation of one company against the profits of another.

v) Limiting the severity of competition by increasing the company’s market power.

3.2 FINANCIAL BENEFITS OF MERGERS

a) Financial constraint: a company may be constrained to grow through internal

development due to shortage of funds. The company can grow externally by acquiring

another company by the exchange of shares and thus, release the financing constraint.

b) Surplus cash: a cash-rich company may face a different situation. It may into have enough

internal opportunities to invest its surplus cash. It may either distribute its surplus cash to this

shareholder or use it to acquire some other company. The shareholders may not really benefit

much if surplus cash is returned to them since they would have to pay tax at ordinary income

tax rate. Their wealth may increase through an increase in the market value of their shares if



surplus cash is used to acquire another company. If they sell their share, they would pay tax

at a lower, capital gains, and tax rate. The company would also be enabled to keep surplus

funds and grow through acquisition.

c) Debt capacity: a merger of two companies, with fluctuating, but negatively correlate,

cash flows can bring stability of cash flows of the combined company. The stability of cash

flows reduce the risk of insolvency and enhances the capacity of the new entity to service a

larger amount of debt. The increased borrowing allows a higher interest tax shield which adds

to the share holder’s wealth.

d) Financing cost: since, the probability of insolvency is reduced due to financial stability and

increased protection to lenders, the merged firm should be able to borrow at a lower rate of

interest. This advantage may be taken off partially or completely be increase in the

shareholders risk on account of providing better protection to lenders.

3.3 ECONOMIC ADVANTAGES OF MERGERS

Economic of mergers:

The economic advantages of a merger are

a) Economic of scale: the operating cost advantage in terms of economics of scale is

considered to be primary motive for mergers in particular for horizontal and vertical

mergers. They result to lower average cost of production and sales due to a higher

level of operation. For instance, overhead costs can be substantially reduced on

account of sharing central services such as accounting and finance, office, executive

and top level management, legal sales promotion and advertisement and so on.

b) Synergy: synergy results from complementary activities. For instance, one firm may

have a substantial amount of financial resources while other has profitable

investment opportunities. One firm may have a strong research and development

team where as the other may have well established brands of its products but lacks

marketing organization and another firm may have very strong marketing

organizations. The merged business unit in all these cases will be more efficient than

the individual firms.



c) Fast growth: a merger often enables the amalgamating firm to grow at rate faster

than is possible under the internal expansion route via. Its own capital budgeting

proposals, because the acquiring company enters a new market quickly, avoiding the

delay associate with building a new plant and establishing a new line of products.

Internal growth is time consuming, requiring research and development, organization

of the product, market penetration and in general a smoothly working organizations.

There may sometimes be an added problem of raising adequate funds to execute the

required capital budgeting projects. A merger obviates all these obstacles and thus,

steps up the pace of corporate growth.

d) Diversification: diversification is another major advantage in a conglomerate

merger. The argument is that a merger between two unrelated firms would tend to

reduce business etc., which in turn, reduces the discount rate/ required rate of return

of the firm’s earnings. And thus increase the market value. Such mergers help

stabilize or smoothen overall corporate income, which would otherwise fluctuate due

to seasonal or economic cycles.

4.1 CORPORATE GOVERNANCE:

It implies that the company would manage its affairs with diligence, transparency,

responsibility and accountability, and would maximize shareholder wealth. Hence, it is

required to design systems, processes, procedures, structures and take decisions to augment

its financial performance and stakeholder value in the long run. Good corporate governance

requires companies to adopt practices an polices which comprise performance accountability,

effective management control by the Board of directors, constitution of Board committees as

a part of the internal control system. Fair representation of professionally qualified, non-

executive and independent Directors on the Board, the adequate timely disclosure of

information and the prompt discharge of statutory duties. In fact, companies are needed to at

least have policies and practices in conformity with the requirements stipulate under clause

49 of the Listing Agreement.



4.2 MEANING AND DEFINITION OF CORPORATE GOVERNANCE

Corporate governance is the set of processes customs policies laws and institutions affecting

the way a corporation is directed administered or controlled. Corporate governance also

includes the relationship among the many stakeholders involved and the goals for which the

corporate is governed.

The principal stakeholders are the shareholders the board of directors employees customers

creditors suppliers and the community at large. It is a system by which companies are

directed and controlled boards of directors are responsible for governance of companies.

Corporate governance is also concerned with the ethics values and morals of a company and

its directors.

According to Cadbury Committee corporate governance is defined as the system by which

companies are directed and controlled.

According to Rafael La Porta corporate governance to a large extent is a set of mechanism

through which companies are directed and controlled.

According to Sternberg corporate governance describes ways of ensuring that corporate

actions assets and agents are directed at achieving the corporate objectives established by the

corporation’s shareholders.

4.3 CHARACTERISTICS OF CORPORATE GOVERNANCE

1. Base On Ethics: corporate governance is based on ethics moral principles and values. So

the board of directors must avoid unfair practices cheating exploitation etc.

2. Universal Application: corporate governance has universal application. That is it is used

by companies all over the world. It is given a legal recognition in many countries. All

companies must use corporate governance voluntarily.

3. Systematic: corporate governance is vey systematic. It is based on laws procedures

practices rules etc. all these laws are made to increase the wealth of the shareholders and to

protect the rights of all the stakeholders of the company.

4. Key Part Of The Contract: good governance goes beyond common sense. It is a key part

of the contract that underpins economic growth in a market economy and public faith in that

system.

5. Assurance To Well – Functioning Of Markets: the role of good governance and

corporate responsibility in helping to assure the well functioning markets needed for

economic growth and development cannot be taken for granted.



4.4 OBJECTIVES OF CORPORATE GOVERNANCE

To eliminate or mitigate conflicts of interest particularly those between managers and

shareholders.

To ensure that the assets of the company are used efficiently and productively and in

the best interests of its investors and other stakeholders.

To create a trust in the corporate and in its abilities.

To exercise effective control on corporate affairs by the board at all times.

To promote business development

To improve the efficiency of the capital markets

To enhance the effectiveness in the service of the real economy.

To promote a healthy environment for long term investment.

4.5 CONSTITUENTS OF CORPORATE GOVERNANCE

1. Board of Directors: the pivotal role in any system of corporate governance is performed

by the board of directors. It stewards the company sets its strategic aim and financial goals

and oversees their implementation puts in place adequate internal controls and periodically

reports the activities and progress of the company in the company in a transparent manner to

all the stakeholders.

2. Shareholders: the shareholders role in corporate governance is to appoint the directors and

the auditors and to hold the board accountable for the proper governance of the company by

requiring the board to provide them periodically with the requisite information in a

transparent fashion of the activities and progress of the company.

3. Management: the responsibility of the management is to undertake the management of the

company in terms of the direction provided by the board to put in place adequate control

systems and to ensure their operation and to provide information to the board on a timely

basis and in a transparent manner to enable the board to monitor the accountability of

management to it.

4.6 STRUCTURE OF CORPORATE GOVERNANCE

Structure is the skeleton or framework which supports companies operations. Its basic

manifestation is the organization chart which itemizes the constituents of the company and

their relationship to each other. Traditionally this has been presented as a hierarchy with the

board at the top and services at the bottom. The structure of a corporation’s governance

determines the efficiency and accuracy of the flow of information through and from a



corporation. Structure is important in governance since it defines the shape and boundaries of

an organization and the inter relationship between its elements. Structure enables individuals

to locate themselves in the company and identify their own interrelationships. With the

support of job descriptions, structure enables employees to identify the people to whom they

owe services and from whom they may expect support.

Elect

Forms

Appoints

The integrity of company’s structure of corporate governance is an increasingly vital aspect

of a corporation’s health. It often indicates the company probability of success or failure in

the long-term.

4.7 MECHANISMS OF CORPORATE GOVERNANCE

Corporate governance mechanisms and controls are designed to reduce the inefficiencies that

arise from moral hazard and adverse selection. There are following mechanisms of corporate

governance.

1. INTERNAL CORPORATE GOVERNANCE CONTROLS: internal corporate governance

controls monitor activities and then take correlative action to accomplish organizational

goals. Examples include.

a. Monitoring By The Board Of Directors: the board of directors with its legal

authority to hire fire and compensate top management safeguards invested capital.

Regular board meetings allow potential problems to be identified discussed and

avoided. While non executive directors are thought to be more independent they may

not always result in more effective corporate governance and may not increase

performance.

b. Remuneration: performance based remuneration is designed to relate some

proportion of salary to individual performance. It may be in the form of cash or non

cash payments such as shares and share options, superannuation or other benefits.

Shareholders

Board of directors

Chief executive and senior executives

Executive

committee



Such incentive schemes however are reactive in the sense that they provide no

mechanism for preventing mistakes or opportunistic behavior and can elicit myopic

behavior.

c. Audit Committees: an audit committee is an operating committee or publicity

held company. Committee members are normally drawn from members of the

company’s board of directors.

Responsibilities of the audit committee typically include

Overseeing the financial reporting process

Monitoring choice of accounting policies and principles

Monitoring internal control process

Overseeing hiring and performance of the external auditors

2. EXTERNAL CORPORATE GOVERNANCE CONTROLS: external corporate

governance encompass the controls external stakeholders exercise over the organization.

Examples include,

a. Debt Covenants: these are agreements between a company and its creditors that the

company should operate within certain limits. This may mean limits to further borrowing

or asset in order to maintain a minimum level of gearing. In order to prevent companies

from meeting the requirements by adjusting their accounting practices rather than by

genuinely maintaining the required level of financial health, debt covenants not only

specify the numbers that should be met but also exactly how they should be calculated

for the purposes of the debt covenant.

b. Government Regulations: government has a lot of concern with regulating and

administrating many areas of human activity such as trade education or medicine.

Governments also employ different methods to maintain the established order such as

secrecy police and military forces making agreements with other states and maintaining

support within the state or the country.

c. Competition: despite shortcomings in corporate governance in many countries

leading emerging economies have vibrant product markets and display as much intensity

of competition as that observed in advanced countries. A central developmental issue is

how to us3e these social for promoting and completing the industrial revolution that

many developing countries embarked on in the second half of the twentieth country.

d. External Auditor: for both external and internal auditors risk plays an important role

in the planning process. As the director of internal audit considers the work schedule for

the yea5r the risks present in the various audit units are considered. Similarly as the

external auditor plans the engagement areas that may prove particularly susceptible to

material misstatement are evaluated.



e. Managerial External Labor Market: globalization of production technological

change and continually falling communication and transpiration costs all combined to

make cross border transport and trade much more feasible and easier in the closing

decades of the 20th century. This process was given added momentum by the removal of

political barriers and the result has been a growing interaction spatially and otherwise

between countries in various parts of the world seeking to take advantage of new

opportunities for trade which also have been enhanced by the lowering if not removal of

tariff and non tariff barriers resulting from international negotiations.

4.8 PRINCIPLES/ESSENTIALS OF CORPORATE GOVERNANCE

Good governance should address all issues that lead to a value addition for the organization

and serve th3e interests of all the stakeholders. Essentials of corporate governance are as

follows

1. Transparency and Disclosure: Transparency implies explaining a company’s policies

and actions to those whom it ahs responsibilities. Such transparency should lead to maximum

appropriate disclosure without jeopardizing the company’s strategic interests. Internally

transparency means openness in company’s relationship with its employees as well as the

conduct of its business in a manner that will bear scrutiny.

A strong disclosure is essential to control the shareholders ability to exercise their voting

rights. Disclosure also helps to improve public understanding of the structure and activities of

enterprises corporate policies and performance with respect to relationship with the

committees in which they operate.

Material information can be as information whose omission or misstatement could influence

the economic decision taken by users of information.

2. Fairness: Organization sho0uld respect the rights of shareholders and enable shareholders

to exercise their rights by effectively communicating information that is relevant timely

understandable and easily accessible. Fairness implies being unbiased and carries with it the

requirement of independence and objectivity giving due consideration to the interests of all

stakeholders involved.

Principles/essentials of corporate governance

Transpar

ency and

disclosure

Fairness Responsi

bility

and

accounta

bility

Trusteesh

ip

Empow

erment

Contro

ls

Ethical

corporate

citizenship



Fairness principles of corporate refer to the manner in which the business is conducted

without any detriment to the interest of the stakeholder’s shareholders employees and the

public as a whole. Business ethics plays a vital role in this context hence they have to be on

par with the ethical code of the society in which a business operates. It is therefore

recommended that the board of directors be comprised of a mix of executive non executive

and independent directors.

Another way that is being used as a tool to increase fairness is known as corporate

governance rating. Here various companies are assessed on aspects of their corporate

governance and the results are published in order to help the firms improve performance on

fairness. This is however not a widespread practice and is most likely unheard of in many

developing countries.

3. Responsibility And Accountability: Responsibility and accountability go hand in hand.

Corporate management is today accountable not to them. Not to the promoters and not to

shareholder alone. Corporate is expected to be a responsible citizen and serve not only the

interest of the shareholders but also in the best interest of the society. Corporate governance

reflects the larger ethics prevailing in society. Corporate governance has shifted the focus to a

broader beneficiary category known as stakeholders who also includes employees and ex

employee’s vendors, business partner’s customer’s client’s regulars society etc. companies

are required to take more active roles in changing the practices and values that are believed to

be harmful to groups outside the company.

4. Trusteeship: Large corporations have both a social and economic objective. Inherent in

the concept of trusteeship is the responsibility to ensure equity namely that the rights of all

shareholders large of small are protected. Moreover corporate governance in large

corporations represents a coalition of interests namely those of the shareholders creditors and

banker’s business associates and employees. This belief therefore casts a responsibility of

trusteeship on the company’s board of directors who is expected to act as trustees to protect

and enhance shareholder value as well as to ensure that the company fulfill its obligations and

responsibilities to its other stakeholders.

The trustee is the person to whom the property is entrusted as administrator to manage it in

accordance with the objects of the trust. A trustee must comply with the following general

duties.

5. Empowerment: Empowerment refers to increasing the spiritual political social

educational gender or economic strength of individuals and communities. Empowerment is

an essential concomitant of organizations core principles of governance that management

must have the freedom to drive the enterprise forward. Empowerment is a process of

actualizing the potential of its employees.

It is monitoring managerial performance and achieving adequate return for the shareholders

by true and fair means by the managerial body. It is also a responsibility to implement system



designed to ensure that the corporation obeys laws. It is acting in good faith with due

diligence and care and in the best interest of the company and its constituents.

Organization should develop codes of ethical conduct for their directors and executives that

promote responsible decision making. Many organizations establish compliance and ethics

programmes to minimize the risk of the firm stepping beyond ethical and legal boundaries.

The board has no obligation to act responsibly when making decisions involving the

corporation’s assets and ultimately stakeholder’s interests and investments. Being socially

and environment responsible is as important as being financially responsible.

6. Controls: Control is a necessary concomitant of core principle of governance. The

freedom of management should be exercised within a framework of appropriate checks and

balances. Control should prevent misuse of power facilities timely management response to

change and ensure that business risks are pre emotively and effectively managed.

The board is responsible for determining the nature and extent of the significant risks it is

willing to take in achieving its strategic objectives. The board should maintain sound risk

management and internal control systems.

7. Ethical Corporate Citizenship: Corporations have a responsibility to set exemplary

standards of ethical behavior both internally within the organization as well as in their

external relationships. Unethical behavior corrupts organizational cultural and undermines

stakeholder value. A corporation should be committed to be a good corporate not only in

compliance with all relevant laws and regulations but also by actively assisting in the

improvement of the quality of life of the people in the communities in which it operates with

the objectives of making them self reliant and enjoy a better quality of life.

The company should develop social accounting systems and carry out social audit of its

operations towards the community employees and shareholders.

-NO CASE STUDY FROM THIS UNIT-

UNIT-5-IMPORTANT QUESTIONS

Explain corporate restructuring, merger, takeover & acquisitions?

Difference between takeover & acquisitions?

Motives for merger & types of mergers?

Principals of corporate governance?

BALAJI INSTITUTE OF I.T AND MANAGEMENT KADAPA 2.5 UNITS-(FROM LAST HAL… · Financial Management,...

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