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MEANING OF FINANCIAL MANAGEMENT

Financial management is that managerial activity which is concerned with the

planning and controlling of the firms financial resources. It was a branch of economics

till 1890, and as a separate discipline, it is of recent origin. Still, it has no unique body of

knowledge of its own, and draws heavily on economics for its theoretical concepts even

today.

The subject of financial management is of immense interest to both academicians

and practicing managers. It is of great interest to academicians because the subject is still

developing, and there are still certain areas where controversies exist for which no

unanimous solutions have been reached as yet. Practicing managers are interested in this

subject because among the most crucial decisions of the firm are those which relate to

finance, and an understanding of the theory of financial management provides them with

conceptual and analytical insights to make those decisions skillfully. [Financial

Management (Ninth Edition), I M Pandey, Pg no. 3]

DEFINITION

According to Soloman, Financial management is concerned with the efficient

use of an important economic resource, namely, Capital funds,

Phillippatus has given a more elaborate definition of the term financial

management. According to him Financial management is concerned with the

management decisions that result in the acquisition and financing of long-term and short-

term credits for the firm. As such it deals with the situations that require selection of

specific assets ( or combination of liabilities ) as well as the problem of size and growth

of an enterprise. The analysis of these decisions is based on the expected inflows and

outflows of funds and their effects upon managerial objectives.

IMPORTANCE OF FINANCIAL MANAGEMENT

The importance of financial management cannot be overemphasized. In every

organization, where funds are involved, sound financial management is necessary. As

Collins Brooks has remarked, Bad production management and bad sales management

have slain in hundreds, but faulty financial management has slain in thousands. Finance

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manager must realize that when a firm makes a major decision, the effect of the action

will be felt throughout the enterprise. For example, an increase in plant and equipment

expenditure will affect the firms cash position, its borrowing capability and its dividend

distribution.

Sound financial management is essential in both profit and non-profit

organizations. The financial management helps in monitoring the effective deployment of

funds in fixed assets and in working capital. The finance manager estimates the total

requirement of funds, both in the short period and the long period. The finance manager

assesses the financial position of the company through working out of the return on

capital, debt-equity ratio, cost of the capital from each source, etc., and comparison of the

capital structure with that of similar companies.

Financial management also helps in ascertaining how the company would perform

in future. It helps in indicating whether the firm will generate enough funds to meet its

various obligations like repayment of the various instalments due on loans, redemption of

other liabilities.

Sound financial management is indispensable for any organization. It helps in

profit planning, capital spending, measuring costs, controlling inventories, accounts

receivable, etc. financial management essentially helps in optimizing the output from a

given input of funds.

OBJECTIVES OF FINANCIAL MANAGEMENT

The objectives of financial management can be put into two categories:

1. BASIC OBJECTIVES

Traditionally the basic objectives of financial management have been (i)

maintenance of liquid assets and (ii) maximization of profitability of the firm. However,

these days there is a greater emphasis on (iii) shareholders wealth maximization rather

than on profit maximization.

Maintenance of Liquid Assets

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Financial management aims at maintenance of adequate liquid assets with the

firm to meet its obligations at all times. It may be noted that investment in liquid assets

has to be adequate-neither too low nor too excessive. The finance manager has to

maintain a balance between liquidity and profitability. There is an inverse relationship

between the two. The more the assets are liquid, less they are profitable and vice versa.

Profit maximization

A business firm is a profit seeking organisaiton. Hence, profit maximization is an

important objective of financial management. However, the concept of profit

maximization has come under severe criticism, in recent times, on account of the

following reasons:

It is a Vague : It does not clarify which profits does it mean; whether short-term or long-

term. Profits in the short-term may be quite different from those in the long-run. For

example, if a firm continues to run its business without having adequate maintenance of

its machinery, the firms profits in the short run may increase because of savings in

expenditure. However, in the long run the firm may suffer since the machine may have to

be replaced or machine may require a heavy expenditure on its repairs because of its

improper upkeep from year to year. Moreover, it is also not clear whether profit

maximization means maximizing absolute profits or simply rate of return.It Ignores Timing : The concept of profit maximization does not help in making a

choice between projects giving different benefits spread over a period of time. The

concept ignores the fact that a rupee received tomorrow. For example, if there are two

projects A and B each requiring equal investment. Project A gives a 20% return for 3

years while project B gives a return of 17% for five years. In order to decide which

project should be preferred, it is not only enough to see the rate of return, but also the

present value of the cash flows available from both the projects. In case of project A, the

rate of return after 3 years and hence it will be more profitable than project B only when

the firm has adequate investment opportunities. In case the firm does not have such

opportunities, project B may be more beneficial.

It Overlooks Quality aspect of Future Activities : The business is not solely run with

the objective of earning higher possible profits. Some firms place a high value on the

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growth of sales. They are willing to accept lower profits to gain stability provided by a

large volume of sales. Other firms use a part of their profits to make contribution for

socially productive purpose. Moreover, profit maximization at the cost of social or moral

obligations is a short-sighted policy even as a pragmatic approach.

Maximisation of wealth

Professor Ezra Soloman has suggested the adoption of wealth maximization as the

best criterion for the financial decision-making. He has described the concept of wealth

maximization as follows:

The gross present worth pf a course of action is equal to the capitalized value of

the flow of future expected benefits, discounted (or capitalized) at the rate which reflects

their certainty or uncertainty. Wealth or net present worth is the difference between gross

present worth and the amount of capital investment required to achieve the benefits. Any

financial action which creates wealth or which has a net present worth above zero is a

desirable one and should be undertaken. Any financial action which does not meet this

test should be rejected. If two or more desirable courses of action are mutually exclusive

(i.e., if only one can be undertaken), then the decision should be to do that which creates

most wealth or shows the greatest amount of net present worth. In short, the operating

objectives for financial management is to maximize wealth or net present worth.Wealth maximisation is, therefore, considered to be the main objective of

financial management. This objective is also consistent with the objective of maximizing

the economic welfare of the shareholders of a company. The value of a companys shares

depends largely on its net worth which itself depends on earning per share (E.P.S). the

finance manager should, therefore, follow a policy which increases the earning per share

in the long run.

Steps for Wealth Maximisaiton

In order to maximize wealth, afirm should take the following steps:

Avoid high levels of risks

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The firm should avoid such projects which involve high profits together with high

risks. This si because accepting of such projects may be disastrous for the frim in the long

run in case any factor goes wrong.

Pay dividends

Payment of regular dividends increases the firms reputation ad consequently the

value of the firms shares. While declaring dividends the market trends and the

expectations of the shareholders must be kept in mind.

Maintain growth in sales

The firm should have a large, stable and diversified volume of sales. This protects

the firm from adverse consequences of recessions, changes in customers preference or

fall in demand for the firms products on account of other reasons. A firm should

therefore consistently seek growth in sales by developing new markets, projects, etc.

Maintain price of firms equity shares

Maximization of shareholders wealth is closely connected with maximization of

the value of the firms equity shares. The firm can take a number of steps to maintain the

value of its equity shares at reasonable levels. For example, the management can

encourage people to invest their savings in the firms shares by explaining their actions.

They can, by highlighting the firms past performance and glorious future, create a new

demand for firms shares which will push up the value of its equity shares. Similarly

adoption of sound investment policies will also considerably help in improving the image

of the firm. It may, however, be noted that wealth maximization objective cannot be

carried too far. It is subject to certain limitations.

Social responsibility

The management cannot ignores its social responsibility, e.g., protecting the

interest of the consumers, paying fair wages to workers, maintain proper working

conditions, providing educational and physical facilities to their workers and involving

themselves in environmental issues like clean air, water, etc.

Some of the social actions are in the long run in the interests of the shareholders

and may therefore be adopted. However, others, e.g., providing clean environment, may

considerably reduce the firms profitability and ultimately the shareholders wealth.

Government constraints

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On account of the growing concept of a welfare state, there after a number of

statutory provisions which considerably reduce a firms freedom to act. Restriction

imposed by the government regarding establishment, expansion, closure, etc., of business

firm may force the management of the shareholders wealth.

In conclusion it can be said that a firm should follow the objective of wealth

maximization to the extent it is viable in the context of its social responsibility and

constraints imposed by government.

2. OTHER OBJECTIVES

The following are the other objectives of financial management:

(i) Ensuring a fair return to shareholders.

(ii) Building up reserves for growth and expansion.

(iii) Ensuring maximum operational efficiency by efficient and effective

utilization of finances.

(iv) Ensuring financial discipline in the organization.

SCOPE OF FINANCIAL MANAGEMENT

Financial management, as an academic discipline, has undergone significant

changes over the year as regards its scope and coverage. As such the role of finance

manager has also undergone fundamental changes over the year. In order to have a better

exposition to these changes it will be appropriate to study both the traditional approach

and the modern approach to the finance function.

Traditional approach

The traditional approach, which was popular in the early part of this century,

limited the role of financial management to raising and administering of funds needed bythe corporate enterprises to meet their financial needs. It broadly covered the following

three aspects:

(i) Arrangement of funds from financial institutions.

(ii) Arrangement of funds through financial instruments, viz., shares, bonds, etc.

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(iii) Looking after the legal and accounting relationship between a corporation and

its sources of funds.

Thus, the traditional concept of financial management included within its scope the

whole gamut of raising the funds externally. The finance manager had also a limited role

to perform. He was expected to keep accurate financial records, prepare reports on the

corporations status and performance and manage cash in a way that the corporation was

in a position to pay its bills in time. The term Corporation Finance was used in place of

the present term Financial Management.

The traditional approach found its first manifestation, though not very systematic,

in 1897 in the book Corporation Finance written by Thomas Greene. It was further

impetus by Edward Meade in 1910 in his work, Corporation finance. However, it was

sanctified firmly by Arthur Dewing in 1919 in his book The Financial Policy of

Corporation. The book dominated the academic corks in the fields of corporation finance

for nearly three decades.

The traditional approach evolved during 1920 continued to dominate academic

thinking during the forties and through the early fifties. However, in the later fifties it

started to be severely criticized and later abandoned on account of the following reasons:

Outsider-looking-in approach

The approach equated finance function with the raising and administering offunds. It thus treated the subject of finance from the viewpoint of suppliers of funds, i.e.,

outsiders, viz., bankers, investors, etc. It followed an outsider-looking-in approach and

not the insider-looking-out approach since it completely ignored the viewpoint of those

who had to take internal financing decisions.

Ignored routine problems

The approach gave undue emphasis to episode or infrequent happenings in the life

of an enterprise. The subject of financial management was mainly confined to the

financial problems arising during the course of incorporation, mergers, consolidation and

reorganization of corporate enterprises. As a result the subject did not give any

importance to day-to-day financial problems of business undertaking.

Ignored non-corporate enterprises

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The approach focused attention only on the financial problems of corporate

enterprises. Non-corporate industrial organizations remained outside its scope.

No emphasis on allocation of funds

The approach confined financial management to issues involving procurement of

funds. It did not emphasis on allocation of funds. It ignored, as pointed out by Soloman,

the following central issues of financial management:

(a) Should an enterprise commit capital funds to certain purpose?

(b) Do the expected returns meet the financial standards of performance?

(c) How should these standards be set and what is the cost of capital funds to the

enterprise?

(d) How does the cost vary with the mixture of financing methods used?

Traditional approach failed to provide answer to these questions. The modern

approach, provides answer to these questions.

Modern approach

The traditional approach outlived its utility due to changed business situations

since mid-1950s. Technological improvements, widened marketing operations,

development of a strong corporate structure, keen and healthy business competition, all

made it imperative for the management to make optimum use of available financial

resources for continued survival. The advent of computer in sixties made large quantum

of information available to the finance manager, based on which he could make sound

decisions. Computers helped in application of powerful techniques of operations

research. The scope of financial management increased with the introduction of capital

budgeting techniques. As a result of new methods and techniques, capital investment

projects led to a framework for efficient allocation of capital within the firm also. During

the next two decades various pricing models, valuation models and investment portfolio

theories also developed.

Efficient allocation of capital on suitable criterion became an important area of

study under financial management. Eighties witnessed an era of high inflation. This

caused the interest rates to rise dramatically. Thus, raising loan on suitable terms also

became a specialized art and more important became the aspect of efficient utilization of

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these scarce funds. In the new volatile environment, capital investment and financing

decisions became more riskier than ever before. These environmental changes enlarged

the scope of finance. The concept of managing a firm as a system emerged. External

factors now no longer could be evaluated in isolation. Decisions to arrange funds was to

be seen in consonance with their efficient and effective use. This total approach to study

of finance is being termed as Financial Management.

Thus, according to modern concept, financial management is concerned with both

acquisition of funds as well as their allocation. The new approach views the term

financial management in a broader sense. In this sense the central issue of financial

policy is the wise use of funds and the central process involved is a rational matching of

advantages of potential uses against the cost of alternative potential uses so as to achieve

the broad financial goals which an enterprise sets for itself.

The modern approach is an analytical way of looking at the financial problems of

a firm. The main contents of the new problem are as follows:

(i) What is the total volume of funds an enterprise should commit?

(ii) What specific assets should an enterprise acquire?

(iii) How should the funds required be financed?

The above questions relate to four broad decision areas of financial management, viz.,

investment decision, financing decision, dividend decision and liquidity decision. These

decisions, which can also be termed as functions outlining the scope of financial

management, are being discussed below. [Element of Financial management(Ninth

Edition), Dr.S.N.Maheshwari, Pg no:A-4 to A-10]

Investment decision

A firms investment decisions involve capital expenditures. They are, therefore,

referred as capital budgeting decisions. A capital budgeting decision involves the

decision of allocation of capital or commitment of funds to long-term assets that would

yield benefits (cash flows) in the future. Two important aspects of investment decisions

are: (a) the evaluation of the prospective profitability of new investments, and (b) the

measurement of a cut-off rate against that the prospective return of new investments

could be compared. Future benefits of investments are difficult to measure and cannot be

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predicted with certainty. Risk in investment arises because of the uncertain returns.

Investment proposals should, therefore, be evaluated in terms of both expected return and

risk. Besides the decision to commit funds in new investment proposals, capital

budgeting also involves replacement decisions, that is, decision of recommitting funds

when an asset becomes less productive or non-profitable.

There is a broad agreement that the correct cut-off rate or the required rate of

return on investments is the opportunity cost of capital. The opportunity cost of capital is

the expected rate of return that an investor could earn by investing his or her money in

financial assets of equivalent risk. However, there are problems in computing the

opportunity cost of capital in practice from the available data and information. A decision

maker should be aware of these problems.

Financing decision

Financing decision is the second important function to be performed by the

financial manager. Broadly, he or she must decide when, where from and how to acquire

funds to meet the firms investment needs. The central issue before him or her is to

determine the appropriate proportion of equity and debt. The mix of debt and equity is

known as the firms capital structure. The financial manager must strive to obtain the best

financing mix or the optimum capital structure for his or her firm. The firms capitalstructure is considered optimum when the market value of shares is maximized.

In the absence of debt, the shareholders return is equal to the firms return. The

use of debt affects the return and risk of shareholders; it may increase the return on equity

funds, but it always increases risk as well. The change in the shareholders return caused

by the change in the profits is called the financial leverage. A proper balance will have to

be struck between return and risk. When the shareholders return is maximized with

given risk, the market value per share will be maximized and the firms capital structure

would be considered optimum. Once the financial manager is able to determine the best

combination of debt and equity, he or she must raise the appropriate amount through the

best available sources. In practice, a firm considers many other factors such as control,

flexibility, loan covenants, legal aspects etc, in deciding its capital structure.

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Dividend decision

Dividend decision is the third major financial decision. The financial manager

must decide whether the firm should distribute all profits, or retain them, or distribute a

portion and retain the balance. The proportion of profits distributed as dividends is called

the dividend-payout ratio and the retained portion of profits is known as the retention

ratio. Like the debt policy, the dividend policy should be determined in terms of its

impact on the shareholders value. The optimum dividend policy is one that maximizes

the market value of the firms shares. Thus, if shareholders are not indifferent to the

firms dividend policy, the financial manager must determine the optimum dividend-

payout ratio. Dividends are generally paid in cash. But a firm may issue bonus shares.

Bonus shares are shares issued to the existing shareholders without any charge. The

financial manager should consider the questions of dividend stability, bonus shares and

cash dividends in practice.

Liquidity decision

Investment in current assets affects the firms profitability and liquidity. Current

assets management that affects a firms liquidity is yet another important finance

function. Current assets should be managed efficiently for safeguarding the firm against

the risk of illiquidity. Lack of liquidity (or illiquidity) in extreme situations can lead to

the firms insolvency. A conflict exists between profitability and liquidity while

managing current assets. If the firm does not invest sufficient funds in current assets, it

may become illiquid and therefore, risky. But it would lose profitability, as idle current

assets would not earn anything. Thus, a proper trade-off must be achieved between

profitability and liquidity. The profitability-liquidity trade-off requires that the financial

manager should develop sound techniques of managing current assets. He or she should

estimate firms needs for current assets and make sure that funds would be made

available when needed.

In sum, financial decisions directly concern the firms decision to acquire or

dispose off assets and require commitment or recommitment of funds on a continuous

basis. It is in this context that finance functions are said to influence production,

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marketing and other functions of the firm. Hence finance functions may affect the size,

growth, profitability and risk of the firm, and ultimately, the value of the firm.

The function of financial management is to review and control decisions to commit or

recommit funds to new or ongoing uses. Thus, in addition to raising funds, financial

management is directly concerned with production, marketing and other functions, within

an enterprise whenever decisions are made about the acquisition or distribution of assets.[

[Financial Management (Ninth Edition), I M Pandey, Pg no: 5]

Apart from the above main functions, following subsidiary functions are also

performed by the finance manager:

To ensure supply of funds to all part of the organization

It is also the finance managers function to ensure that funds are available to every

part of the organization as and when it needs them so as to help in smooth operations of

the activities of the organization.

Evaluation of the financial performance

The financial performance of the various units of the organization is to be

evaluated from time to time to detect any fault in the financial policy and take the

remedial action at appropriate time, if necessary.

To negotiate with bankers, financial institutions and other suppliers of

credit

Bankers, financial institutions and other suppliers of credit are the different

sources of funds. It is necessary for the company to negotiate with them so as to obtain

the funds at most favourable terms.

To keep track of stock exchange quotations and behaviour of stock

market prices

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Stock exchange quotations are the barometers of the economy as a whole. By

keeping an eye on the stock market, the finance manager is in a position to plan the

policy of the business enterprise with regard to finance more effectively.

Thus, we see that the Financial Management has emerged as an area of study that

encompasses variety of analytical tools and vigorous analysis. It has changed from an

area which was primarily concerned with procurement of funds to one that includes the

management of assets, the allocation of capital and the valuation of firm. With the

changing environment the scope of financial management will also change, to accept the

challenge of new environment. [Elements of Financial Management(Ninth Edition),

Dr.S.N.Maheshware, Pg no:A-12]

RATIOS INVOLVED IN FINANCIAL MANAGEMENT

Ratios are relationships expressed in mathematical terms between figures which

are connected with each other in some manner. Obviously, no purpose will be served by

comparing two sets of figures which are not at all connected with each other. Moreover,

absolute figures are also unfit for comparison. Ratios can be expressed in two ways.

1. Time : When one value is divided by another, the unit used to express the quotient is

termed as Times .

2. Percentage : If the quotient obtained is multiplied by 100, the unit of expression is

termed as Percentage .

Overall profitability ratio

It is also called as Return on Investment (ROI) or Return on Capital Employed

(ROCE). It indicates the percentage of return on the total capital employed in the

business. It is calculated on the basis of the following formula:

Operating profitOverall profitability ratio = ------------------- * 100

Capital employed

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The term capital employed has been given different meanings by different

accountants. Some of the popular meanings are as follows:

i. Sum-total of all assets whether fixed or current,

ii. Sum-total of fixed assets,

iii. Sum-total of long-term funds employed in the business, i.e.,

Share capital + Reserves & Surplus + Long term loans

( Non business assets + Fictitious assets )

Earning per share (E.P.S)

In order to avoid confusion on account of the varied meanings of the term capital

employed, the overall profitability can also be judged by calculating earning per share

with the help of the following formula:

Net profit after tax and preference dividend

Earnings per share = -----------------------------------------------------

Number of equity shares

Price earning ratio (P.E.R)

This ratio indicates the number of times the earning per share is covered by its

market price. This is calculated according to the following formula:

Market price per equity share

Price earning ratio = -----------------------------------Earning per share

Gross profit ratio

This ratio expresses relationship between gross profit and net sales. Its formula is:

Gross profit

Gross profit ratio = ---------------- * 100Net sales

Net profit ratio

This ratio indicates net margin earned on a sale of Rs.100. It is calculated as

follows:

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Net operating profit

Net profit ratio = ------------------------- * 100Net sales

Net operating profit is arrived at by deducting operating expenses from grossprofit.

Operating or Expenses ratio

This ratio is a complementary of net profit ratio. In case the net profit ratio is

20%, it means that the operating ratio is 80%. It is calculated as follows:

Operating costs

Operating ratio = ------------------- * 100Net sales

Operating costs include the cost of direct materials, direct labour and other

overheads, viz., factory, office or selling. Financial charges such as interest, provision for

taxation, etc., are generally excluded from operating costs.

Pay-out ratio

This ratio indicates what proportion of earning per share has been used for payingdividends. The ratio can be calculated as follows:

Dividend per equity sharePay-out ratio = -------------------------------

Earning per equity share

A complementary of this ratio is Retained earning ratio. It is calculated as

follows:

Retained earning per equity shareRetained earning ratio = ---------------------------------------

Earning per equity share

Or

Retained earnings

Retained earning ratio = --------------------- * 100

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Total earnings

Dividend yield ratio

This ratio is particularly useful for those investors who are interested only in

dividend income. The ratio is calculated by comparing the ratio of dividend per share

with its market value. Its formula can be put as follows:

Dividend per share

Dividend yield ratio = -------------------------- * 100

Market price per share

Fixed interest cover

The ratio is very important from the lenders point of view. It indicates whether

the business would earn sufficient profits to pay periodically the interest charges. The

higher the number, the more secure the lender is in respect of his periodical interest

income. It is calculated as follows:

Income before interest and tax

Fixed interest cover = --------------------------------------Interest charges

The standard for this ratio for an industrial company is that interest chargesshould be covered sex to seven times.

Fixed dividend cover

This ratio is important for preference shareholders entitled to get dividend at a

fixed rate in priority to other shareholders. The ratio is calculated as follows:

Net profit after interest and tax

Fixed dividend cover = --------------------------------------Preference dividend

Debt service coverage ratio

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The interest coverage ratio, as explained above, does not tell us anything about

the ability of a company to make payment of principal amounts also on time. For this

purpose debt service coverage ratio is calculated as follows:

Net profit before interest and taxDebt service coverage ratio = ------------------------------------------------

Principal payment instalment

Interest + -----------------------------------1 Tax rate

The principal payment instalment is adjusted for tax effects since such payment is

not deductible from net profit for tax purpose.

Fixed assets turnover ratioThis ratio indicates the extent to which the investments in fixed assets contribute

towards sales. If compared with a previous period, it indicates whether the investment in

fixed assets has been judicious or not. The ratio is calculated as follows:

Net asset

Fixed asset turnover ratio = ----------------------Fixed assets (net)

Working capital turnover ratio

This is also known as Working capital leverage ratio. This ratio indicates whether

or not working capital has been effectively utilized in making sales. In case a company

can achieve higher volume of sales with relatively small amount of working capital, it is

an indication of the operating efficiency of the company. The ratio is calculated as

follows:

Net sales

Working capital turnover ratio = --------------------

Working capital

Working capital turnover ratio may take different forms for different purposes.

Some of them are being explained below:

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Debtors turnover ratio (Debtors velocity)

Debtors constitute an important constituent of current assets and therefore the

quality of debtors to a great extent determines a firms liquidity. Two ratios are used by

financial analysts to judge the liquidity of a firm. They are (i) Debtors turnover ratio and

(ii) Debt collection period ratio

Credit sales

Debtors turnover ratio = -----------------------------------Average accounts receivable

b) Debt collection period ratio

The ratio indicates the extent to which the debts have been collected in time. It

gives the average debt collection period. The ratio is very helpful to the lenders because it

explains to them whether their borrowers are collecting money within a reasonable time.

An increase in the period will result in greater blockage of funds in debtors. The ratio

may be calculated by any of the following methods:

Months (or days) in a year

(a) ---------------------------------

Debtors turnover

Average accounts receivable X Months (or days) in a year

(b) ------------------------------------------------------------------------Credit sales for the year

Accounts receivable

(c) -----------------------------------------------Average monthly or daily credit sales

c) Creditors turnover ratio (Creditors velocity)

It is similar to Debtors turnover ratio. It indicates the speed with which the

payments for credit purchases are made to the creditors. The ratio can be computed as

follows:

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Credit purchase

Creditor turnover ratio = -------------------------------

Average accounts payable

The term Accounts payable include Trade creditors and Bills payable .

In case the details regarding credit purchase, opening and closing accounts payable have

not been given the ratio may be calculated as follows:

Total purchase

Creditor turnover ratio = ---------------------

Accounts payable

d) Debt payment period enjoyed ratio (Average age of payable)

The ratio gives the average credit period enjoyed from the creditors. It can be

computed by any one of the following methods:

Months (or days) in a year(a) ---------------------------------

Creditors turnover

Average accounts payable X Months (or days) in a year(b) ------------------------------------------------------------------------

Credit purchase for the year

Average accounts payable

(c) ----------------------------------------------------

Average monthly (or daily) credit purchase

e) Stock turnover ratio

This ratio indicates whether investment in inventory is efficiently used or not. It,

therefore, explains whether investment in inventories is within proper limits or not. The

ratio is calculated as follows:

Cost of goods sold during the yearStock turnover ratio = ------------------------------------------

Average inventory

Average inventory is calculated by taking stock levels of raw materials work-in-

process, finished goods at the end of each month, adding them up and dividing by twelve.

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f) Working capital leverage ratio

Working capital leverage indicates the way in which the profitability and return

on the investments are affected due to working capital management. The Overall Return

on investment (ROI) depends basically on two factors namely: Net profit ratio and

Capital employed turnover ratio.

Capital employed constitutes of fixed + working capital. The overall return on

capital employed depends both on Net profit ratio and Turnover ratio. The Return on

investment will, therefore, be affected by change in any of the following:

(i) Net profit margin,

(ii) Fixed capital,

(iii) Working capital, and

(iv) Total capital employed.

Liquidity ratios

These ratios are also termed as Working capital ratio or Short-term solvency

ratio. An enterprise must have adequate working capital to run its day-to-day operations.

Inadequacy of working capital may bring the entire business operation to a grinding halt

because of inability of the enterprise to pay for wages, materials and other regular

expenses.

The important liquidity ratios are as follows:

a) Current ratio

This ratio is an indicator of the firms commitment to meet its short-term

liabilities. It is expressed as follows:

Current assets

Current ratio = ------------------------Current liabilities

Current assets mean assets that will either be used up or converted into cash

within a years time or during the normal operating cycle of the business, whichever is

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longer. Current liabilities mean liabilities payable within a year or during the operating

cycle, whichever is longer, out of the existing current assets or by creation of current

liabilities. Book debts outstanding for more than 6 months and loose tools should not be

included in current assets. Prepaid expenses should be taken as current assets.

b) Quick ratio

This ratio is also termed as Acid test ratio or Liquidity ratio . This ratio is

ascertained by comparing the liquid assets (i.e., assets which are immediately convertible

into cash without much loss) to current liabilities. Prepaid expenses and stock are not

taken as liquid assets. The ratio may be expressed as:

Liquid assets

Quick ratio = ----------------------Current liabilities

c) Super quick ratio

This is a variation of quick ratio. The ratio is calculated as follows:

Cash and marketable securitiesSuper quick ratio = -----------------------------------------

Current liabilities

OrCash and marketable securities

Super quick ratio = -----------------------------------------

Quick liabilities

d) Defensive interval ratio

This ratio examines the firms liquidity position in terms of its ability to meet

projected daily expenditure from operations. It is calculated as follows:

Quick assetsDefensive interval ratio = --------------------------------------------

Projected daily cash requirements

Projected daily cash requirements are computed as follows:

Projected cash operating expenses= -------------------------------------------

Number of days in a year

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Projected cash operating expenses are computed on the basis of past experience

and future plans. They include cost of goods sold (excluding depreciation) and selling

and administration expenses payable in cash.

Stability ratios

These ratios help in ascertaining the long-term solvency of a firm which depends

basically on three factors:

(i) Whether the firm has adequate resources to meet its long-term funds

requirements;

(ii) Whether the firm has used an appropriate debt-equity mix to raise long-

term funds;

(iii) Whether the firm earns enough to pay interest and instalment of long-term

loans in time.

The capacity of the firm to meet the last requirement can be ascertained by

computing the various coverage ratios, for the other two requirements, the following

ratios can be calculated.

a) Fixed asset ratio

This ratio explains whether the firm has raised adequate long-term funds to meet

its fixed assets requirements. It is expressed as follows:

Fixed assets

Fixed asset ratio = ---------------------Long-term funds

The ratio should not be more than 1. If it is less than 1, it shows that a part of the

working capital has been financed through long-term funds. This is desirable to some

extent because a part of working capital termed as core working capital is more or less

of a fixed nature. The ideal ratio is 0.67.

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Fixed assets include net fixed assets (i.e., original cost-depreciation to date) and

trade investments including shares in subsidiaries. Long-term funds include share capital

reserves and long-term loans.

b) Capital structure ratios

These ratios explain how the capital structure of a firm is made up or the debt-

equity mix adopted by the firm. The following ratios fall in this category:

Capital gearing ratio

Capital gearing (or leverage) refers to the proportion between fixed

interest or dividend bearing funds and non-fixed interest or dividend bearing funds in the

total capital employed in the business. The fixed interest or dividend-bearing funds

include the funds provided by the debentureholders and preference shareholders. Non-

fixed interest or dividend-bearing funds are the funds provided by the equity

shareholders. The amount, therefore, includes the Equity share capital and other

Reserves. A proper proportion between the two funds is necessary in order to keep the

cost of capital at the minimum.

Funds bearing fixed interest or fixed dividendsCapital gearing ratio = --------------------------------------------------------

Total capital employed

OrFunds bearing fixed interest or fixed dividends

Capital gearing ratio = --------------------------------------------------------

Equity shareholders funds

In case the amount of fixed interest or fixed dividend-bearing funds is more than

the equity shareholders funds, the capital structure is said to be high geared. If the

amount of equity shareholders funds is more than the fixed interest or dividend-bearing

funds, the capital structure is said to be low geared. In case the two are equal, the

capital structure is said to be even geared.

The gearing ratio is useful in indicating the extra residual benefits accruing to the

equity shareholders. Such a benefit accrues to the equity shareholders because the

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company earns a certain rate of return on total capital employed but is required to pay to

the preference shareholders and debentureholders only at a fixed rate. The surplus earned

on their funds can be utilized for paying dividend to the equity shareholders at a rate

higher than the rate of return on the total capital employed in the company. Such a

situation is called Trading on Equity.

Debt-equity ratio

The debt-equity ratio is determined to ascertain the soundness of the long-

term financial policies of the company. It is also known as External-Internal equity

ratio. It may be calculated as follows:

External equities

Debt-equity ratio = ---------------------Internal equities

The term external equities refers to total outside liabilities and the term internal

equities refers to shareholders funds or the tangible net worth. In case the ratio is 1 (i.e.,

outsiders funds are equal to shareholders funds) it is considered to be quite satisfactory.

In case debt-equity ratio is to be calculated as a long-term financial ratio, it may

be calculated as follows:

Total long-term debt

(i) Debt-equity ratio = ---------------------------Total long-term funds

Shareholders funds(ii) Debt-equity ratio = --------------------------

Total long-term funds

Total long-term debt(iii) Debt-equity ratio = -------------------------

Shareholders funds

Method (iii) is the most popular. Ratios (i) and (ii) give the proportion of long-term

debt/shareholders funds in total long-term funds (including borrowed as well as owned

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funds). While Ratio (iii) indicates the proportion between shareholders funds (i.e.

tangible net worth), and the total long-term borrowed funds.

Ratio (i) and (ii) may be taken as ideal if they are 0/5 each, while the ratio (iii) may

be taken as ideal if it is 1. in other words, the investor may take debt-equity ratio as quite

satisfactory if shareholders funds are equal to borrowed funds, may also not be

considered as unsatisfactory if the business needs heavy investment in fixed assets and

has an assured return on its investment, e.g., in case of public utility concerns.

It is to be noted that preference shares redeemable within a period of 12 years from

the date of their issue should be taken as a part of debt.

Proprietary ratio

It is a variant debt-equity ratio. It establishes relationship between the

proprietors funds and the total tangible assets. It may be expressed as:

Shareholders fundsProprietary ratio = -------------------------

Total tangible assets

[Principles of Management Accounting (Thirteenth Edition), Dr.S.N.Maheshwari,

Pg no:B-23 to B-50]

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